Authorized tax practitioners - including CPAs, enrolled agents and enrolled actuaries - cannot be forced to testify against their clients regarding communications that relate to tax advice (IRC Sec. 7525).

The law embodies two critical concepts. First, the privilege is the client's, not the practitioner's. A practitioner must have the client's consent to claim communications are privileged. The privilege also is only an extension of the attorney-client privilege; all of the problems, issues and benefits presented by the attorney-client privilege now apply to the new tax-practitioner privilege.

Second, the scope of the new privilege is fairly narrow. For example, non-tax consulting work and most tax return preparation work are outside the scope because they are not considered "tax advice." In addition, the law specifically excludes certain communications, such as those related to criminal matters. Basically, the privilege is retroactively revoked in criminal cases. As a result, it is important for clients to seek counsel from an attorney experienced in criminal tax matters if necessary.

Clients also need to be clear on other dealings that are excluded from the new privilege rule.

• Communications involving matters under the jurisdiction of other government agencies, such as the SEC and FTC, are not privileged.

• Issues involving state and local tax questions are not privileged.

• Private litigation or suits not involving the United States government are not extended this privilege. Communications in lawsuits between private individuals or companies for breach of contract, negligence or similar actions are not protected by the privilege.

• Finally, the privilege does not apply to any written communications with a director, shareholder, officer, employee, agent or representative of a corporation in connection with the direct or indirect participation in a tax shelter [IRC Sec, 7525(b)]. This is an extremely broad exclusion because the purpose of any tax-planning proposal brought to a corporation is to reduce income tax.

What is "Tax Advice?"
The law vaguely defines tax advice as "advice given by an individual with respect to a matter which is within the scope of the individual's authority to practice before the IRS" [IRC Sec. 7525(a)(3)(B)]. Included in this definition should be such things as tax planning memoranda, tax risk assessment memoranda, tax representation communications and memos concerning tax (or income) characterization (capital gains versus ordinary).

It seems to follow that simultaneous memos to a practitioner's files, noting client discussions about tax issues, should be privileged. It should not make any difference whether the tax advice involves prospective or completed transactions.

Although tax advice does not include advice in non-tax areas and generally does not include tax return preparation services, where a practitioner gives advice about both tax and non-tax issues, the tax related issues should be covered.

Privilege Can Be Waived
The right of privilege can be waived in many ways. Even though the privilege is a client privilege, either the client or the tax practitioner can waive it. Of course, if the tax practitioner waives it without the client's consent, the practitioner may face a malpractice claim.

Clients can waive the right to privileged communications by disclosing communications to the IRS, telling a third party about the communications or by disclosing the communications in the client's financial statements. Likewise, the practitioner can waive the privilege through an intentional or inadvertent disclosure to third parties.

Although not certain, it seems likely that the presence of any third party not involved in rendering tax advice waives the privilege. For example, a meeting attended by the client, the tax practitioner and a banker to discuss various transactions, probably waives the privilege as to the tax advice rendered at the meeting, since the banker is not involved in the rendition of tax advice.

Although this may seem unfair, courts have consistently held in the attorney-client privilege area that the presence of the third party waives the right of privilege because there is no expectation of privacy with the third party present.

Responding to Summons or Other Requests for Protected Communications
Since the right of privileged communication belongs to the client, the tax practitioner should not provide privileged information demanded by the IRS in a summons or other document request without the client's consent, and perhaps the advice of legal counsel.

This may mean that a summons enforcement proceeding is brought by the IRS in Federal District Court. That, however, provides the client with the opportunity to claim the privilege. Turning the information requested in the summons or document request over to the IRS without the client's consent is probably a waiver of the privilege, and could subject the practitioner to a malpractice claim.

Increasing the Likelihood that Communications will be Deemed Privileged
Practitioners can take action to protect the client and ensure that privileged communications remain so.

• Clearly label privileged communications. Only those communications that may be protected by the privilege should be labeled. Otherwise, the courts may give little or no weight to the notation.

• Privileged communications should not be included in the general correspondence file, tax return file or in tax return or financial statement work papers, since such inclusion could be deemed a waiver of the privilege.

• Access to the privileged tax advice file should be restricted to those engaged in rendering tax advice. If non-authorized tax practitioners have access to the information, they must be involved in rendering the advice. For example, if privileged information (such as a tax-planning memorandum) is stored electronically, it should be password-protected or at least have a unique file extension.

It is also a good idea for practitioners to include language in their engagement letters that tells clients that a privilege exists. For example, depending on state law, an appropriate clause might read:

"Certain communications involving tax advice between you and our firm may be privileged, and not subject to disclosure to the IRS. By disclosing the contents of those communications to anyone, or by turning over information about those communications to the government, you may be waiving this privilege. To protect your right to privileged communication between yourself and our firm, please consult with us or your attorney prior to disclosing any information about our tax advice."

What is Next?
It may seem that the new privilege creates more problems than it solves. However, attorneys have faced these issues for years and have still managed to protect privileged communications with their clients. Be aware, be educated, and be happy that there's a new privilege for taxpayers. They do not come around very often.

First published on Jan. 17, 2000.