Limiting IRS Access to Your CPA & Tax Attorney Records – Houston Tax Attorneys

A core principle of U.S. law and a foundation of our legal system is the presumption of innocence. The burden of proof lies with the accuser, not the accused.

This underpins the right against self-incrimination and the right to legal counsel to mount a vigorous defense. However, this framework unravels if the accuser can access confidential communications between the defendant and counsel. The attorney-client and work product privileges aim to prevent this.

These protections have been limited in civil tax disputes between taxpayers and the IRS. The IRS is typically afforded a presumption that its administrative determinations are correct, leaving taxpayers to disprove claimed underpayments. So there is essentially a presumption of guilt.

Then, by asserting civil tax penalties, even if there is no evidence supporting such an assertion, the IRS can often gain access to taxpayer-counsel communications. It does this by causing the taxpayer–the accused–to assert reasonable cause defense that they relied on their tax advisors. The defense opens the door to the IRS to get the tax advisor’s records and communications.

While the door is open, it is not entirely open. Nuances remain. A recent case, Townley v. United States (M.D. Ga. 2023), provides an opportunity to consider this topic.

Facts & Procedural History

In Townley, the taxpayers claimed deductions for conservation easement contributions on amended returns. The taxpayers used CPAs and tax attorneys to advise and assist with the reporting of the charitable conservation easement.

After prepaying amounts to the IRS assuming the deductions were disallowed, the taxpayers filed an amended return and sued for a refund. The IRS counterclaimed for tax penalties due to excessive refund claims under Section 6676. This penalty applies when a taxpayer claims an excessive amount as a refund or credit on their tax return.

The taxpayers asserted their defense by arguing they had reasonable cause based on professional tax advice. The IRS then sought the workpapers from the taxpayers’ legal counsel, arguing that the taxpayers had waived privilege by providing records of advisors involved in preparing the returns.

The taxpayers objected to producing protected work product held by their litigation counsel, retained after filing the returns for the refund suit. Thus, the court had to decide whether the litigation counsel’s documents had to be produced or were protected.

Excessive Refund Claim Penalties & Reasonable Cause

The excessive refund claim penalty under Section 6676 applies when a taxpayer claims an excessive amount as a refund or credit on their tax return. The penalty is set at 20% of the disallowed refund or credit amount. This penalty can apply even if the taxpayer has a reasonable basis for the claimed refund if the amount is considered excessive.

Tax penalties may be abated if the taxpayer shows reasonable cause, as established in the Supreme Court’s landmark United States v. Boyle case. Reasonable cause requires the taxpayer to demonstrate they exercised ordinary business care and prudence in taking the position resulting in the underpayment. Reliance on a tax professional’s advice can constitute reasonable cause in some circumstances.

One aspect of when reasonable cause may be available is when there is a substantial understatement of tax that is due to reasonable reliance on professional tax advice, as outlined in the leading case on point (Neonatology Associates, P.A. v. Commissioner). Under this line of cases, the courts generally evaluate if the tax advisor was competent and had sufficient expertise, and whether the taxpayer provided necessary information. If these factors are met, the courts will generally not impose penalties or abate penalties.

Reasonable cause is a common defense to civil tax penalties. Asserting this defense often leads to a waiver of privilege for tax advisor records.

About the Attorney-Client & Work Product Privileges

There are two privileges that are commonly asserted to protect attorney-client communications and attorney records. This includes the attorney-client privilege and the work product privilege.

The attorney-client privilege protects confidential legal communications and advice. The rules for this are set out in Federal Rule of Evidence 501. FRE 501 establishes that communications between an attorney and a client related to seeking or providing legal advice are privileged and generally protected from compelled disclosure. This privilege can be waived, allowing the discovery of protected information. For example, voluntarily disclosing attorney-client communications to third parties may waive the privilege. Using the tax advisor to further a crime is another example.

Attorney work product provides qualified protection for materials prepared in anticipation of litigation. This protection is provided in Federal Rule of Civil Procedure 26. FRCP 26 shields documents and other materials, including the mental impressions and legal theories of attorneys, that are prepared in advance of litigation. Work product protection can also be waived. For instance, sharing work product with adversaries or using them extensively for non-litigation purposes may waive protection.

This brings us back to civil tax penalties and reasonable cause. To evaluate claims of reasonable cause for defense, the IRS typically seeks discovery of tax advisor records. This can arise in court or earlier in the process, when the IRS issues a summons to obtain attorney records. The IRS has had some succdess in getting attorney records. Courts have found this serves as a privilege waiver for advised-upon returns and related documents provided to the tax advisors.

Tax Litigation Counsel Workpapers

In the Townley case, the IRS sought the litigation counsel’s workpapers, including protected notes, memos, and communications. The argument is that the IRS did this to determine the scope of the taxpayers’ reasonable cause defense.

The IRS argued that it was unfair for taxpayers to selectively waive privilege as a “sword” for the reasonable cause defense while “shielding” related attorney work product as a “protection.”. This sword and shield argument asserts that privilege should not allow advantageous use of protected materials while blocking access to related information.

The court rejected the IRS’s argument that it was unfair for taxpayers to selectively waive privilege. It distinguished the litigation counsel’s work product from the records of other advisors relied upon for filing the returns. The court noted that the waiver rules are clear in that they do only apply pre-litigation for items disclosed to prepare and file the tax returns. The court declined to order disclosure of litigation counsel’s protected materials.

Mitigating Privilege Waiver Risks

Given the potential for penalty assertions to compel disclosure of taxpayer-counsel communications, taxpayers should take steps to minimize unintended privilege waivers when relying on the advice of tax advisors for larger and likely-contested items.

First, taxpayers should selectively disclose only necessary information to advisors needed to support reasonable cause. The tax advisor needs to be informed but does not need to know everything. Providing extraneous documents and communications heightens waiver risks. Carefully tracking and logging information furnished to advisors can help control exposure.

Second, taxpayers should enter written engagement agreements that narrowly define the scope of the advisor’s review. Limiting the advisory role to discrete questions or tax positions can confine potential privilege waivers.

Third, taxpayers should avoid verbatim sharing of attorney advice or communications with advisors. Paraphrasing counsel’s guidance, rather than forwarding original documents, reduces risks.

Finally, taxpayers should consult their tax attorney before producing any documents to the IRS, even if penalties are unsubstantiated. Thoughtfully navigating requests can help uphold privilege by avoiding inadvertent waivers.

The Takeaway

This case highlights the nuances involved when taxpayers assert reasonable cause defenses to tax penalties. While relying on professional tax advice can justify penalty abatement, it often requires waiving privilege for advisor records. However, as Townley demonstrates, this waiver may not extend to unrelated litigation counsel workpapers. Determining the scope of privilege waivers requires careful analysis of the specific facts and circumstances. Taxpayers should thoughtfully consider the implications before disclosing any potentially protected information to avoid unintended waivers of privilege.