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Use of a Kovel Accountant in Indirect Method Audits by Cory Stigile

In civil tax audits that include potentially sensitive issues, counsel will often engage a team of representatives, including a forensic accountant. Engagement of the accountant by counsel should be carefully designed to extend the attorney-client privilege to communications with the accountant pursuant to the engagement by counsel.

The Kovel Accountant. Although Code Section 7525 extends common law protections of confidentiality to tax advice rendered between a taxpayer and a federally-authorized tax practitioner (to the extent such communications would be considered privileged if they occurred between a taxpayer and counsel), this statutory privilege only applies to non-criminal tax matters before the IRS and non-criminal tax proceedings in federal court. The protections afforded by Code section 7525 are not available when truly needed the most — when a civil tax proceeding moves into the criminal arena.  It also may not be available in state-related tax proceedings, or non-tax civil litigation.

Pursuant to United States v. Kovel, 296 F.2d 918 (2nd Cir. 1961), the attorney-client privilege is extended to an accountant retained specifically to assist an attorney in rendering legal services to a client, both during the investigative stages of the case and if necessary, during trial. If the accountant is appropriately engaged by counsel, the common law attorney-client privilege will apply to all communications rendered in furtherance of the legal services being provided to the client, both during the examination stages of the audit and, if necessary, during any subsequent civil or criminal proceedings.

A critical inquiry is often whether counsel should retain the taxpayer’s prior accountant or a new accountant. Many practitioners prefer to engage a new accountant to avoid the necessity of delineating between non-privileged communications (communications prior to counsel’s engagement of the accountant), and privileged communications (communications following counsel’s engagement of the accountant). Retention of a new accountant avoids issues relating to whether information possessed by the accountant may have been obtained prior to the accountant’s engagement by counsel.

Counsel’s engagement of the accountant should be in writing, and should indicate that the accountant is acting under the direction of counsel in connection with counsel’s rendering of legal services to the client, communications between the accountant and the client are confidential and are made solely for purposes of enabling counsel to provide legal advice; the accountant’s work-papers are held solely for counsel’s use and convenience and subject to counsel’s right to demand their return; and the accountant is to segregate their work papers, correspondence and other documents gathered during the course of the engagement and designate such documents as property of counsel.

Assistance in Indirect Method Audits. Historically, conventional audit techniques have been discovered to be grossly inadequate for the purpose of demonstrating an understatement of taxable income. In such event, the government has often resorted to one or more indirect methods of detecting unreported income by essentially auditing a taxpayer, rather than a return.

The use of indirect methods of proving income, historically referred to as the IRS Financial Status Audit Techniques (FSAT), is not prohibited by Code Sec. 7602(e). If the examiner has a “reasonable indication” that unreported income exists, the IRS has the authority to use an indirect method of reconstructing income to determine whether or not the taxpayer has accurately reported total taxable income received. The indirect method need not be exact, but must be reasonable in light of the surrounding facts and circumstances.

The use of a “formal” indirect method, however, is not precluded by the presentation of books and records. Use of an indirect method is often supported by circumstances that, individually or in combination, would support: (1) a financial status analysis that cannot be balanced; i.e., the taxpayer’s known business and personal expenses exceed the reported income per the return and nontaxable sources of funds have not been identified to explain the difference; (2) irregularities in the taxpayer’s books and weak internal controls; (3) gross profit percentages change significantly from one year to another, or are unusually high or low for that market segment or industry; (4) the taxpayer’s bank accounts have unexplained items of deposit; (5) the taxpayer does not make regular deposits of income, but instead uses cash for many transactions; (6) a review of the taxpayer’s prior and subsequent year returns show a significant increase in net worth not supported by reported income; (7) there are no books and records (examiners should determine whether books and/or records ever existed, and whether books and records exist for the prior or subsequent years. If books and records have been destroyed, determine who destroyed them, why, and when); or (8) no method of accounting has been regularly used by the taxpayer or the method used does not clearly reflect income.

Indirect methods include a fully developed Cash-T, percentage mark-up, net worth analysis, source and application of funds or bank deposit and cash expenditures analysis. However, examiners must first establish a reasonable indication that there is a likelihood of under-reported or unreported income. Examiners will then request an explanation of the discrepancy from the taxpayer. If the taxpayer cannot explain, refuses to explain, or cannot fully explain the discrepancy, a FSAT may be necessary. The government routinely uses the various indirect methods to reconstruct income including specific item; net worth plus expenditures; bank deposits; and a combination of the above methods. The accountant may be called upon to analyze indirect methods used by government to develop unreported income.

Relevant inquiries include the standard of living of the taxpayer. What do the taxpayer and their dependents consume economically? How much does it cost to maintain this consumption pattern? Is reported net income sufficient to support this standard of living? What are the possible sources of funds to support these expenditures?

What is the accumulated wealth of the taxpayer? How much has the taxpayer expended in the acquisition of capital assets? When and how was this wealth accumulated? Has reported income been sufficient to fund the accumulations? What is the economic history of the taxpayer? What is the long term pattern of profits and return on investment in the reported business activity? Is the taxpayer’s business expanding or contracting? Does the reported business history match the changes in the taxpayer’s standard of living and wealth accumulation? Is reported interest income increasing or decreasing?

What is the business environment for the taxpayer’s industry? What is “typical” profitability and return on investment for the taxpayer’s market segment and locality? What are typical patterns of non-compliance in the taxpayer’s market segment? What are the competitive pressures and economic health of the market segment within which the taxpayer operates?

Has the taxpayer made assertions to receipts of funds which were considered to be non-taxable? Do claims of non-taxable sources of support make economic sense (cash hoard, credit history)? How credit worthy is the taxpayer in view of the taxpayer’s assertion that funding was secured from loans? In situations where the taxpayer has asserted that funds were received from other than conventional lending institutions, what was the lender’s source of funds? Was it a disguised loan of funds that originated with the taxpayer?

The Kovel accountant’s responsibility in analyzing the above indirect methods of proof may include analyzing bank statements and financial information; assisting the attorney in interviewing witnesses; developing a cash-on-hand figure; assisting the attorney in developing questions for the agent which may highlight weaknesses in the government’s position; and joining the attorney in meetings with the examining agent in an attempt to further explain and highlight weaknesses in the agent’s position.

A civil examination involving potentially sensitive issues where civil or criminal fraud potential exists requires the utmost of judgment, discretion and caution. The primary examination objectives are to limit the scope of the inquiry; to avoid the presentation of false or misleading information; to avoid false statements by the taxpayer or the taxpayer’s representative; and to limit the information provided so as to avoid the waiver of the privilege against self-incrimination.

Notwithstanding extreme resource challenges, the IRS remains well equipped to identify potentially fraudulent returns as a result of increased transaction and information reporting, better developed audit plans and techniques which focus on specific industries, substantially increased access to computerized data banks and an overall increased level of scrutiny of the taxpayer, the taxpayer’s business, the taxpayer’s standard of living and how these relate to issues reported – or not – on the return under examination.

CORY STIGILE – For more information please contact Cory Stigile – stigile@taxlitigator.com  Mr. Stigile is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a CPA licensed in California, the past-President of the Los Angeles Chapter of CalCPA and a Certified Specialist in Taxation Law by The State Bar of California, Board of Legal Specialization. Mr. Stigile specializes in tax controversies as well as tax, business, and international tax. His representation includes Federal and state controversy matters and tax litigation, including sensitive tax-related examinations and investigations for individuals, business enterprises, partnerships, limited liability companies, and corporations. His practice also includes complex civil tax examinations. Additional information is available at https://www.taxlitigator.com


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