Kovel agreement basics for you and your client

Consider this scenario. You’re introduced to a potential client. While you are speaking with the prospect, the individual mentions that he has certain financial accounts held in foreign financial institutions and that he recently heard about the Report of Foreign Bank and Financial Accounts filing requirements. He’s concerned that he may have an outstanding filing obligation and has received an IRS notice about the IRS’s streamlined filing compliance procedures (SFCP). Because he’s never worked with a tax adviser and is unsure what the SFCP entails, he would like your help. What’s your next thought? It should be, “Stop. Our conversation is not privileged. You should engage counsel.”

Occasionally, clients may need more than a CPA can offer. For example, taxpayers required to comply with complex IRS programs, such as the SFCP, or who want to protect themselves from disclosure of communications and documentation addressing certain tax positions, may be better served by engaging counsel to provide legal advice at the outset. Similarly, taxpayers facing potential litigation due to significant underreported income or other fraud indicators may need legal representation. Nevertheless, while counsel is qualified to provide legal advice and/or litigation services, they may not have enough of an understanding of complex accounting or tax rules to successfully service the client. Enter the Kovel agreement.

WHY USE KOVEL AGREEMENTS?

A Kovel agreement is an arrangement whereby a client engages counsel to provide legal services, and counsel, in turn, engages specialists, such as CPAs, to support its services to the client. The CPA interprets technical accounting, financial, and tax concepts into more easily understandable language for the client and counsel. When a Kovel agreement is properly drafted and executed, protections that are typically limited to the client’s interactions with counsel — namely, attorney-client privilege and attorney work product privilege — are extended to specialists engaged by counsel on the client’s behalf. The result? A wider scope of communications and documents receive protection from disclosure to third parties.

RELEVANT PRIVILEGES EXPLAINED

Attorney-client privilege is a legal concept that protects confidential communications between attorneys and clients that are made for the purpose of obtaining or giving legal advice. The privilege, which is owned by the client, allows a client to refuse to disclose and prevent others from disclosing confidential communications (see Black’s Law Dictionary (11th ed. 2019)). It is intended to encourage full and candid communications between attorneys and their clients without the fear that such communications will be disclosed to a third party. The privilege does not apply to communications made in the commission or furtherance of criminal activities, such as fraud or tax evasion.

The attorney work product privilege permits attorneys to withhold from production “documents and other tangible things” that contain the attorney’s impressions and insights and that were prepared by counsel “in anticipation of litigation or for trial” (Fed. R. Civ. P. 26(b)(3)). It also can extend to materials prepared by other parties, such as CPAs, engaged by counsel on a client’s behalf.

SEC. 7525 MAY NOT PROVIDE SUFFICIENT PROTECTION

While tax practitioner-client privilege under Internal Revenue Code Sec. 7525 is similar to attorney-client privilege in providing protections for communications between a taxpayer and a tax practitioner, this privilege has significant shortcomings. For example, it applies solely to tax advice and not to tax compliance or business advice. It is also limited to noncriminal matters before the IRS or in federal courts in matters involving the IRS and does not apply to private civil actions, tax shelters, state and local tax advice, or matters before the SEC. In addition, it only applies to communications between the practitioner and the taxpayer. Finally, the privilege is not available upon the commencement of a criminal investigation or prosecution. Accordingly, no party should place significant reliance on this privilege.

KOVEL AGREEMENTS: WHAT TO KNOW

Similar to a CPA firm’s engagement letter with its client, a Kovel agreement between counsel and the CPA governs the services between the parties. Counsel takes the lead in drafting the agreement. Before signing the agreement, the CPA should review the document with their own counsel and consider the following:

• The scope of services in a Kovel agreement generally states that counsel is engaging the CPA to assist in providing legal services to the counsel’s client and will often specify the client and the matter at issue.
• A Kovel agreement should state that it is counsel’s responsibility to direct the CPA’s services, and the CPA takes instruction from counsel for all aspects of the engagement.
• A Kovel agreement typically states that the workpapers created by the CPA firm belong to the attorney in order to maintain privilege. However, the CPA firm should be able to retain its own copies.
• As the CPA is working solely at the direction and supervision of counsel, counsel should be primarily responsible for liability and/or indemnity claims made by the client or third parties if the matter is not resolved to the client’s satisfaction.
• A Kovel agreement should identify the party responsible for the payment of the CPA’s fees, which, in most cases, is the client.
• A Kovel agreement may be signed by the client, in addition to counsel and the CPA, especially if the client is responsible for payment of the CPA’s fees.

IMPORTANT CONSIDERATIONS WHEN WORKING WITH COUNSEL UNDER A KOVEL AGREEMENT

CPAs engaged pursuant to a Kovel agreement should receive instructions from counsel on how to conduct the engagement, including instructions related to the CPA firm’s use of subcontractors. The instructions should include guidance on how to protect available privileges as well as caveats regarding the types of actions that may waive privileges.

Counsel should instruct the CPA how to address communications to counsel and/or the client and what type of banner to include on emails and documents prepared at counsel’s direction, such as “Confidential/Prepared at the direction of Counsel.”

To mitigate the risk of inadvertent disclosure, access to the CPA’s engagement files should be limited solely to those individuals who are members of the engagement team.

POTENTIAL PITFALLS

A client may be uncomfortable engaging counsel to provide legal services and pressure counsel to include the client’s current CPA on the engagement team. However, including the current CPA might not be the best idea. Prior knowledge of an issue is not protected by the Kovel agreement and may cause the CPA to inadvertently waive one or more privileges. Generally speaking, communications between the CPA and the client are not protected. Prior communications may come back to haunt the client and the CPA if a tax authority investigates the client and compels the CPA to produce documents or provide testimony.

CPAs should exercise caution to protect the privileges noted above. A CPA’s failure to abide by the privilege requirements, such as the intentional or inadvertent communication or sharing of documents with any third party, can result in a waiver of privilege for all communications and documents, a situation that may damage the client’s case.

Absent counsel’s specific approval, none of the communications or documents prepared pursuant to the Kovel agreement should be repurposed for any engagement, such as in the preparation of tax returns. Otherwise, a tax authority may assert that the communications and/or documents created by the CPA at counsel’s direction served a purpose other than furtherance of counsel’s legal services.

Did you know?

Kovel agreements take their name from a 1961 appellate court decision, Kovel, 296 F.2d 918 (2d Cir. 1961).

Karen Nakamura, CPA, is a risk control consulting director at CNA. For more information about this article, contact specialtyriskcontrol@cna.com.

Continental Casualty Company, one of the CNA insurance companies, is the underwriter of the AICPA Professional Liability Insurance Program. Aon Insurance Services, the National Program Administrator for the AICPA Professional Liability Program, is available at 800-221-3023 or visit cpai.com.

This article provides information, rather than advice or opinion. It is accurate to the best of the author’s knowledge as of the article date. This article should not be viewed as a substitute for recommendations of a retained professional. Such consultation is recommended in applying this material in any particular factual situations.

Examples are for illustrative purposes only and not intended to establish any standards of care, serve as legal advice, or acknowledge any given factual situation is covered under any CNA insurance policy. The relevant insurance policy provides actual terms, coverages, amounts, conditions, and exclusions for an insured. All products and services may not be available in all states and may be subject to change withoutnotice.