The 1961 Yankees occupy a special place in team history because, in my humble opinion, they were the only truly transcendent Yankee team between Joe DiMaggio and Derek Jeter. Mickey Mantle could have been a hero in a Sophocles play. He could have easily broken every offensive record in the book, but a tragic flaw, or rather flaws, kept him from his full potential. Yet, even at half speed, he ran laps around everybody else. Fellow outfielder Roger Maris really only had two or three good years, but what years they were. This Yankee team also featured Hall of Famers Yogi Berra (at one time, my next-door neighbor) and Whitey Ford. These guys were essentially complementary players on that squad, which should tell you something.

If a bleary-eyed Mickey Mantle would have opened a lawyer or accountant trade journal in December of 1961 and flipped towards the back, just before the classifieds and obituaries, he may have found a write-up about a rather obscure Second Circuit case: United States v. Kovel. Various courts and codes have whittled away at this decision over the years, but it still stands firm as a case that can extend the attorney-client privilege to an accountant or other financial professional. Very simply, any communication between an attorney and a taxpayer that is deemed privileged under the attorney-client privilege will also be deemed privileged if it is between a “federally authorized tax practitioner” and a taxpayer. If you think that’s not a big deal, you’ve probably never been audited.

Background

Nothing occurs in a vacuum. Circuit Judge Henry Friendly, who sadly was a bit Sophoclesian himself, did not simply roll out of bed one morning, rub the cobwebs from his eyes, take a few sips of Maxwell House, and decide to extend the attorney-client privilege. In decisions like 1954’s Brown v. Board of Education and the limitation on search warrants in 1961’s Mapp v. Ohio, the Supreme Court under Chief Justice Earl Warren was quite literally rewriting the law, to the delight of some and the chagrin of others.

Politically, Americans no longer liked “Ike.” A brash Jack Kennedy declared in his 1961 inaugural address that “The torch has been passed to a new generation,” and he was right. A still-expanding postwar economy was butting heads against a still-expanding postwar government, and something had to give.

The Case

Louis Kovel was, in Judge Friendly’s rather understated terms, a former IRS agent who had some “accounting skills.” Since leaving the Service in the mid-1940s, he had been something of an in-house expert witness with a prestigious tax law defense firm in New York City. The government was snooping around a client’s records, and just two days before the statute of limitations would have expired, Mr. Kovel was subpoenaed to testify before a grand jury.

The next day, he refused to answer any questions, other than name, rank and serial number, on the grounds that the communications were privileged. A clearly irked federal judge, in something akin to a drumhead courts martial, sentenced Mr. Kovel to one year in jail for contempt.

Judge Friendly got right to the heart of the matter. On the one hand, “The investigation of truth and the enforcement of testimonial duty demand the restriction, not the expansion, of [evidentiary] privileges.” On the other hand, “it is absolutely necessary that a man. . .should be able to place unrestricted and unbounded confidence in the professional agent, and that the communications he so makes to him should be kept secret.”

The confidential communications privilege already applied to “ministerial” functions. For example, the Court recognized that in delivering legal services, an attorney relies upon non-lawyers, such as paralegals and secretaries. These individuals are regularly exposed to confidential information. If the information obtained by paralegals and secretaries as a result of their involvement in the case was not privileged, the government would have a “field day” subpoenaing them to come into court to testify about what they learned in “closed door” meetings. But as Judge Friendly recognized, disclosure of information to these individuals does not constitute a waiver of the privilege.

Judge Friendly also recognized that there will be times when attorneys find it helpful to engage professionals from outside of the firm, especially in an area as technical as accounting. Comparing an accountant with a foreign language interpreter, Judge Friendly made a shrewd observation, shining the light on a major shortcoming of those in the legal profession: “Accounting concepts are a foreign language to some lawyers in almost all cases.” This has been echoed by many a law professor, not the least of which was my evidence professor, who never missed an opportunity to complain about how hard it was to teach students about statistical evidence, since “most of [them] went to law school because [they] couldn’t do math and science in the first place.”

In applying this principal to accountants, an attorney may want the accountant to meet with his client and obtain information directly from him. In those cases, the attorney needs reassurance that the information disclosed by his client will be cloaked in the attorney-client privilege just as if the attorney had obtained it directly from the client.

Judge Friendly reasoned that the only way this can happen – at least in a tax practice – is through an arrangement where the lawyer engages the accountant to become part of the legal team. This marked the “birth” of the Kovel accountant.

Judge Friendly went on to hold that the government had the burden to disprove the privilege, as opposed to the taxpayer having the burden of proof to establish it.

The Next Forty Years

The government grudgingly codified Kovel into Section 7525 of the Internal Revenue Code. More precisely, the government codified some of it and ignored the rest. Judge Friendly clearly envisioned the privilege extension as quite broad. But Section 7525 made some key limitations:

• The privilege is only as broad as the attorney-client privilege. And when it comes to tax matters, the attorney-client privilege isn’t anything to write home about. The privilege only protects communications involving “tax advice.” But remember, we’re not talking about tax advice given by a tax preparer. Instead, we’re talking about tax advice given by an attorney. Thus, before a court will find that a tax preparer’s tax advice is protected by the attorney-client privilege, that tax advice must be “a matter that is sufficiently within the professional competence of an attorney.” Tax matters that are outside the professional competence of an attorney are not privileged. One such example is the preparation of tax returns.
• The privilege applies only in noncriminal tax matters before the IRS and noncriminal tax proceedings in Federal court brought by or against the United States. Like the absence of police in a high-crime area after dark, the privilege is not available when it is needed the most: when an investigation is or is about to turn criminal. Under these circumstances, anything said by the taxpayer to his accountant is not privileged. Ironically, Mr. Kovel would not be entitled to the privilege that bears his name.
• The privilege applies only to communications between a “federally authorized tax practitioner” and the taxpayer. “Federally authorized tax practitioners” include those who are authorized to practice before the IRS, such as CPAs, enrolled agents, and enrolled actuaries. Arguably, if the lawyer gets involved, such involvement destroys the privilege.
• No protection exists for written communications between a tax practitioner and “a director, shareholder, officer, or employee, agent, or representative of a corporation in connection with the promotion of the direct or indirect participation of such corporation in any tax shelter.”

