Communications between taxpayers and attorneys are protected against forced disclosure by the doctrine of attorneyclient privilege. The prohibition against forced disclosure has been extended to materials collected or prepared by an attorney in anticipation of litigation under the so-called work-product doctrine. Occasionally, protected documents are disclosed inadvertently. In such cases, the courts must decide if the disclosure waives the right of privilege. One view is that a documents disclosure automatically waives privilege. Another is that inadvertent disclosure will not waive privilege because the disclosure was not sanctioned by the holder of the privilege.
A third view exists. In National Helium Corp. v. United States (219 Ct. Cl. 612, 1979), the court considered whether the taxpayer intended to waive the right of privilege and the precautions taken to prevent disclosure. More recently, in Carter v. Gibbs (909 F.2d 1450, 1990), the Federal Circuit Court appeared to adopt a rule that all disclosures waive privilege but stopped short of overruling National Helium .
In August 1996, IBM filed a motion for partial summary judgment maintaining thatas a matter of lawit was entitled to certain foreign tax credits. As part of the litigation, IBM turned over to the Internal Revenue Service a large number of documents as part of the discovery process. Included were four documents covered by attorneyclient privilege. In its suit, IBM requested that the documents be returned since it had not intended to waive its right of privilege. The IRS refused, on the grounds their disclosure automatically waived the right of privilege.
Result: For the IRS. The court applied the test enunciated in National Helium . Although IBM was able to prove it did not intend to waive privilege, it was unable to prove it took sufficient precautions to prevent the inadvertent disclosure. Taxpayers need to review their procedures for preventing disclosure, including those for computer files and programsgiven the IRSs ability to obtain these items. In a footnote, the court said any disclosure should waive privilege and that it expects prior precedent, including National Helium , to be overturned. If this occurs, it is essential that taxpayers guard against accidental disclosure of privileged material.
IBM v. United States , U.S. Court of Federal Claims, 37 Fed. C1. 599; 1997 U.S. Claims Lexis 33.
Prepared by Edward Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa .IRS Focuses on Accounting Methods
The IRS recently stepped up its review of accounting methods in various types of businesses and professions, requiring some to change methodsusually from the cash method to the accrual method. The IRS may require such a change if it finds the current method does not clearly reflect the entitys income or if it finds the business is holding inventory and, therefore, must use the accrual method even though the business does not primarily hold merchandise for sale. For example, a veterinarian who sells prescriptions or other products may be considered to have inventory even though he or she is primarily engaged in a service profession.
Two recent cases may help clients whose accounting methods are being reviewed by the IRS. In both, the Tax Court found for the taxpayers and did not require them to change accounting methods despite the IRSs findings.
Case no. 1: The taxpayer, an S corporation service business, provided nurses to hospitals and other health care facilities. The corporation generated less than $5 million a year in gross receipts and had always used the cash method of accounting. The corporation paid the nurses directly and billed the client within 30 days. The IRS argued that the cash method did not clearly reflect the corporations income because it resulted in a mismatch of income and deductions. The corporation took an immediate deduction for the wages it paid but did not recognize the payments from the clients as income until they were received.
Result: For the taxpayer. While the Tax Court agreed with the IRS that a mismatch occurred when the cash method was used, it said mismatching was inherent in the cash method. As long as the taxpayer used the method consistently, a clear reflection of income would result. The court viewed the IRS action as clearly unlawful, plainly arbitrary and not substantially justified in holding for the taxpayer. The court ordered the IRS to reimburse the taxpayer for attorneys fees and other costs incurred in the case.Austin v. Commissioner (TC memo 1997-157).
Case no. 2: Galedrige, an asphalt-paving contractor, picked up asphalt directly from its supplier daily. The asphalt had to be used within two to five hours from the time it was picked up or it became too hard. Because asphalt cannot be melted, reused or returned for credit, the company discarded any unused asphalt at the end of the day. It deducted the asphalt as a supplies expense in the years in which it was purchased. The IRS, however, considered the asphalt to be merchandiseand therefore inventorywhich must be accounted for under the accrual method to clearly reflect income. If a taxpayer wants to use another method, such as the cash method, it must demonstrate that (1) the cash method would produce substantially the same results as the accrual method and (2) the IRSs determination that a change in accounting method is required is an abuse of discretion.
Result: For Galedrige. The Tax Court found that the asphalt did not fall under the definition of merchandise held for sale; instead, it was a supply consumed while the taxpayer provided a service. The fact the asphalt was useless in a matter of hours was the determining factor, not the taxpayers lack of any asphalt on hand at the end of the day. It also found that the taxpayer did not maintain an inventory because it did not keep raw materials or finished goods on hand.
The court noted that failure to maintain an inventory alone would not preclude the IRS from requiring the taxpayer to use the accrual method if it was necessary to clearly reflect income. According to the court, the IRS generally is not permitted to reject a taxpayers method of accounting as long as the method clearly reflects income, is authorized by law and has been consistently used by the taxpayer. Even though the taxpayer did not have an unreasonable amount of advance purchases or payments of suppliestherefore causing a mismatch of income and expensesthis did not mean income was not clearly reflected.
Finally, the court rejected the IRS argument that the cash method did not clearly reflect income because the taxpayers liability would have been higher during the years in question using the accrual method. The court said the best accounting method is not necessarily the one that results in more taxes being paid in a particular year.Galedrige Construction, Inc. v. Commissioner (TC memo 1997- 240).
The Austin case may help support a service businesss or professions use of the cash method. The Galedrige case may be useful to a business providing a service with a product that becomes unusable in a short period, such as concrete or certain other construction materials and supplies. Galedrige also provides a good summary of the current tax law and cases regarding a change of accounting method.
Prepared by Maria Luzarraga Albanese, editor, AICPA client newsletters.