Accounting Documents Protected by the Work Product Doctrine and the Kovel Doctrine

The work product doctrine generally protects “documents and tangible things that are prepared in anticipation of litigation or for trial by or for another party or its representative.[1]“ [T]o qualify for protection against discovery under Rule 26(b)(3), documents must have two characteristics:

·       they must be prepared in anticipation of litigation or for trial, and

·       they must be prepared by or for another party or by or for that other party's representative.[2] 

Only work product created in anticipation of litigation qualifies for protection under the work product doctrine. In the case of a tax controversy, the simultaneous nature of the IRS's examination and the taxpayer’s ongoing tax and legal obligations presents a challenge in determining whether the taxpayer or their representatives created a document in anticipation of litigation. Under the right circumstances, a party may create work product during the course of an IRS investigation in anticipation of litigation[3].  In contrast, documents that would have been prepared for a party's tax filings regardless of the IRS examination would not qualify as work product[4]. Consequently a court must examine the underlying facts to determine when the party claiming work product protection reasonably anticipated litigation and the nature of the document's purpose.

Under IRC §7525(a)(1) the common law protections of confidentiality applies to a communication between a taxpayer and an attorney with respect to tax advice. The same common law protections of confidentiality applies to a communication between a taxpayer and an attorney and communication between a taxpayer and any federally authorized tax practitioner to the extent the communication would be considered a privileged communication if it were between a taxpayer and an attorney. Generally, the privilege does not apply to communications regarding the preparation of tax returns[5].

In U.S. v. Burga, 124 AFTR 2d 2019-XXXX, (DC CA), 08/16/2019 the district court held that some documents created by an accountant were protected under the tax practitioner privilege and under the holding in Kovel because the documents were produced to help an attorney to give legal advice, not merely to produce a tax return.

The Court of Appeals for the Second Circuit previously held that attorney-client privilege also applies to communications made in the presence of an accountant who is indispensable to the consultation between lawyer and client. The court held that the privilege attached to a communication made to the attorney, in the presence of an accountant employed by the attorney, if the communication was made in confidence for the purpose of getting legal advice from the lawyer[6].

The tax practitioner privilege does not protect communications made in the presence of an accountant if the accountant is there merely to provide accounting services[7].

In Burda the attorney hired an accountant to, according to statements the accountant submitted to the district court, "review and, if necessary and/or possible, amend" the tax returns that the IRS was examining, as well as "prepare returns for" future years. The accountant also said, that he "performed services which were of a character and quality necessary for the [attorney] to provide appropriate and accurate legal and tax advice to [Burga] including reviewing and interpreting tax and financial information and documents."

The IRS asked Burga to produce documents that the accountant had prepared. Burga said the documents were protected under IRC §7425 and by the Kovel doctrine.

The IRS said the documents were not protected because the accountant was merely providing accounting services, i.e., he was preparing tax returns.

The district court held that IRC §7425 and Kovel did apply to protect some of the documents that the accountant produced. The court also recognized that some of the accountant's documents were merely related to his preparing tax returns and were not protected.

The court found that the accountant's statement that he was hired to prepare tax returns did not preclude the possibly that he also provided tax advice. The court looked to his statement as evidence that he may have provided tax advice in addition to preparing tax returns. The court found that this statement was enough to have both IRC §7425 and Kovel apply.

The court ultimately decided to appoint a special master review the documents to determine which ones were protected because they contained tax advice provided by the accountant and which ones were merely related to preparing tax returns.

Practice Pointer: The practical point is that in any tax controversy if an accountant is going to be retained as part of the client representation, protecting the work product of the accountant is critical. Clearly any written documents or communications must be kept separate and labeled as “property of the attorney [name]“ and those reflecting tax preparation must be kept separate so as to not destroy the privilege.

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[1] Fed. R. Civ. P. 26(b)(3)(A).

[2] In re California Pub. Utils. Comm'n, 892 F.2d 778, 780–81 (9th Cir.1989).

[3] United States v. Roxworthy, 457 F.3d 590, 594–600 [98 AFTR 2d 2006-5964] (6th Cir. 2006).

[4] See United States v. Richey, 632 F.3d 559, 568 [107 AFTR 2d 2011-573] (9th Cir. 2011).

[5] U.S. v. McEliogt, 115 AFTR 2d 2015-1433 (DC CA 2015).

[6] U.S. v. Koval, 9 AFTR 2d 366, 296 F.2d 918 (2^nd Cir. 1961).

