Kovel Agreements

Kovel Agreements - Because there is NO federal Accountant-Client privilege, Accountant-Client communications are NOT protected from disclosure in federal court. A Kovel Agreement is a key tool to help protect these communications.

• In sensitive tax matters, the answer to this dilemma is the Kovel letter, named after United States v. Kovel. Your tax lawyer hires an accountant. In effect, the accountant is doing your tax accounting and return preparation, but reporting as a subcontractor to your lawyer.
• Properly executed, it imports attorney-client privilege to the accountant’s work and communications. 
• In recent years, the IRS has won several key decisions in the federal courts that limit the extent of the protections afforded to clients under the Kovel Rule. Recent IRS lawsuits eroding the Kovel Rule are United States v. Richey, the Ninth Circuit refused to protect an appraisal that a taxpayer, lawyer and accountant were trying to keep from the IRS. In United States v. Hatfield, the court forced disclosure of discussions between the lawyer and accountant. 
• The Kovel Rule takes its name from Louis Kovel, an IRS agent who later joined a law firm specializing in tax cases, lending his expertise in tax accounting. In 1961, Kovel was sentenced to prison for refusing to answer questions in court about discussions with a client, which he believed to be protected by the principle of lawyer-client privilege. His conviction was overturned upon appeal. 
• In the Kovel case, a law firm specializing in tax law employed an experienced accountant on its own staff. In the course of representing a client that was the target of a grand jury investigation for various income-tax offenses, the taxpayer communicated information to the accountant and the accountant prepared work for the client at the direction of the attorneys. 
• When the accountant appeared before the grand jury and refused to answer questions, the judge held him in criminal contempt and sentenced him to a year in prison. The accountant challenged that decision to the Second Circuit. The Second Circuit held that the attorney-client privilege extends to communications made by a client to an accountant in the attorney's employ incident to the client's obtaining legal advice from the attorney. The court analogized the accountant's role to that of a translator helping the attorney who is "ignorant of the [client's] foreign language" to give more effective legal advice (Kovel, 296 F.2d at 921-22). 
• Since Kovel, courts have recognized both a privilege protection that attaches to communications between the accountant and taxpayer client, as well as a work product protection that attaches to the accountant's work papers and file. 
• Although California state courts have not yet addressed Kovel, under California Evidence Code §954, accountants may be included in the attorney-client privilege if their presence furthers the interest of the client and is reasonably necessary to assist the lawyer in giving the client legal advice. The key is that the accountant's job is to assist the attorney, not the taxpayer, in navigating the accounting complexities that are incident to defending the criminal tax lawsuit. 
• Two privileges may apply to an accountant’s tax advice to a client: the practitioner-client privilege granted by IRC §7525 and the work product privilege established by the Supreme Court in Hickman v. Taylor, 329 U.S. 495 (1947) and codified in the Federal Rules of Civil Procedure. Fed. R. Civ. P. 26(b)(3). 
• The application of each privilege is based on specific standards that are carefully weighed by the court when the privilege is claimed. If the practitioner and the client have maintained a defensive posture throughout the communication and documentation process, it is more likely that the privilege will be upheld and IRS access will be denied. 
• A statutory “tax preparation” privilege was added in 1998 (IRC §7525(a)(1)) but is inapplicable to criminal tax cases, so is of little value. 
• The federal tax practitioner privilege only applies in civil tax proceedings before the IRS and in federal court brought by or against the United States (see 26 USC §7525).
• In addition, the privilege does not extend to communications about tax return preparation [see United States v. KPMG LLP, 237 F. Supp. 2d 35, 39 (D.D.C. 2002); United States v. Gurtner, 474 F.2d 297, 299 (9th Cir. 1973)]. 
• Nor does it apply to communications regarding tax shelters (which the statute defines broadly) or made in furtherance of a crime or fraud [see 26 U.S.C. § 7525(b); United States v. BDO Seidman, LLP, 492 F.3d 806, 819 (7th Cir. 2007) (describing crime-fraud exception)].
• And, the statutory privilege does not protect the accountant's work product from disclosure (see KPMG, 237 F. Supp. 2d at 39).
• Importantly, although clients may prefer it for efficiency and cost reasons, a CPA should not agree to a Kovel arrangement if he/she has already been acting as the taxpayer client's CPA. If you are the taxpayer client's longtime accountant, the line between your work as an accountant and your work as the attorney's consultant may be blurred.
• What the CPA knew and when the CPA knew it vis-a-vis the Kovel arrangement will become critical, and possibly difficult to establish. Although the CPA's instinct may be to continue helping his/her longtime client, the CPA may actually be doing the client a disservice by taking on the Kovel engagement. Instead, recommend another qualified accountant to serve as the Kovel accountant and with whom you can work to provide information regarding your pre-Kovel work.
• If you are the new Kovel accountant, you should advise your client to stop communicating with the longtime CPA directly. Instead, information gathering from the prior CPA should be done by the legal team, including the Kovel accountant. Be aware that the party asserting the attorney-client privilege has the burden of establishing the privileged nature of the communications. A CPA and the Kovel attorney should follow these best practices to ensure that the taxpayer client can meet that burden: 
• Memorialize the Kovel relationship in writing (with a Kovel letter) before any services are performed. The engagement letter should be on the law firm's letterhead and addressed directly to the Kovel accountant.
• The letter should state clearly that the law firm is engaging the accountant directly and that the accountant is rendering services to aid the attorney in the provision of legal services (rather than the accountant providing the taxpayer client with tax-related services). Examples of services that typically fall within a Kovel engagement are reviewing tax returns and determining errors; reviewing financial records for unreported income or inappropriate write-offs; advising the attorney on technical tax issues, and computing taxes to assist in criminal sentencing issues.
• Whereas many standard law firm engagement letters state that any work product generated is the property of the "client," the language should state that the work product generated by the accountant is the property of the law firm. In essence, the law firm becomes your client. 
• Although the attorney is not required to be involved in every communication between you and the client, the attorney should oversee all those communications, and work you perform under the Kovel arrangement must be done at the direction of the attorney.
• Make sure you address any letters or memos you prepare to the law firm, not to the taxpayer client or "the file." 
• While it is acceptable for the taxpayer ultimately to pay your bills as the Kovel accountant, it's a good idea to have the billing run through the attorney first. Or, the attorney may take a bigger retainer at the outset from the taxpayer client and pay you with those funds. 
• You should prominently label all correspondence "attorney-client privileged" and all work papers "attorney work product." 
• In the rare case where you, as the existing CPA, are engaged as the Kovel accountant, you should implement an ethical wall in your accounting firm so that professionals who were involved in preparing prior returns will not have access to Kovel privileged communication.