The effect of the IRS Restructuring and Reform Act of 1998 on federal income tax controversies.

• Author: Frantzen, Tamara L.

On July 22, 1998, President Clinton signed the IRS Restructuring and Reform Act of 1998 (the Act).(1)(*) The Act represents the culmination of years of focus and debate on taxpayer rights, privilege issues, and overall improvements to the administration of federal tax law. The Act contains several administrative and procedural provisions that affect, in some cases significantly, the manner in which taxpayer controversies with the Internal Revenue Service will be handled in the future. This article summarizes these key provisions as they affect tax controversies at the audit, the IRS Office of Appeals, and judicial levels.

Conduct of IRS Audits

The Confidentiality Privilege

Under common law, confidential communications between a client and its attorney, acting as an attorney, for the purpose of securing legal advice are protected from disclosure to the IRS under the attorney-client privilege.(2) Prior to the Act, the privilege was limited to dealings between the taxpayer and its attorney (or individuals retained by the attorney to assist the attorney in rendering legal advice)(3), but not to dealings between the taxpayer and its other tax advisers.(4)

The Act extends under limited conditions the common law attorney-client privilege to communications with respect to tax advice rendered to the taxpayer by its "federally authorized tax practitioner" made on or after July 22, 1998.(5) A "federally authorized tax practitioner" is an individual authorized under federal law to practice before the IRS (i.e., attorneys, certified public accountants, enrolled agents, and enrolled actuaries).

The new confidentiality privilege is subject to various limitations. For instance, the privilege does not apply to criminal administrative and judicial tax proceedings.(6) It also is inapplicable to communications between a federally authorized tax practitioner and a corporate director, shareholder, officer, employee, agent, or representative in connection with the promotion of the corporation's direct or indirect participation in any tax shelter.(7) A "tax shelter" for these purposes is defined by reference to section 6662(d)(2)(C)(iii) and includes any partnership, other entity, investment plan or arrangement, or any other plan or arrangement having as a significant purpose the avoidance or evasion of federal income tax.(8) Congress deemed these communications to fall outside of the "routine relationship" between a taxpayer and its tax adviser and thus undeserving of privilege protection.(9) In addition, the privilege does not operate to limit the ability of other regulatory bodies, such as the Securities and Exchange Commission, from obtaining information and thus the privilege cannot be asserted in administrative or judicial dealings with those regulatory bodies.(10)

Moreover, the privilege applies only with regard to "tax advice," which is defined in the Act broadly as advice given by the federally authorized tax practitioner with respect to matters within the scope of that individual's authority to practice before the IRS..(11)

The confidentiality privilege is further limited by the common law principles governing the attorney-client privilege. The overarching principle is that the new privilege applies only to the extent that a communication would be privileged had it occurred between a taxpayer and its attorney.(12) For instance, the Conference Report provides that information used in preparing a tax return -- a document destined for disclosure to the IRS -- is not protected.(13) The privilege also does not protect general business Advice(14) or other communications intended for disclosure to third parties, including annual reports and similar public disclosures.(15) The common law conditions under which the attorney-client privilege is waived, such as disclosure to a third-party, apply with equal force to the confidentiality privilege.(16)

The application of the statutory and common law restrictions on privileged communications is fraught with ambiguity and ripe for controversy absent guidance from Congress or the IRS. For example, if the taxpayer's certified public accountant raises a sensitive tax issue during the course of preparing the taxpayer's annual report or tax return, do the ensuing communications relating to that issue with that accountant, or even with other members of the same accounting firm, relate to "tax advice" or to the preparation of the annual report or tax return that is intended to be disclosed to third parties? Similarly, if a communication relates to both tax and non-tax advice, is it protected under the confidentiality privilege in its entirety, in part, or not at all?