[7] Gonzales v. U.S., 110 AFTR 2d 2012-6083 (9^th Cir. 2012).

IRS Approves spousal rollover although decedent’s IRA did not designate a beneficiary

Generally, a surviving spouse may make a tax-free spousal rollover from a deceased spouse's IRA only if the survivor is designated as the IRA’s beneficiary. However, in PLR 201931006, IRS said this general rule did not apply—and a tax-free spousal rollover was approved where the decedent failed to designate an IRA beneficiary, died without a will, and the surviving spouse was the administrator and sole heir to the decedent’s estate. 

A surviving spouse designated as the beneficiary of an IRA need not leave the IRA in the decedent's name. The surviving spouse can either:

·       roll over the decedent's IRA into an IRA in the spouse's name; or

·       elect to treat the decedent's IRA as the spouse's own IRA. 

However, the regulations state the election to treat the decedent's IRA as the surviving spouse beneficiary's IRA is available only if the spouse is “the sole beneficiary” of the IRA and has an unlimited right to withdraw amounts from it. Note the sole beneficiary requirement is not met if a trust is named as the IRA's beneficiary, even if the spouse is the sole beneficiary of the trust (but see PLR 201923002).

There is no immediate tax if distributions from an IRA are rolled over to an IRA or other eligible retirement plan, annuity, or tax-sheltered annuity. For a rollover to be tax-free, the amount distributed from the IRA generally must be recontributed to an IRA or other eligible retirement plan no later than 60 days after the date that the taxpayer received the withdrawal from the IRA. A distribution rolled over after the 60-day period generally will be taxed (and also may be subject to a 10% premature withdrawal penalty tax). An individual is permitted to make only one nontaxable 60-day rollover between IRAs in any 1-year period.

In PLR 201931006 the Decedent established an IRA but failed to designate a beneficiary for the account. The IRA was maintained by a custodian that provided that if no beneficiary is designated for the IRA, the account balance remaining at the decedent’s death would be payable to her estate. The decedent died without a will and, under relevant state law, the decedent’s surviving spouse was the sole heir to the estate. The decedent’s surviving spouse was also the sole administrator of the estate.

The decedent’s surviving spouse intended to distribute the IRA to the estate, and as administrator of the estate, pay the proceeds of the IRA to himself. Within 60 days of receipt, he would roll over the proceeds of the IRA into one or more IRAs in his name.

The surviving spouses asked IRS to rule that:

·       the surviving spouse be treated as the payee or distributee of the IRA proceeds;

·       The IRA would not be treated as an inherited IRA; and

·       He will be eligible to do a tax-free 60-day rollover from the decedent’s IRA to his own IRA. 

The ruling points out that the surviving spouse would not be permitted to treat the IRA as his own, because he was not named the beneficiary of the IRA. However, because he was the administrator and sole heir to the estate he was effectively the individual for whose benefit the account was maintained. As a result, if the surviving spouse receives a distribution of the proceeds of the IRA, he could roll over the distribution into his own IRA.

In response to the ruling requests, IRS concluded that:

·       The surviving spouse will be treated as the payee or distributee of the proceeds from the IRA;

·       that the IRA would not be treated as an inherited IRA; and

·       That the surviving spouse will be eligible to make a tax-free rollover of the proceeds from the decedent’s IRA to an IRA set up and maintained in his own name, as long as the rollover occurred no later than 60 days after the proceeds were received by the surviving spouse in his capacity as administrator of the estate, and all other applicable requirements were satisfied.

In this case the surviving spouse was “lucky” in that he was the sole heir of the estate and the state statue was favorable.  In many case where clients are doing their estate planning the non-probate assets are overlooked.  Non-probate assets do not pass through the will; they pass by beneficiary designation. Therefore it is incumbent when doing your estate plan that you confirm that you have properly designated the beneficiaries of your retirement accounts, IRA’s etc., your life insurance, annuities, and other non-probate assets

IRS explains revocation of passports of taxpayers with significant debt

With the summer in full swing with taxpayers traveling to foreign destinations, the IRS in IR 2019-1451, 8/8/19  has reminded taxpayers that they may not be able to renew their current passport, or obtain a new passport, if they are delinquent in paying federal taxes.

In 2015 Congress enacted “The Fixing America's Surface Transportation (FAST) Act” and added a new Code section, IRC §7345.  Under IRC §7345, taxpayers having a "seriously delinquent tax debt" is, unless an exception applies, grounds for denial, revocation, or limitation of a passport.

