The Internal Revenue Service (IRS) has broad statutory authority to investigate and audit taxpayers.[i] In many cases, the IRS attempts to fulfill this statutory authority through seeking communications made between taxpayers and third parties, such as tax return preparers and CPAs. Oftentimes, the IRS is authorized to obtain these communications.
However, there are methods to protect communications made between taxpayers and accountants. One such method is referred to as a Kovel agreement. Under that agreement, the taxpayer engages a tax attorney who, in turn, engages the services of a tax accountant. When done properly, federal courts have recognized that communications amongst these parties are not subject to disclosure under the theory that such communications are protected by the attorney-client privilege.
This Insight discusses both the common law doctrine of attorney-client privilege and the more recent statutory right of client-accountant privilege. In addition, this Insight discusses the Kovel case and the general requirements of a Kovel agreement.
The Attorney-Client Privilege.
The attorney-client privilege is the oldest common law privilege recognized by the courts. And, the Kovel agreement arises under this privilege. Under the attorney-client privilege, communications amongst attorneys and their clients are generally not subject to disclosure.[ii] The purpose of the attorney-client privilege is clear: to encourage full and frank communications amongst attorneys and their clients thereby promoting broader public interests in the observance of law and the administration of justice.[iii]
Federal courts have universally held that the attorney-client privilege extends to certain third parties who assist attorneys.[iv] For example, the attorney-client privilege extends to communications made to non-lawyers who assist attorneys, including secretaries and file clerks.[v] And, in the seminal case of U.S. v. Kovel,[vi] the Second Circuit Court of Appeals recognized that accountants who are engaged by attorneys to provide work product and assist in legal advice may also be covered under the attorney-client privilege.
The Accountant-Client Privilege.
Historically, federal courts have not recognized an analogous common law doctrine of privilege for communications amongst clients and accountants. However, in 1998, Congress statutorily provided such a privilege when it enacted Section 7525 of the Code. That provision provides:
With respect to tax advice, the same common law protections of confidentiality which apply to a communication between a taxpayer and an attorney shall also apply to a communication between a taxpayer and any federally authorized tax practitioner to the extent the communication would be considered a privileged communication if it were between a taxpayer and an attorney.[vii]
Although Section 7525 provides some significant protection against disclosure of certain communications to the IRS, there are significant differences between the statutory accountant-client privilege and the common law attorney-client privilege. As an initial matter, Section 7525 only applies to “noncriminal tax matter[s] before the Internal Revenue Service” and “noncriminal tax proceeding[s] in Federal court brought by or against the United States.” Thus, this privilege may not be asserted in IRS criminal matters and/or criminal judicial proceedings brought by the United States. Moreover, because Section 7525’s scope only applies to these specific matters, communications amongst clients and accountants may nevertheless be sought in other alternative contexts, such as non-IRS government investigations, state court litigation, and federal litigation where the United States is not a party. Conversely, the attorney-client privilege has none of these exceptions, i.e., it is much broader.
The Kovel Doctrine.
In 1961, the Second Circuit Court of Appeals issued its decision in Kovel. In that case, Mr. Kovel was a former IRS agent who became employed by a law firm. During his private employment, a grand jury in the Southern District of New York initiated an investigation against one of the law firm’s clients. As a result, Mr. Kovel was subpoenaed to appear before the grand jury and testify. During his appearance, Mr. Kovel contended that because he was an employee of the law firm, he was not authorized to disclose any communications amongst him and the client due to attorney-client privilege.
The United States Attorney’s Office contended that the attorney-client privilege did not apply to Mr. Kovel because he was not an attorney. The district court agreed and compelled Mr. Kovel to answer the grand jury’s questions. When Mr. Kovel refused, the district court held him in contempt. On appeal, the Second Circuit Court of Appeals reversed his contempt conviction and stated:
What is vital to the privilege is that the communication be made in confidence for the purpose of obtaining legal advice from the lawyer. If what is sought is not legal advice but only accounting service . . . or if the advice sought is the accountant’s rather than the lawyer’s, no privilege exists.[viii]
The Kovel Agreement.
Since the decision in Kovel approximately sixty years ago, federal courts have had numerous occasions to flesh out the requirements of a Kovel agreement. Generally, these decisions have held that taxpayers bear the burden of showing the existence of a Kovel agreement. Moreover, these federal decisions have held that substance often matters. For example, Kovel agreements have failed where: (1) the accountant did not have a separate agreement with the attorney; (2) the engagement agreement specified that the taxpayer (and not the attorney) was the client; and (3) the tax accountant sought payment for services directly from the taxpayer.[ix]
In many civil cases, Kovel agreements may not make sense. But, as shown above, Kovel agreements do have their place in effective tax defense, particularly where there is an ongoing or potential criminal investigation against the taxpayer. In these cases, the taxpayer should ensure that a Kovel agreement has been entered into prior to making any harmful communications to an accountant or CPA. Accountants and CPAs should also stop representation where criminal tax matters arise and a Kovel agreement has not been entered into.
[i] I.R.C. § 7602.
[ii] See Upjohn Co. v. U.S., 449 U.S. 383 (1981).
[iii] Upjohn, 449 U.S. at 389.
[iv] See U.S. v. Adlman, 68 F.3d 1495 (2d Cir. 1995).
[v] See Von Bulow v. Von Bulow, 811 F.2d 136, 146 (2d Cir. 1987).
[vi] 296 F.2d 918 (2d Cir. 1961).
[vii] I.R.C. § 7525(a)(1).
[viii] Kovel, 296 F.2d at 922.
[ix] See, e.g., Adlman, 68 F.3d at 1500.
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