These limitations, along with subsequent caselaw, place a great deal of uncertainty into Kovel agreements. For example, while some courts outright deny the privilege when it comes to communications made solely for tax preparation, others acknowledge an element of legal advice in the preparation of returns. Case in point is the Ninth Circuit Court of Appeals. The Ninth Circuit extends the privilege to communications made to obtain legal advice about a reporting position on a return, such as whether a specific item can be claimed as a deduction.

As if that was not disturbing enough, there is also a great deal of uncertainty as to what communications are covered. So, the prophylactic nature of a Kovel agreement is directly proportional to your attorney’s research and advocacy skills. The better he or she is, the better off you are.

What to Do

If you are an attorney and want to retain an accountant, you must tread very carefully. Current law requires strict compliance with Section 7525 and a well-documented paper trail. Unless you want the accountant spilling his guts to a grand jury, metaphorically speaking, a written Kovel agreement that is specific to the client and case must be consummated.

Second, the attorney should engage the Kovel accountant and not the client. This ensures that the accountant is working for the lawyer, and not for the client. It’s nearly impossible to extend the attorney-client privilege to someone who is not employed by the lawyer or law firm. In addition, the lawyer should pay, or at least approve the accountant’s invoices.

Finally, a new accountant, rather than the client’s existing accountant, should be hired. And the roles of the original accountant and the new accountant must be kept distinct so that the new accountant is cloaked in the attorney-client privilege. This strategy is designed to safeguard your client by preventing the IRS from obtaining information that might incriminate him.

Now don’t expect your client to embrace this strategy. He’ll want to use his own accountant and he’ll list a number of “good” reasons why – from budgetary concerns to relationship issues to comfort level. But using the original accountant is a recipe for disaster.

Why? Let’s begin with the notion — widely held by tax lawyers — that the accountant-taxpayer privilege is narrow. As a result, it is not unreasonable to assume that the information and documents relied upon by the preparer to prepare the original returns will not be privileged. This could not be any more true than in the case of an examination that starts out simple enough but then takes a turn for the worse. You know the one I’m talking about. It’s what causes tax professionals to wake up in the middle of the night with beads of sweat pouring down their foreheads and their hearts racing: a fraud referral specialist has referred the case to CI for investigation. In this nightmarish situation, information relied upon by the tax preparer is all but certain to make its way into the “grubby” hands of the IRS .

Similarly, in preparing the amended returns, the preparer – regardless of whether he is the “original” preparer or a “new” one – is likely to uncover additional information that confirms that there were serious problems with the original return and that might even provide a roadmap to the fraud.

And this is where things could go south fast. If the original preparer is used to amend the returns, he may not be able to distinguish between what he learned prior to the time the Kovel agreement went into effect and what he learned after the Kovel agreement went into effect.

But only the latter – i.e., that which was learned within the scope of the Kovel agreement – is protected by the attorney-client privilege. That which was learned pre-Kovel is, as they say, par for the course. The net effect is that if the defense cannot convince the judge that information subpoenaed by the IRS was obtained within the scope of the Kovel agreement, the judge will order the defense to turn it over to the government. The danger, of course, is that it just might be the “smoking gun” that the government needs to convict your client.

This is not a risk worth taking. This is why you must overcome your client’s objections and convince him that it is best to start out fresh and hire an independent accountant. But it does not end there. The roles of both accountants must be kept distinct to ensure that the Kovel accountant is cloaked in the attorney-client privilege. This will eliminate the risk that information obtained by the Kovel accountant is misclassified and treated as if it was discovered by the original accountant, outside of the Kovel agreement. Because the information would be fully discoverable, the stakes could not be higher.

Recognizing that there will be times when the budget does not permit hiring a new accountant and that there is no other choice but to use the existing one, precautionary steps must be taken to ensure that information obtained during the course of the Kovel engagement is kept separate and apart from information that was obtained prior to the engagement.

Properly executed, a Kovel agreement gives the preparer the freedom to communicate with the taxpayer and the taxpayer’s attorney, ensuring that the taxpayer gets the best possible representation.

Work Product Doctrine

While Section 7525 does not provide any protection for tax practitioners’ work product, thankfully there is the Work-Product Doctrine.

The work-product doctrine is a judicially-created privilege that applies to materials prepared by an attorney acting for his client, or by another representative of the client (e.g., an expert in analysis), in anticipation of litigation.

The Supreme Court first announced the work-product doctrine in Hickman v. Taylor, 329 U.S. 495, 510 (1947), and it was later codified in Federal Rule of Civil Procedure Rule 26(b)(3).

Material within the scope of the work-product privilege includes opinion work product (assessment of legal positions) and summaries of the testimony of potential witnesses.

The work product privilege is similarly narrow. For reports, models, spreadsheets and other documents to be protected, they must have been prepared directly pursuant to legal advice. In other words, you cannot “cc” your lawyer on an email and expect the privilege to apply. Nor is an accountant’s work papers protected by the doctrine.