A seriously delinquent tax debt is generally an assessed tax debt that exceeds $50,000 (adjusted for inflation for calendar years beginning after 2016; currently $52,000) and for which a notice of lien has been filed under IRC §6323).  Under IRC §7345(b)(2), a seriously delinquent tax debt does not include a debt for which: there is an agreement in place to repay the debt under IRC §6159 or IRC §7122; or collection is suspended because of a collection due process hearing under IRC §6330 or because innocent spouse relief under IRC §6015(b), (c) or (f) is requested or pending.

In addition, IRC §7508(a)(3) provides that certification of a seriously delinquent tax debt under IRC §7345will be postponed while an individual is serving in an area designated as a combat zone or participating in a contingency operation.

In February 2019, IRS issued IR 2019-23, which provided that when a taxpayer no longer has a seriously delinquent tax debt, because he paid it in full or made another payment arrangement, IRS will reverse the taxpayer's certification within thirty days. It also provided steps taxpayers can take to avoid having IRS notify State and circumstances under which IRS will not issue certifications to State.

The Information Release lists circumstances under which IRS may ask State to exercise its authority to revoke a taxpayer's passport. For example, IRS may recommend revocation if IRS had reversed a taxpayer's certification because of his promise to pay, and he failed to pay. IRS may also ask State to revoke a passport if the taxpayer could use offshore activities or interests to resolve his debt but chooses not to.

Before contacting State about revoking a taxpayer's passport, IRS will send Letter 6152, Notice of Intent to Request U.S. Department of State Revoke Your Passport, to the taxpayer to let him know what IRS intends to do and give him another opportunity to resolve his debts. Taxpayers must call IRS within 30 days from the date of the letter. Generally, IRS will not recommend revoking a taxpayer's passport if the taxpayer is making a good-faith attempt to resolve his tax debts.

The IRS can help taxpayers resolve their tax issues and expedite reversal of their certification to State. When expedited, IRS can generally shorten the 30 days processing time by 14 to 21 days. For expedited reversal of their certification, taxpayers will need to inform IRS that they have travel scheduled within 45 days or that they live abroad.

For expedited treatment, taxpayers must provide the following documents to IRS:

·                 Proof of travel. This can be a flight itinerary, hotel reservation, cruise ticket, international car insurance, or other document showing location and approximate date of travel or time-sensitive need for a passport.

·                 Copy of letter from State denying their passport application or revoking their passport. State has sole authority to issue, limit, deny, or revoke a passport.

The Information Release also repeats the information from IR 2019-23 regarding steps taxpayers can take to avoid having IRS notify State and circumstances under which IRS will not issue certifications to State.

IRS has begun sending letters to virtual currency owners advising them to pay back taxes and/or file amended returns

In IR-2019-132, July 26, 2019, the Internal Revenue Service has begun sending letters to taxpayers with virtual currency transactions that potentially failed to report income and pay the resulting tax from virtual currency transactions or did not report their transactions properly.

"Taxpayers should take these letters very seriously by reviewing their tax filings and when appropriate, amend past returns and pay back taxes, interest and penalties," said IRS Commissioner Chuck Rettig. "The IRS is expanding our efforts involving virtual currency, including increased use of data analytics. We are focused on enforcing the law and helping taxpayers fully understand and meet their obligations."

The IRS started sending the “educational letters” to taxpayers last week. By the end of August, more than 10,000 taxpayers will receive these letters.

For taxpayers receiving an educational letter it purpose is to help taxpayers understand their tax and filing obligations and how to correct past errors.

Last year the IRS announced a Virtual Currency Compliance campaign to address tax noncompliance related to the use of virtual currency through outreach and examinations of taxpayers. The IRS will remain actively engaged in addressing non-compliance related to virtual currency transactions through a variety of efforts, ranging from taxpayer education to audits to criminal investigations.

Virtual currency is an ongoing focus area for IRS Criminal Investigation.

IRS Notice 2014-21 states that virtual currency is property for federal tax purposes and provides guidance on how general federal tax principles apply to virtual currency transactions. Compliance efforts follow these general tax principles. The IRS will continue to consider and solicit taxpayer and practitioner feedback in education efforts and future guidance.

Taxpayers who do not properly report the income tax consequences of virtual currency transactions are, when appropriate, liable for tax, penalties and interest. In some cases, taxpayers could be subject to criminal prosecution.

