An Attorney, A CPA and Confidentiality

Do you have privacy protection if you tell me something as your CPA?

Your first thought might be yes, as your CPA might be the financial doppelganger to an attorney.

Then again, the answer might be no, as your CPA is not in fact an attorney – unless he/she is one of those rare birds that pairs-up a JD/CPA.

What got me thinking along these lines is the recent case US v Galloway.

Let’s travel to 2006. The IRS notifies Galloway that his 2003 return has been pulled for audit.

Audit starts.

In the middle of the audit Galloway’s CPA fires him. Why? Galloway did not pay his fees.

In 2008 Galloway gets sent to CID (Criminal Investigation Division), the part of the IRS that carries badges and guns.

As a heads-up: you NEVER want to deal with CID. It is one thing to argue with regular IRS, appeal penalties, stretch out a payment plan and so on. All that crowd wants is your money. CID investigates criminal conduct and they have a different goal: to put you in jail.

CID agents went to his business offices in Bakersfield, California. Upon their approach, a man in the office locked the door and called the police.

The CID agents also called the police and informed them there were two plain clothed and armed federal agents waiting for them to arrive.

The man stepped out of the building and provided them with the name of an attorney. The CID agents cleared out before the police arrived.

Nothing. Suspicious. There.

Since that visit went so well, CID next issued a summons for production of documents to the former CPA.

The CPA met with them, explained his relationship with Galloway and answered questions on how he prepared Galloway’s 2003 return. No great surprise: Galloway had forwarded QuickBooks information; the CPA asked a few questions, massaged a few numbers and produced a tax return. Happens in a thousand CPA offices every day.

There was a smidgeon of a problem, though.

Remember that the CPA had started the Galloway audit. As part of the audit, Galloway had provided him more paperwork, including additional and replacement QuickBooks runs. No big deal - usually.

What was unusual was that the new QuickBooks runs did not match-up to the earlier run the CPA used for the tax return.  

Galloway was charged with four counts of attempting to evade tax.

What to do?

Galloway sought to suppress all evidence obtained from his prior CPA. Why? Code Section 7609. The AICPA Code of Professional Conduct. Equitable authority. Applebee’s 2 for $20 menu.

You get it: kitchen sink. Galloway was throwing everything he had.

And this brings us to the Couch case from 1973. It was a Supreme Court case, so it is big-time precedent.

Couch owned a restaurant. At issue was unreported income. Cash. Pocket. Wink. You understand.

The IRS issued a subpoena to Couch’s accountant for books, records, bank statements, cancelled checks, deposit ticket copies, Sunday newspaper coupons and unexpired S&H green stamps.

Couch said: hold up. She had provided all that stuff to her accountant, so subpoenaing her accountant rather than her personally was nonetheless a violation of her Fifth Amendment right against self-incrimination.

I like her argument.

Ultimately – as Captain Picard would say – her argument was futile.

The Court was short and swift: Couch had no “legitimate expectation of privacy” upon providing information to a third-party with the goal of processing, straining and compressing that same information onto a government tax return.

Back to Galloway.

As you can see, he was taking a low-probability swing on a high-and-tight fastball.

He struck out. He could not make enough separation between his situation and Couch to avoid the precedent.

How do tax CPAs handle situations like Galloway in practice?

First of all: interaction with CID is rare. One can have a long career and never see the criminal side of the IRS.  

I have run into CID once or twice over 30+ years, most recently in connection with a fraudulent tax preparer in northern Kentucky. I also recently (enough) represented a client whose file was submitted by Exam to CID, but CID rejected the matter. The client was eye-rollingly negligent, but Exam hyperventilated (I thought then and now) and started seeing intent where only stupidity abounded.  

Anyway, here is what the CPA should recommend:

(1) Have the client hire an attorney

(2) Have the attorney hire the CPA

Under this arrangement, the CPA works for the attorney. He/she is protected under the attorney’s confidentiality privilege and cannot be compelled to testify unless the attorney releases him/her. The attorney will not – of course -  do any such thing.

