Tax Court Addresses Implied Waiver of the Attorney-Client Privilege

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1 Tax Court Addresses Implied Waiver of the Attorney-Client Privilege The Tax Court Holds That Raising Good-Faith and State-of-Mind Defenses to Accuracy-Related Penalties Could Result in an Implied Waiver of the Attorney-Client Privilege SUMMARY On April 16, 2014, in AD Investment 2000 Fund LLC v. Commissioner, 142 T.C. No. 13, the Tax Court held that, by putting into issue their own legal knowledge, understanding, and beliefs with respect to a particular tax position in order to establish their defenses to accuracy-related penalties, taxpayers forfeited the attorney-client privilege with respect to certain communications relevant to the content and formation of such legal knowledge, understanding, and beliefs. The decision is a good reminder that a taxpayer may waive the attorney-client privilege when contesting the imposition of penalties notwithstanding that the taxpayer has not expressly relied on an opinion of tax counsel as its affirmative defense. DISCUSSION In two consolidated cases, each a partnership-level action, two partners (the partners ), each in a different partnership, petitioned the Tax Court for review of IRS determinations that adjusted partnership items and also imposed accuracy-related penalties for transactions that in similar circumstances the IRS and the courts have characterized as tax shelters. In support of its penalty determinations, the IRS had asserted that the underpayment of tax was attributable to (1) a substantial understatement of income tax, (2) a gross valuation misstatement, or (3) negligence or disregard of the rules and regulations. The Tax Court decision did not address the merits of the transactions themselves; instead, the decision addressed only an IRS motion to compel production of six tax opinion letters from the partnerships legal counsel that New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 apparently advised the partnerships that it was more likely than not that the anticipated tax benefits of the transactions would be upheld for federal income tax purposes. In contesting the motion to compel production of the tax opinions, the partners argued that the partnerships were not required to produce the tax opinions to the IRS because each tax opinion was a privileged communication between attorney and client. The IRS responded that, notwithstanding that the tax opinions constituted attorney-client communications, the attorney-client privilege had been waived under the common-law doctrine of implied waiver because the partnerships (acting through the partners) placed otherwise privileged matters in controversy by relying on affirmative defenses to the penalties that turned on the partnerships beliefs or state of mind. The partners raised two defenses with respect to the penalties, one with respect to all three grounds raised by the IRS to support its penalty determinations and one only with respect to the substantial understatement of income tax. With respect to all three grounds, the partners asserted that the partnerships and their partners had reasonable cause for and acted in good faith with respect to the tax treatment of any items resulting in the asserted underpayment of tax. With respect to the substantial understatement of income tax, the partners asserted that the partnerships and their partners had substantial authority for their tax position and that the partnerships and their partners reasonably believed that their tax position was more likely than not the proper tax treatment. 1 The Tax Court stated that, with respect to the substantial-authority defense, a taxpayer could satisfy the reasonable belief requirement by either one of two ways. First, a taxpayer could show that it itself analyzed the pertinent facts and authorities and, in reliance upon that analysis, reasonably concluded in good faith that there was a greater than fifty-percent likelihood that the tax treatment of the item would be upheld if challenged by the IRS (the self-determination method). Second, a taxpayer could rely on the tax opinion of a professional tax advisor if the tax opinion was based on the tax advisor s analysis of the pertinent facts and authorities and unambiguously stated that the tax advisor concluded that there was a greater than fifty-percent likelihood that the tax treatment of the item would be upheld if challenged by the IRS (the reliance on professional advice method). The IRS conceded that the partners raised only the first method (self-determination) and not the second method (reliance on professional advice) to show that the partnerships satisfied the belief requirement of the substantial-authority defense. Nevertheless, the IRS argued that the partners had still placed the tax opinions in controversy by relying on reasonable cause/good faith and reasonable-belief defenses that put into issue the partnerships beliefs. The IRS argued that, even under the first method, the tax opinions were relevant to the subjective inquiries into reasonableness and good faith, which in turn placed 1 The cases involved the 2000 tax year. For tax years ending after October 22, 2004, taxpayers may no longer use the substantial-authority defense for any item attributable to a tax shelter as defined in Section 6662(d)(2)(C)(ii) of the Internal Revenue Code. -2-

