Your client's next audit or lawsuit could be won or lost because of it
Fellow practitioners—please direct your attention to a well-written and thought-provoking article providing client-saving advice on a topic that may not be uppermost in your minds when working on estate plans and tax returns: privilege.
In "Anticipating the Audit Call: Thinking About Controversy at the Planning Stage," which appears in the January/February 2008 edition of Probate & Property, starting on page 20, authors John W. Porter and Stephanie Loomis-Price, of Baker Botts L.L.P. in Houston, and Charles E. Hodges II, of Chamberlain, Hrdlicka, White, Williams & Martin in Atlanta, caution estate planners that letters, memoranda and other documents prepared by an attorney, a client or any of the client's other advisors participating in the estate-planning process may in the future be reviewed by an Internal Revenue Service agent, appeals officer, IRS counsel or the finder of fact (a judge or jury) in a transfer tax audit or dispute.
Although certain documents may be protected from discovery, if the client's business and financial (that is to say, non-tax) reasons for engaging in a transaction are clearly documented, the client may find it helpful to waive any applicable privileges and use the documentation to refute an IRS argument that the client engaged in the transaction solely to avoid taxes.
Keeping this potential audience in mind during the planning stage may pay off for the client down the road during an audit or litigation.
Of course, certain communications between a client's advisors and between advisors and the client may be privileged. According to the authors, all estate planners should have general knowledge about five types of privileges that may be applicable in a transfer tax audit or litigation.
• Attorney-client privilege. The attorney-client privilege protects from disclosure confidential communications between attorney and client made for the purpose of obtaining legal advice. The authors discuss five considerations related to the privilege:
(1) For the privilege to apply, the communication must be made in confidence. The privilege will be waived if the communication is made in the presence of a third party. However, communications with accountants or other third party advisors made to assist the attorney in providing advice to the client are generally protected.
(2) Keep in mind that if an attorney's invoices are requested in discovery, the description on the invoices of the legal services performed is generally privileged.
(3) In some jurisdictions the privilege has been found to extend only to communications regarding legal advice, as opposed to general business advice. It is often hard to distinguish between legal advice and business advice. According to the authors, the better approach looks to the "dominant purpose" of the communication.
(4) The question of whether the privilege applies to the preparation of tax returns by attorneys is unsettled. Some courts have found the preparation of returns does not constitute the rendering of legal advice. Others have held that information provided for the preparation of tax returns also may have been provided for the purpose of obtaining legal advice and may be privileged.
(5) The authors point out that in some cases, the client may benefit from waiving the privilege. For example, if the IRS alleges an underpayment of tax, the client may contend that he had reasonable cause for the underpayment because he relied on the advice of tax advisors. To show reasonable reliance on the advice, the client may have to disclose otherwise privileged information. That’s one reason why the estate planner should keep this in mind when preparing legal opinions and correspondence.
• Work-product doctrine. The work-product doctrine, although technically not a privilege, does protect from disclosure the work product of an attorney or the attorney's staff prepared in anticipation of litigation. The doctrine is defined in Federal Rules of Civil Procedure 26(b)(3) and, as the authors note, is intended "to encourage lawyers to thoroughly prepare for litigation (whether pending or not) through investigation of the good and the bad, without fear of being forced to disclose their thoughts and analysis."
The authors emphasize that the doctrine may be applicable to the work product of transactional attorneys, because in many jurisdictions it’s not necessary that litigation be imminent for the doctrine to apply.
It Can Get Tricky
• Privilege related to valuation appraisals. The appraisal can be a significant document in the planning process, providing the basis for the taxpayer's position on the value of property transferred. The authors recommend that generally the attorney, rather than the client, hire the appraiser. This arrangement will allow the client to argue that the appraiser's unused correspondence or other documents are privileged, because the appraiser was hired to help the attorney provide legal advice.
The authors also wisely caution that once the appraiser decides on a value, the attorney and appraiser should communicate orally about the value before the appraiser prepares a written report—so that any differences of opinion can be resolved before anything is put in writing.
Finally, keep in mind that if the client ends up using the appraiser's report, any documents in the appraiser's file may be discoverable.
• Tax practitioner privilege. With respect to tax advice, Internal Revenue Code Section 7525 provides that the same common law protection of confidentiality that applies to a communication between a taxpayer and an attorney also applies to a communication between a taxpayer and a federally authorized tax practitioner that would have been privileged if it were between a taxpayer and an attorney. A federally authorized tax practitioner includes certified public accountants, enrolled agents and enrolled actuaries. The privilege encompasses tax advice and tax representation and, the authors note, arguably does not apply to the preparation of tax returns. It also is available only in non-criminal tax proceedings.
Still, the tax practitioner privilege is limited. That why the authors suggest that, when the assistance of an accountant is needed, the attorney (rather than the client) hire the accountant. As the article states: "Communications made to an accountant who is assisting an attorney in providing legal services (not accounting services) to a client are protected by the attorney-client privilege."
A written engagement letter that is properly drafted can help preserve the privilege. The authors recommend that the engagement letter specify that the accountant is hired by the attorney and working under the attorney's direction. The letter also should make clear that the accountant's work is for the purpose of providing legal advice and any communications to the accountant are made solely to enable the attorney to provide legal advice to the client.
• Physician-patient privilege. The authors note that it’s becoming more common for the IRS to request a decedent’s medical records. State law usually protects such information under a physician-patient privilege. But it’s not settled whether such a privilege exists in federal law —which is usually the law that applies in a tax audit or litigation. Federal courts are authorized to determine on a case-by-case basis whether a privilege exists and at least one circuit, the U.S. Court of Appeals for the Fifth Circuit, has held that there is no federal physician-patient privilege. The Supreme Court has yet to decide the issue, although it has ruled that a psychotherapist-patient privilege should be recognized.
We urge all professionals working in estate planning or tax reporting areas to review this excellent article in its entirety. Your next audit or related litigation may proceed more favorably if you take the time to do so.