This set-up is called a “Kovel,” by the way. Not surprisingly, it refers to a case by the same name.

What did Galloway’s accountant do wrong?

To be fair: nothing. Galloway was no longer a client. He was under no obligation to chase Galloway down.

Galloway really should have thought of that before stiffing the CPA for his fee.

Let’s however say Galloway was still a client. 

Folks, at the first hint or whiff of a criminal investigation I am (1) firing you or (2) you are providing me with a Kovel. Those are the only two options.

But it requires the accountant to recognize the danger signs.

Like a combined civil-criminal IRS examination, for example. Those are borderline unfair, as the IRS will pretend there is no criminal side to it. They introduce an unsettling miasma of entrapment, and they require the tax practitioner to realize that he/she is being played.

But that is not what happened with Galloway. CID went to his office, for goodness’ sake.

There was not a lot of subtlety there.

Lawsuits, Attorney Fees and What Is A “Relator” Anyway?

I have a friend who was considering employment litigation earlier this year. His job has sufficient visibility that it attracts people – some unpleasant and others unhinged. Couple that with a political-correctness-terrified employer and you have a combustible mix.

The taxation of litigation damages leaves room for improvement. Certain types of litigation – say personal injury or employment – are commonly done on a contingency basis. This means that the attorney does not receive fees unless the case is successful or settled. A common contingency fee is one-third. A rational tax system would recognize that the litigant received 67 cents on the dollar and assess tax accordingly. Our system does not do that.

Our tax Code wants to tax the litigant on the full proceeds, although one-third or more went to the attorney. The Code does allow one to deduct that one-third as a miscellaneous itemized deduction. It sounds great but many – if not most – times it amounts to nothing. Why? 

·        Miscellaneous itemized deductions are deductible only to the extent that they exceed 2% of your adjusted gross income (AGI). Swell that AGI to unrepresentative levels - say by the receipt of damages – and that 2% can amount to a high hurdle.

·        Even that result can be overridden by the alternative minimum tax (AMT). The AMT does not allow miscellaneous deductions at all. Forget about deducting that contingency fee if you are an AMT taxpayer, which you likely will be.

·        Then you have states, such as Ohio, which do not allow itemized deductions. The damages are sitting in your AGI, though. It stinks to be you.

How did we get to this place?

We know that the tax Code allows one to deduct business expenses against related business income. There may be restrictions – entertainment expenses, for example, or limitations on depreciation – but overall the concept holds. The result of this accounting exercise enters one’s tax return as net profit or loss.

But not always.

For example, I am in the trade or business of being an employee of my accounting firm. My salary enters my individual tax return as gross income. What if I have business expenses relating to the practice?  The IRS allows me to deduct those, but not directly against my salary. The IRS instead wants me first to itemize and then claim my accounting-practice expenses therein as a miscellaneous deduction. Miscellaneous deductions are the redheaded stepchild of itemized deductions. They are never deductible in full, and depending on one’s situation, they may not be deductible at all.

Extrapolate this discussion to the recipient of a legal settlement and you have the issue I have with accounting-practice expenses – but greatly magnified, as the dollars are likely more substantive.

So I was pleased to review the case of Bagley v United States.

Richard Bagley had an MBA and a M.S. in accounting. He worked for TRW Inc, and from 1987 to 1992, he was the Chief Financial Manager for their space and technology group. TRW did a lot of work for the government, meaning they had to follow certain accounting procedures when requesting payment from the government. Remember that Bagley was in charge of the accounting, and you have a good idea of where the story is going.

Bagley became aware of bad accounting. He nonetheless signed certifications to the government, mostly because he needed the job. He did the good soldier thing and reported his concerns to his superiors. TRW in turn notified him that he was going to be laid off because of a corporate reorganization, rising tides, Punxsutawney Phil not seeing his shadow and the Chicago Cubs missing the World Series.

He was laid off in 1993.