Advance Payment for Goods--Reg. 1.451-5 Removed by TD 9870

Prior to the TCJA, Reg. §1.451-5 provided special rules for advanced payment for goods and long term contracts. These rules were superseded by revised IRC §451(c). The prior regulations implementing IRC §451 allowed taxpayers generally to defer the recognition of advance payment for goods until the tax year in which the payments were properly accruable under the taxpayer's method of accounting for tax purposes if that method results in the payments being included in gross income no later than when they are includible in gross receipts under the taxpayer's method of accounting for financial reporting purposes.[1]

Revised IRC §451(c) and its election to defer advance payments removed the deferral method provided by Reg. §1.451-5.[2] On July 15, 2019 the Treasury issued T.D. 9870 and removed Reg. §1.451-5 and its cross references. Removing Reg. §1.451-5 ensures that the new deferral rules of IRC §451(c) apply uniformly and consistently to all taxpayers and simplifies tax administration. The rules of IRC §446 regarding changes in methods of accounting apply to taxpayers changing a method of accounting for advance payments from a method described in Reg. §1.451-5 to another method of accounting[3]. The removal of Reg. §1.451-5 is effective for tax years ending on or after Jul. 15, 2019. 

Current Rule

Code §451(c) generally requires an accrual method taxpayer that receives any advance payment described in IRC §451(c)(4) during the tax year to include the advance payment in income in the tax year of receipt or make an election to:

(1) include any portion of the advance payment in income in the tax year of receipt to the extent required under Code Sec. 451(b); and

(2) include the remaining portion of the advance payment in income in the following tax year.  

Under IRC 451(c)(2) a taxpayer may make a deferral election for any portion of the advance payment that is otherwise required to be included in gross income under financial statement rules.  If the election is made the advance payment would be included in gross income in the tax year in which it is received and the remaining portion of the advance payment would be included in gross income in the tax year following the tax year in which it is received.[4] An item of gross income is received by the taxpayer if it is actually or constructively received, or if it is due and payable to the taxpayer.[5]

Treasury and the IRS expect to issue guidance for the treatment of advance payments to implement the TCJA amendments to IRC §451. In the meantime, taxpayers with or without applicable financial statements may continue to rely on Rev. Proc. 2004-34 for the treatment of advance payments. Until new guidance is issued, the IRS will not challenge a taxpayer’s use of Rev Proc 2004-34 to satisfy the requirements of IRC § 451, although it will continue to verify on examination that taxpayers are properly applying Rev Proc 2004-34[6].

How to elect to defer inclusion of advance payments in income. The IRS is instructed to provide details on making the election to defer the inclusion of advance payments in income. This includes the time, form and manner, and the categories of advance payments. The election will be effective for the tax year with respect to which it is first made and for all subsequent tax years, unless the taxpayer obtains the IRS's consent to revoke the election.[7]

Change of accounting method. The computation of taxable income under the deferral election for advance payments is treated as a method of accounting.[8] In the case of any qualified change of accounting method for the taxpayer's first tax year beginning after December 31, 2017, the change is treated as initiated by the taxpayer and made with the IRS's consent. A qualified change of accounting method is any change of accounting method that is required by the new income recognition rules or was prohibited and is now permitted under the new rules.[9] For a qualified change of accounting method involving income from a debt instrument with original issue discount (OID), taxpayers should use a six-year period for taking into account any required IRC §481 adjustments.[10]

What is an Advance Payment?

Rev. Proc. 2004-34 allows a one-year deferral in certain cases of prepaid income. The ruling pertains to prepayment for services to be rendered before the end of the next succeeding year. In particular, Rev. Proc. 2004-34 provides that a payment received by a taxpayer is an advance payment if:

(1)    the inclusion of the payment in gross income for the taxable year of receipt is a permissible method of accounting for federal income tax purposes;

(2)    the payment is recognized by the taxpayer (in whole or in part) in revenues in the taxpayer's applicable financial statement for a subsequent taxable year or, for taxpayers without an applicable financial statement, the payment is earned by the taxpayer (in whole or in part) in a subsequent taxable year; and

(3)    the payment is for

(a) services;

(b) the sale of goods;

(c) the use (including by license or lease) of intellectual property;

(d) the occupancy or use of property, if the occupancy or use is ancillary to the provision of services (for example, advance payments for the use of rooms or other quarters in a hotel, booth space at a trade show, campsite space at a mobile home park, and recreational or banquet facilities, or other uses of property so long as the use is ancillary to the provision of services to the property user);

(e) the sale, lease, or license of computer software;

(f)  guaranty or warranty contracts ancillary to an item or items described in subparagraph (a), (b), (c), (d), or (e), above;

(g) subscriptions (other than subscriptions for which an election under IRC §455 is in effect), whether or not provided in a tangible or intangible format;

(h) memberships in an organization (other than memberships for which an election under IRC §456 is in effect);

(i)              an eligible gift card sale; or

(j)  any combination of items described in subparagraphs (a) through (i) above.

