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'Financial Status' Audit Can Lead to Big Problems

The financial status audit technique, used in about 20% of all IRS examinations, has come under increased fire from professional organizations like the American Institute of Certified Public Accountants (AICPA). The technique, formerly called the "economic reality audit," is considered by many tax professionals to blur the distinction between civil and criminal investigatory activities on the part of the Service. Further, since IRS examiners generally demand taxpayers submit to interviews without representation by counsel, the audit technique could place some taxpayers at greater risk should the investigation become criminal in nature. Adding to this risk is the fact that CPAs do not enjoy the same client privilege as attorneys and, therefore, may be compelled to testify against their clients in any subsequent proceedings.

In a recent issue of AICPA's monthly magazine, The Tax Adviser, the organization urged its members to "resist" IRS agents who ask financial status questions during audits. AICPA also encourages tax professionals to implement a series of other safeguards designed to protect both the taxpayer and accountant from disclosure of financial status information. Finally, practitioners are urged to encourage clients to seek legal counsel in earlier stages of IRS audit investigations.

The Attorney-Client Privilege Is An Important Protection.

Discussions between a client and an attorney are privileged communications that cannot be disclosed by the attorney without consent from the client. The privilege extends to all communications between the parties, whether written or oral, made for the purpose of obtaining legal advice or assistance. It exists as a practical recognition that attorneys can only provide effective counsel if they are fully informed of all facts related to the subject of the representation. If clients feared the consequences of disclosing adverse information to their attorneys, then they would be ill-equipped to aid clients in avoiding unfavorable, perhaps even criminal, outcomes.

Attorney-client privilege is a broad protection for the client. It has even been applied to prevent disclosure of details discussed during consultations where the lawyer was not ultimately retained to represent the client. It has been applied to stop disclosure years after representation ceased. It also applies to prevent disclosure of information given to the attorney by many of the client's agents, such as employees, accountants, doctors and insurers. The only requirements are an expectation of confidentiality and an attorney-client relationship.

The Accountant-Client Relationship Is Not Privileged.

Accountants hold a form of fiduciary relationship with their clients. That is, they hold a special trust, and the law charges them with special obligations and responsibilities on behalf of their clients. For example, it would be improper for an accountant to use information obtained from a client for personal profit. The fiduciary relationship also creates an obligation of confidentiality with respect to such information. However, this obligation of confidentiality is not privileged. An accountant can be compelled to disclose information even though it was obtained through confidential discussions during the course of representation. And a client has no legal right to prevent the disclosure, even if they mistakenly believed that their remarks would remain private.

The distinction is an important one for both the taxpayer and the accountant. Financial status audits are not criminal investigations. They are audit techniques used by IRS agents early in the investigatory process. Obviously, a taxpayer faced with the potential of criminal sanctions would want to limit disclosure of confidential information if possible. But where no privilege exists, the taxpayer would be helpless to limit disclosure.

The tax professional could face a double bind. On the one hand, their ability to provide competent service to their clients may be impeded by the client's unwillingness to disclose non-privileged information. Thus, they may be unaware of important relevant facts. On the other hand, fully informed accountants may find themselves compelled to disclose information to IRS agents which will serve as a basis for future criminal allegations against their clients.

AICPA urges tax professionals to resist financial status audit questions. In response, the IRS has indicated that it does not intend to revise the controversial practice. It may be that the safest course of action for both accountants and taxpayers is to encourage clients to seek legal representation at the earliest stages of IRS audit activity. Only then may the client fully disclose the information necessary to assure that their position is properly assessed without creating added risk for the client and conflict for the accountant.

Issue 5

New Business Checklist*

__ Choose mgmt. advisors: an accountant, attorney, and banker.
__ Develop business plan, including cash flow projections.
__ Select business form/year-end.
__ Choose business location.
__ Negotiate lease terms.
__ Design facility layout.
__ Prepare legal documents (i.e. partnership agreements, articles of incorporation, minutes, bylaws, federal identification numbers, state/local license applications, sales tax identification numbers, etc.)
__ Order office furnishings, equipment, supplies and stationery.
__ Order telephone service.
__ Purchase insurance (i.e. health, malpractice, liability, workers' compensation, etc.)
__ Register business name.

__ Establish product prices.
__ Promote business opening.
__ Interview and hire employees.
__ Select and implement an accounting system.

__ Develop personnel policies and procedures.
__ Prepare quarterly payroll returns/verify timely tax deposits.
__ Prepare financial statements.
__ Perform year-end tax planning, at least one month before close.
__ Prepare annual federal, state, and payroll returns.
__ Develop job descriptions.
__ Perform annual insurance coverage review.
__ Prepare/maintain employee files.
__ Establish petty cash policy.
__ Join industry associations.
__ Verify Yellow Pages ads.
__ Register trademarks.

*This list is for guidance only. No final conclusions should be reached by completing it without further review and consultation.

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