In 1994 he brought a wrongful termination lawsuit against TRW.  He lost that lawsuit.

In that same year, he filed a False Claims Act (FCA) on behalf of the United States against TRW.

There is a peculiarity about a FCA lawsuit that we should discuss. Although Bagley brought the FCA lawsuit, the action was technically brought by the United States against TRW for fraud. Bagley stood-in as an agent for the United States, and his status was that of “relator.”

Bagley took this matter seriously.

During the 1994 to 2003 time period, Bagley exclusively worked on his FSA prosecution activity, and was not otherwise employed.”

He maintained a contemporaneous log of hours he worked on the litigation. He attended meetings with his attorney and government counsel. He spent a lot of time looking through TRW documents. He stayed involved because the attorneys

… weren’t accountants and hadn’t spent 25 years working with TRW and didn’t have an in-depth understanding of TRW’s accounting system or the people or the products or anything about the company which was  necessary to understand how the frauds occurred and where the evidence was.”

He logged approximately 5,963 hours working on the FCA. He put in those hours 

… in order to successfully prosecute the claims so that [he] would receive an award.”

In 2003 TRW paid the government, which in turn paid Bagley $27,244,000. He in turn paid his attorney $8,990,520. TRW also paid Bagley’s attorneys $9,407,295 and issued the Form 1099 to Bagley.

NOTE: This is standard treatment. The payment to the attorney is imputed to the litigant.

He filed his 2003 Form 1040. There was some complexity on how to handle the attorney fees paid directly by TRW, so he amended the return. He went the usual route of deducting the attorney fees as a miscellaneous deduction. He amended a second time, this time showing the relator litigation as Schedule C self-employment income. He was now deducting the attorney fees directly – and fully - against the litigation proceeds.

The IRS bounced the seconded amended return.

There really was only one issue: did Bagley’s litigation activity rise to the level of Bagley being self-employed?

The Court went through the analysis:

·        Pursuing the activity in a business-like manner

·        Expertise

·        Time and effort expended

·        Success in carrying on similar activities

·        History of income and losses with respect to the activity

·        Financial status while pursuing the activity

·        Elements of personal pleasure or recreation

·        Regularity and continuity

The IRS argued along different lines. They reminded the Court of the origin and character of the activity giving rise to the FCA claim. Bagley’s claim was that of an informant, according to the IRS, not that of a relator prosecuting the case. According to them, it was Bagley’s status as an informant, not his activities as a relator – that drive the tax consequence.

The Court decided that an action under the FCA was different from a tort action, as the “gravamen” of a FCA action was fraud against the government. The relator stands in the shoes of the government in order to prosecute the claim. This consequently was not a personal claim that Bagley had undertaken. He had no personal stake in the damages sought – all of which, by definition, were suffered by the government.

The Court decided that Bagley did have a trade or business, and that the second amended return was correct. The government was to refund him approximately $3,874,000 plus interest for his 2003 tax year.

Note the tax year involved: 2003. This case was decided just this summer. Sometimes these matters take a while to resolve, but this was an especially slow boat on a lazy river.

OBSERVATION: The facts are too unique for this case to provide much precedence, but I am pleased that Bagley won. Frankly, a minor change to the tax law would make this case obsolete and remove the tax nightmare from future litigation settlements. Simply allowing the litigant to recognize the net damages as income would solve this matter. It would also reflect the equity of the transaction. Do not hold your breath, though.

Couples Must Now File Separate Powers of Attorney

Starting March 1, 2012 married couples will have to file separate powers of attorney for their tax representative.

It used to be that both spouses could sign one power naming a representative. You may recall that you signed near the top of page 2. That has changed because of increased sensitivity to privacy and data security.

There is another change on the power, but the change applies to tax representatives. The representative must now include his/her PTIN on the power. Tax advisors may remember that the IRS has discussed increased practitioner enforcement, including automatic referral to the Office of Professional Responsibility of a practitioner associated with a substantial understatement penalty. The PTIN is a way to identify a specific return to a specific tax preparer.