Tax Blog/Blawg

With the IRS’s increasing emphasis on transfer pricing and other tax issues that depend upon economic and scientific concepts and analyses, tax attorneys frequently rely on non-legal professionals to provide expert assistance in areas with which an attorney might not be familiar.  While this non-legal expertise helps facilitate the attorney’s representation of her client, the introduction of these non-legal professionals into the attorney-client relationship poses an obvious concern about breaching the attorney-client privilege.  Ordinarily, if someone other than the attorney and the client is included in a communication, the attorney-client privilege is unavailable.

For the last fifty years, however, taxpayers and their attorneys have relied on so-called Kovel engagements to extend the zone of privilege to include communications with certain non-legal professionals.  In a Kovel engagement, the attorney retains the non-legal professional to provide technical advice that enhances the attorney’s ability to provide informed legal advice to her client.

Kovel engagements take their name from a 1961 appellate court decision, United States v. Kovel, 296 F.2d 918 (2d Cir. 1961), in which a law firm hired an accountant to assist in its representation of a client under investigation for tax fraud.  When the accountant was held in contempt of court for refusing to answer questions in front of a grand jury, the Second Circuit reversed the contempt citation, reasoning that the accountant was akin to a “translator,” helping the attorney provide legal advice that depended upon an unfamiliar “language” (i.e., accounting).  As a result, communications among the accountant, the attorney, and the ultimate client were protected from disclosure through an extension of the attorney-client privilege.

As my colleague, Phil Karter, pointed out around this time last year, however, the IRS has made rumblings about challenging Kovel engagements in certain contexts.  In our experience, it is unusual for an IRS exam team to challenge the validity of a putative Kovel engagement, even one involving an accounting firm.  Nevertheless, trusted advisors aren’t hired to protect their clients from only usual challenges; good counseling frequently demands that we anticipate the unusual as well.  In that spirit, I offer below a few thoughts, based on recent experiences, about good practices in managing Kovel engagements.

First, recall that, from the perspective of the non-legal advisor, the attorney is the client in a Kovel engagement.  As a result, advisors should address all correspondence related to the engagement (e.g., memoranda and reports) to the attorney, and anytime the “client” is defined in the correspondence, it should be defined as the attorney, not the ultimate client whom the attorney is serving.  Memoranda that are intended to provide advice to the attorney should not be addressed to “The File.”  Such careless drafting raises unnecessary questions by suggesting, however weakly, that the document was written not for the purpose of assisting counsel, but as an internal rumination by the advisor.  (To be sure, in a litigation context, such documents might nevertheless be protected by the work product doctrine; however, as a matter of good practice, attorneys and their advisors should not undermine any claims of privilege simply because of imprecise drafting.)

Second, because the attorney is the client in a Kovel engagement, traditional engagement letters employing “boilerplate” provisions are generally not appropriate.  For instance, some service providers include language in their engagement letters stating that their work product remains their property during, and at the conclusion of, the engagement.  Such a provision is inconsistent with the nature of the Kovel arrangement in which the work product becomes part of the attorney’s files.  (The work product is, after all, intended to assist the attorney in the provision of legal advice.)

Third, special considerations arise when (as in the original Kovel case) the non-legal advisor being retained is (or works for) an accounting firm.  Often times, a client will want to engage its financial auditor to advise the attorney.  From the client’s perspective, such an arrangement has obvious benefits: accounting firms often bring industry-specific expertise, and their institutional familiarity with the client can help reduce the costs of the engagement.  For all its benefits, the involvement of a firm with a pre-existing relationship also raises important issues.  As the Second Circuit noted, the facts surrounding a putative Kovel arrangement must establish that the accountant's communications were “made in confidence for the purpose of obtaining legal advice from the lawyer.”  United States v. Adlman, 68 F.3d 1495, 1499-1500 (2d Cir. 1995).  Thus, questions can arise about the nature and scope of a putative Kovel engagement involving an accounting firm that has a pre-existing relationship with the ultimate client.

For example, information gained by the accounting firm in its capacity as an advisor under a Kovel engagement must be distinguished from information gained by the firm in its capacity as a financial auditor.  While information learned under the Kovel engagement can be protected, information learned under the auditing relationship cannot.  As a result, all parties in those circumstances should take care to establish protocols at the outset of the relationship for identifying and protecting information and communications that are intended to fall within the scope of the Kovel engagement.  Pre-emptive consideration of these protocols will help minimize the risk of challenge.

As with so much else in the tax law, the substance (and not the form) of a putative Kovel engagement will determine whether it will ultimately be respected.  Therefore, once the parties have laid out appropriate protocols, they must also ensure that those protocols are followed throughout the engagement.

As suggested last year, the IRS may become more aggressive about challenging Kovel engagements.  Nevertheless, so long as clients and their advisors take steps to protect the substance of the arrangement (including the above considerations), the associated risks can be managed.