3 into issue the state of mind of the principal of the partnerships. In disputing the IRS s arguments, the partners argued that (1) neither of their defenses even alluded to any reliance on counsel, (2) the mere fact that an attorney-client communication is relevant is not enough to waive the attorney-client privilege, and (3) a general good faith defense does not waive the privilege. The Tax Court engaged in a more nuanced analysis than either the IRS or the partners. Citing in particular two cases from the U.S. Court of Appeals for the Second Circuit 2 (to which appeal in the cases presumptively lies), the Tax Court looked at the facts and the specific context of the assertion of the privilege and decided that fairness required disclosure of the six tax opinions to the IRS. Following established precedent, the Tax Court stated that a taxpayer may forfeit the privilege afforded attorney-client communications by putting into issue the taxpayer s subjective intent in deciding how to comply with the law. While an objective defense that a person did in fact follow the law does not waive the privilege, the Tax Court observed that a subjective defense that the person acted in good faith may waive the privilege otherwise protecting attorney-client communications with respect to the law in question. Once a party brings its knowledge and beliefs regarding the law into issue, the other party is entitled to discover the basis of that knowledge and those beliefs. Turning to the facts of the cases, the Tax Court found that, by arguing self-determination, the partners put three things into contention: (1) the partnerships knowledge of the pertinent legal authorities, (2) the partnerships understanding of those legal authorities and their application of that law to the facts, and (3) the partnerships belief that, if challenged, their tax positions would more likely than not succeed in the courts. The partners thus placed the partnerships legal knowledge, understanding, and beliefs into contention, and the Tax Court found those to be topics upon which the tax opinions could bear. Therefore, the Tax Court held that if the partners wanted to rely on the legal knowledge, understanding, and beliefs of someone acting for the partnerships (the principal of the partnerships) to establish that the partnerships reasonably and in good faith believed that their claimed tax treatment of the items in question was more likely than not the proper treatment, it was only fair that the IRS be allowed to inquire into the bases of that person s knowledge, understanding, and beliefs, including the tax opinions (if that individual considered them in forming his knowledge, understanding, and beliefs). Noting that the partners did not dispute that the six tax opinions were relevant to the good-faith element of the partners defense of reasonable cause and good faith, the Tax Court held that the same analysis applied equally to that penalty defense as well. The bottom line, according to the Tax Court, was that, by placing the partnerships legal knowledge and understanding into issue in an attempt to establish the partnerships reasonable legal beliefs in good faith 2 United States v. Bilzerian, 926 F.2d 1285 (2d Cir. 1991), and Pritchard v. County of Erie (In re County of Erie), 546 F.3d 222 (2d Cir. 2008). -3-

4 arrived at (a good-faith and state-of-mind defense), petitioners [i.e., the partners] forfeit the partnerships privilege protecting attorney-client communications relevant to the content and the formation of their legal knowledge, understanding, and beliefs. What does this decision mean for taxpayers and tax advisors? First, the Tax Court noted that, even though the partners did not rely on professional advice to contest the penalties, the partnerships apparently received the tax opinions well before their tax returns were due, and the partners never claimed that those acting for the partnerships ignored the tax opinions. Consequently, one may interpret the Tax Court s decision as simply reaffirming a general principle in the specific context of tax cases: taxpayers may not use the attorney-client relationship as a sword to justify their actions and, at the same time, as a shield to prevent the IRS from looking at the advice of counsel. Second, if a taxpayer puts into issue its own knowledge, understanding, and beliefs regarding a tax position, or its good faith with respect thereto, any relevant legal opinion or other advice or analysis, whether it supports the tax position or not, may come into play. Finally, the decision reminds us that, notwithstanding the care taxpayers and tax advisors take to preserve the attorney-client privilege, courts may still find implied waiver in many situations. Moreover, it may often be necessary to waive the attorney-client privilege in order to establish a defense to penalties. * * * Copyright Sullivan & Cromwell LLP

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