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.

New Jersey and the Telecommuter

We are visiting state taxation today. Our trip this time will take us to New Jersey, and it will highlight how tax law can simultaneously arrive at a technically correct but bumble-headed conclusion.

Let’s say you manufacture parts in New Jersey. Would you expect to file and pay state income tax to New Jersey?

That one is easy - of course. You are doing business there – in the meaningful sense of the phrase. You have a building, you have employees. You park your car out front. You visit Chipotle for lunch. You are there.

Let’s make this more challenging. You do not manufacture parts. You do not manufacture anything. You develop software. Your offices are in Rockville, Maryland. You do not have offices in New Jersey. You do not park your car in New Jersey or visit their Chipotle for lunch. You are not there. You have an employee who moves to New Jersey. You like her. You keep her on board.

Like a Jim Croce song, you have a name.  Your name is Telebright.

Let’s have her work from her new home. She begins her workday at 9:00 a.m. by checking with her project manager, who is based in Boston. She receives daily work assignments. When done, she uploads her work and sends it to you. She is expected to work 40 hours a week. She could live on the moon, for what location matters to her work.

She does not solicit customers. She does not have sales responsibility. She does not refresh products, or stock shelves, or install, or service. She does not supervise employees. She does not have management authority. You do not even reimburse for her office-in-home. She travels twice a year to Maryland. By the way, you do not pay for the travel – rather she pays for those trips out of her own pocket.

You – being enlightened – take New Jersey withholding taxes out of her paycheck so that she has no rude April 15^th surprise.

New Jersey surfaces, somewhat like the mutant alligator in a bad Sci-Fi network movie. New Jersey says that you are doing business in the state, and it wants you to … (wait on it) … pay corporate income taxes!

The case goes before the New Jersey Tax Court. The court cites the New Jersey statute:

Every domestic or foreign corporation which is not hereafter exempted shall pay an annual franchise tax for each tax year, as hereafter provided … for the privilege of doing business , [or] employing or owning capital or property … in this state.”

The Court then reflects philosophically:

The term ‘doing business’ is used in a comprehensive sense and includes all activities which occupy the time or labor of men for profit.”

It rolls up its sleeves and grittily reviews the law (N.J.A.C. 18:7-1.9(b)):

Whether a foreign corporation is doing business in New Jersey is determined by the factors in each case. Consideration is given to such factors as:

(4) The employment in New Jersey of agents, officers and employees.”

Oh, oh. This is going to go wrong, isn’t it? Or is it possible the court will recognize that a lone employee in the state hardly amounts to a corporate beachhead?  Here is the Court:

There is no one, single controlling factor nor is there a bright line standard that determines whether a foreign corporation’s in-state activities meet the Director’s regulatory requirements for doing business. Rather, it is only by close scrutiny of all the facts of the case, taken as a whole, that a final determination can be made. ”

It then digs in like a free agent seeking a new sports contract and drives for the bright line.

It cannot be disputed that plaintiff satisfies factor 4 … by employing Ms. … in New Jersey.”

[Telebright] agreed to permit Ms. … regularly to perform her duties at her New Jersey home.”

This consistent contact with New Jersey was not sporadic, occasional or intermittent.”

But the Court pauses. Will it realize that you are being a good sport for even keeping her employed after the move? Will it acknowledge that this is not a 19^th century economy, when a county seat could not be more than a day’s travel for any resident of the county? It hesitates:

“While it is true that [Telebright] has never maintained an office in New Jersey, nor solicited business here ….”

No! Not now Tax Court of New Jersey! You are so close!

The Court shakes it off:

 … [its] daily contact with the State through its employee is sufficient to trigger application of the CBT Act.”

The mere fact that Ms. … is the only … employee in this State does not change the court’s decision.”

Yes, the court determined that Telebright was responsible for New Jersey corporate tax because it permitted an employee to work from her home in New Jersey.

Why does this upset me?

One reason is that reasoning like this would have me filing taxes with India if I hired an on-line bookkeeper there.

Another reason is that I have read court decisions like this for more than two decades now. After a while it is like watching WWE wrestling – there really isn’t much suspense about who is going to win. There was a time when a state at least tried to develop coherent doctrines and workable principles. In recent years however state tax has become more like a hijacking on a Sopranos episode.

Another reason is this is an employee-hostile decision.

I have a friend and client, for example, who lives in Kentucky and commutes to California. Yes, you read that right. He works a week here in Kentucky and a week near San Francisco. He is situated well enough at the company that he floated the idea of having an “office” here. The company turned him down. Why? Because they do not have a footprint in Kentucky and his “office” could create one. So he commutes every other week to California. I suspect he may be their only Kentucky-resident employee.

If you were Telebright, what would you do? Would you not permit your employee to work from home, never mind the reasons? Would you even keep her as an employee?

Who gains here? Tony … er, Trenton gets a few dollars from its next mark … er, taxpayer. Who loses? For now, the company loses. In the future, the loser will be the next employee who wants to work from a New Jersey residence for an out-of-state company whose tax advisor has read Telebright.