Contrary to popular belief, there is no accountant-client privilege recognized in federal law. However, in 1998, Congress enacted a limited privilege for tax advice. Section 7525 extends the same common law protections of confidentiality that apply to communications between a taxpayer and an attorney to communications between a taxpayer and any "federally authorized tax practitioner." IRC § 7525(a)(1).
Thus, if the communication would be considered privileged if it was between a taxpayer and an attorney, then so too will it be privileged if it is between the taxpayer and a federally authorized tax practitioner. IRC § 7525(a)(3)(A). The term, "federally authorized tax practitioner" applies to any individual who is authorized to practice before the IRS. For example, it includes CPAs, enrolled agents, and enrolled actuaries.
Unfortunately, while highly praised at the time of its enactment, the 7525 privilege does not provide much protection for communications between an accountant and his client. As a preliminary matter, the privilege is only as broad as the attorney-client privilege. And the attorney-client privilege in tax matters is troublesome at best.
Most importantly, the privilege is not available when it is needed the most – during a criminal investigation or prosecution. Indeed, if an investigation is or is about to turn criminal, anything said by the taxpayer to his account will not be privileged.
However, that does not mean that discussions between a taxpayer and his accountant that are, shall we say, "sensitive in nature" – i.e., because they involve fraudulent admissions that are potentially incriminating – are never privileged. Indeed, such discussions can be privileged, but only if the accountant is a Kovel accountant.
In delivering legal services, an attorney will often need the assistance of non-lawyers who will become privy to confidential information. For example, paralegals and other assistants in the lawyer's firm will become privy to sensitive information. Disclosures of information to these individuals will not constitute a waiver of the privilege.
In addition to in-house assistance, attorneys may also find it helpful to engage professionals outside the firm. In tax cases, attorneys routinely hire outside accountants. The lawyer may want the accountant to meet with the client and obtain information directly from him, and cloak that information in the attorney-client privilege just as if the lawyer obtained it directly from the client.
The traditional method by which that is done, at least in a tax practice, is through an arrangement where the lawyer engages the accountant to become part of the legal team. This arrangement was approved, and the attorney-client privilege was held to extend to the accountant, in the case of United States v. Kovel, 296 F.2d 918 (2d Cir. 1961).
Here, as in many areas of the law, it is critical that if you are going to retain an accountant, you do it correctly. First, the only way to bring the accountant under the cloak of the attorney-client privilege is through consummating a Kovel agreement.
Second, as a matter of procedure, the attorney should engage the Kovel accountant, rather than the client. This ensures that the accountant is working for the lawyer, and not for the client. It is also recommended that the lawyer pay or at least approve the accountant's invoices.
Third, it is essential that a new accountant, rather than the client's existing accountant, be hired. The reason has to do with controlling the flow of information and, specifically, putting up legal barriers to the IRS's access to information that might harm the client.
Of course, it is only natural that the client will want to use his existing accountant. And he'll list any one of a number of seemingly "good" reasons. For example, the client is comfortable with him, they presumably have a good relationship, there are budgetary concerns, and the accountant is up to speed with everything.
However, that is precisely the problem. In preparing the original return, the preparer had access to information and documents that are usually not privileged. In a criminal investigation, the IRS can get to that information.
Also, in preparing the amended return, the preparer will likely uncover other information that reveals that there were serious problems in the initial return filing and may even offer a roadmap to the fraud. If the original preparer is used for the amended return, the taxpayer will then be at risk that the return preparer cannot clearly establish what he learned prior to the time the privilege became effective.
In other words, it might be difficult to distinguish between what the accountant learned outside the Kovel engagement and what he learned only within the scope of the Kovel engagement. Because only the latter is protected by the attorney-client privilege, this is clearly not a risk worth taking. For that reason, it is best for the lawyer to start out fresh and hire an independent accountant.
Assuming that the budget does not permit hiring a new accountant and there is no other choice but to use the existing one, extra steps must be taken to ensure that the information related to the Kovel engagement is clearly separate from the information learned in the accountant's other engagements.
Finally, to the extent that you engage a Kovel accountant, what tasks should he be assigned? His primary function should be to assist you in gathering all potentially relevant information. You should then turn that information over to an independent return preparer to prepare the amended returns. Right about now, you are probably asking yourself, "What sense does that make?" If the independent return preparer isn't a Kovel accountant, doesn't that put us right back in the same quagmire we were in at the beginning?
The short answer is, "no." While the independent return preparer's work is certainly discoverable by the IRS, the information upon which it was based isn't. Indeed, that information was gathered by the Kovel accountant, and therefore remains privileged. The lesson to be learned here is that keeping the roles distinct best preserves the attorney-client privilege.