 What Are Not Advance Payments

Under Rev. Proc. 2004-34, the term “advance payment” does not include:

•           Insurance premiums, to the extent the recognition of those premiums are governed by Subchapter L;

•           Payments with respect to financial instruments (for example, debt instruments, deposits, letters of credit, notional principal contracts, options, forward contracts, futures contracts, foreign currency contracts, credit card agreements, financial derivatives, etc.), including purported prepayments of interest;

•           Payments with respect to service warranty contracts for which the taxpayer uses the accounting method provided in Rev. Proc. 97-38;[11]

•           Payments with respect to warranty and guaranty contracts under which a third party is the primary obligor;

•           Payments subject to IRC §§871(a), 881, 1441, or 1442;

•           Payments in property to which IRC §83 applies;

•           Rent; and

•           Any other payment identified by the IRS for this purpose.[12]

Advance Payment” Defined Under IRC §451(c)(4)

Under IRC §451(c)(4) an “advance payment” is any payment:[13]

• the full inclusion of which in the taxpayer’s gross income for the tax year of receipt is a permissible method of accounting under IRC §451 (determined without regard to IRC §451[14];
• any portion of which is included in revenue by the taxpayer in a financial statement described in IRC §451(b)(1)(A)(i) or IRC §451(b)(1)(A)(ii) for a later tax year[15] and
• which is for goods, services, or other items as the IRS may identify for these purposes[16].

Except as otherwise provided by the IRS, an advance payment does not include:

• rent[17];
• insurance premiums governed by subchapter L (IRC §801 through IRC §848)[18];
• payments as to financial instruments[19];
• payments as to warranty or guarantee contracts under which a third party is the primary obligor[20];
• payments subject to:
• IRC §871(a) (i.e., the tax on income of nonresident alien individuals not connected with a U.S. business),
• IRC §881 (i.e., the tax on income of foreign corporations not connected with a U.S. business),
• IRC §1441 (i.e., the tax withheld on certain amounts paid to foreign persons), or
• IRC §1442 (i.e., the tax withheld from income of foreign corporations)[21].
• payments in property to which IRC §83 (taxation of property transferred in connection with the performance of services., and
• any other payment identified by the IRS for purposes of IRC §451(c)(4)(B)[22].

An item of gross income is received by the taxpayer if it is actually or constructively received, or if it is due and payable to the taxpayer[23].

            Until Treasury issues new guidance regarding advance payment for goods, taxpayer can rely on IRC §451(c)(4) for treatment of advance payments.

           

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[1] See Reg. §1.451-5(b)(1)(ii)(a).

[2] See H.R. Rep. No. 115-466, at 429 n.880 (2017) (Conf. Rep.).

[3] T.D. 9870.

[4] IRC §451(c)(1)(B), as added by TCJA.

[5] IRC §451(c) (4)(C), as added by TCJA.

[6] Notice 2018-35, Sec. 3.

[7] IRC §451(c)(2), as added by TCJA.

[8] IRC §451(c)(2)(B), as added by TCJA.

[9] TCJA §13221(d).

[10] TCJA §13221(e)(2).

[11] 1997-2 CB 479.

[12] IRC §451(c)(4)(B), as added by the TCJA.

[13] IRC § 451(c)(4)(A).

[14] IRC § 451(c)(4)(A)(i).

[15] IRC § 451(c)(4)(A)(ii).

[16] IRC § 451(c)(4)(A)(iii).

[17] IRC § 451(c)(4)(B)(i).

[18] IRC § 451(c)(4)(B)(ii)

[19] IRC § 451(c)(4)(B)(iii)

[20] IRC § 451(c)(4)(B)(iv)

[21] IRC § 451(c)(4)(B)(v)

[22] IRC § 451(c)(4)(B)(vii)

[23] IRC § 451(c)(4)(C).