Unfortunately, dual-purpose communications or communications that depart from their original focus can undermine the protection of the privilege. Thus, until guidance is issued, taxpayers should exercise caution in their dealings with tax advisers and clearly distinguish (and identify) sensitive tax-related communications for which tax advice (and, hence, confidentiality) is sought from other communications that are either wholly or in part tax-related or which potentially are subject to third-party disclosure. In the same vein, taxpayers must carefully analyze the role and capacity of the adviser to whom the communications are directed to ensure that privilege is preserved.

In the event that this distinction is not maintained, taxpayers dealing with attorney and non-attorney tax advisers may under certain conditions be able to rely on the protection of the work product doctrine, a qualified privilege that protects from disclosure certain materials prepared by or in some cases for an attorney in anticipation of litigation.(17) The taxpayer still faces the challenge, however, in applying the work product doctrine to determine whether the information at issue was prepared "in anticipation of litigation."

The new confidentiality privilege applies to federal tax matters. It does not trump the applicability (or inapplicability) of state common law privileges as applied to information involved in state tax controversies. In addition, the federal privilege does not guarantee that items protected under the federal confidentiality statute retain their cloak of privilege in private litigation with parties other than the IRS. For these reasons, taxpayers should exercise caution in state tax or private controversies and may wish to have their attorneys retain non-attorney tax advisers (rather than retaining the non-attorneys directly).

Taxpayer Assistance Orders

If a taxpayer is suffering or is about to suffer a significant hardship as a result of how the IRS is conducting an examination of the taxpayer or the manner in which the IRS is administering the Code, the taxpayer since 1988 has had the right to bring this hardship to the attention of the office of the National Taxpayer Advocate.(18) The Taxpayer Advocate's office has authority to issue a Taxpayer Assistance Order (TAO) to require the IRS, for instance, to release levied property or cease or refrain from taking certain actions against the taxpayer.(19)

The Act attempts to clarify the TAO procedure by spelling out the circumstances under which a TAO should be issued. Specifically, it provides that a "significant hardship" exists if the taxpayer faces one of the following four conditions: (1) an immediate threat of adverse action; (2) a greater than 30-day delay in resolving account problems; (3) significant costs; or (4) irreparable injury or a long-term adverse effect.(20) The four specified conditions are intended to provide guidance to the IRS for issuing a TAO and are not intended to represent an exclusive list of factors giving rise to a "significant hardship." This provision is effective July 22, 1998.

Civil Damages for Unauthorized Collection

Under prior law, a taxpayer could sue the United States in a federal district court for up to $1 million in civil damages arising from the reckless or intentional disregard of the Code or regulations by IRS employees or officers in connection with the collection of federal tax.(21) The Act broadens the taxpayer's right to sue for such misconduct occurring after July 22, 1998. Specifically, it retains the $1 million damage cap for reckless or intentional disregard of the tax law, but now allows a taxpayer to recover up to $100,000 in damages arising from simple negligent disregard of the tax law by an IRS employee or officer in connection with the collection of federal tax.(22)

The Act further extends the right to sue to third parties who are adversely affected by improper IRS collection activity occurring after July 22, 1998.(23) The Act also reinstates the limitation that no civil damages may be awarded unless the taxpayer or the third-party litigant exhausts administrative remedies available within the IRS.(24)

Third-Party Contact: Pre-Contact Notification to Taxpayer

The IRS has broad investigative authority under sections 7602 and 7609 to contact third parties, including third-party recordkeepers, in connection with the examination of a taxpayer. Under prior law, the IRS was required to notify the taxpayer of this contact after the contact was made (i.e., within three days of serving a summons on the third party).(25)

The Act reverses this procedure by requiring the IRS to provide the taxpayer with reasonable notice in advance that the IRS may make contact with third parties in connection with an examination of the taxpayer.(26) The IRS also must periodically provide the taxpayer with a record of persons contacted.(27) No pre-contact notice is required, however, for contacts (1) authorized by the taxpayer; (2) for which notice would jeopardize collection efforts or would involve reprisal against any person; or (3) relating to a pending criminal...