Under the tax code, the confidentiality privilege only applies in non-criminal tax matters. But United States v. Kovel (2nd Cir. 1961) stepped in to extend the attorney-client privilege to cover accountants who are engaged by tax counsel in furtherance of the provision of legal services. This privilege would apply in audits or trial, civil or criminal.
When hiring that accountant, the issue of timing is important. Hiring a new accountant—versus the taxpayer's existing accountant—could avoid a headache: separating out privileged versus non-privileged materials. Remember, the Kovel rule only protects those accounting materials prepared in furtherance of the attorney's work. Regardless of which accountant is used, the parties should adopt a crystal-clear agreement specifying that the accountant's role is in furtherance of the taxpayer's legal defense.
Tax lawyers need accountants to help rebut the government's use of indirect accounting methods to establish taxpayer income. For example, accountants will help to explain or justify the following:
- unbalanced records (expenses exceed reported income);
- irregularities and weak internal controls;
- gross profit percentages are not aligned with comparable companies;
- unexplained deposits;
- unexplained net worth increases;
- no books and records; or
- lack of accounting method, or use of a method that does not clearly reflect income.
Indirect methods of proving income include a Cash-T, percentage mark-up, net worth analysis, deposit and expenditure analysis, such methods are referred to as the IRS Financial Status Audit Techniques (FSAT). These methods are not prohibited under IRC § 7602.
In furtherance of its audit, the government scrutinizes the following patterns of the taxpayer's economic behavior:
- Standard of living;
- Family's economic consumption;
- The true cost of family's consumption patterns;
- Whether reported net income sufficiently supports the taxpayer's standard of living;
- Other sources of funds to help explain expenditures;
- Accumulated wealth;
- Costs expended on recent capital expenditures;
- The taxpayer's economic history (long-time patterns in business and investments);
- Whether reported business history matches the changes in the taxpayer's standard of living and wealth accumulation;
- Whether reported interest income is increasing or decreasing;
- Patterns of noncompliance in the taxpayer's business;
- Competitive pressures and health of the taxpayer's business model and environment;
- Assertions that any funds are non-taxable;
- If the taxpayer claims that receipts are from loans, how credit worthy is the taxpayer to support that assertion.
The hired accountant to whom Kovel protection is sought must analyze the above and help formulate theories. The accountant would analyze bank statements, financial reports, witnesses, and cash-on-hand models. The accountant could help with legal strategy, and help craft questions to question the government's evidence. The attorney-client privilege would also cover the accountant who attends meetings with the examining agent.
Good judgment must be applied when a civil matter starts to escalate into possible criminal territory. Generally, the tax lawyers objectives are to 1) limit the scope of the inquiry; 2) avoid the production of false or misleading statements; and 3) avoid producing more than necessary to avoid waiver of the privilege against self-incrimination.
The IRS is in the business of enforcing collection. Despite budget restrictions, it is well equipped to identify mismatched and fraudulent returns based on monitored transaction and information-reporting requirements. The IRS continues to improve its audit techniques, and can hone those techniques to address particular business industries. It enjoys increased access to computerized banking data.
Against the IRS's powerful resources, the outgunned tax lawyer must do everything possible to protect the circle of information that supports the taxpayer's defenses.
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