There was a bit of frission in the libertarian-leaning sectors of the Internet over a Tax Court ruling that was depicted as ending attorney-client privilege. And it was even more convenient that this supposedly earth-shaking ruling came close on the heels of Tax Day.
As much as rights are slowly being eroded, and attorney-client privilege is among them, these posts were completely off base. As we’ll explain, based on the speedy work of tax maven Lee Sheppard, who weighed in at Forbes, the case in question, AD Investment 2000 Fund LLC v. Commissioner, 142 T.C. No. 13 (2014), did no such thing. You might find it instructive to know why.
The simple answer is that attorney-client communications are privileged only to the extent that the attorney and client take proper steps. For instance, if you bring a third party into a conference with your lawyer about a possible suit and it’s not an agent of yours, you’ve probably tainted that communication. In this case, the litigation defense strategy adopted by the defendant against the IRS made it essential to examine certain communications with the attorney in order to validate the claims the defendant was making.
And on top of that, the defendant’s position isn’t terribly sympathetic either. As Sheppard explains, the battle was over a dodgy tax shelter called Son of BOSS. Taxpayers who tried using that gimmick lost in court on the tax treatment long ago. The ones who are still fighting are no longer disputing the basic question of whether they owe the tax and interest. They do. No getting out of that. The court fights are over whether they owe penalties too. Per Sheppard:
Son of BOSS was a hokey shelter that didn’t work. It was very popular with folks who got instantaneously rich in the tech bubble and had big capital gains all in a single taxable year. It was heavily flogged by big accounting firms. Rich people are often naïve, and think tax practitioners can waive a magic wand to get them out of taxes….
The taxpayers who continue to fight SOB penalties cases generally have the resources to fight for a long time. The IRS offered a settlement to SOB customers a decade ago (Announcement 2004-46, 2004-21 IRB 964). Some customers didn’t take the settlement because they thought it was chintzy and could afford to litigate.
Now the amount of the penalty was 20% of the deficiency, which isn’t chump change. But what is the grounds for defense against a penalty? This taxpayer was the managing partner of a partnership used to try to achieve the failed Son of BOSS ruse. He argued that he had undertaken his own research into the applicable law and the situation at hand, and had a good faith basis for believing that his position had better than even odds of prevailing if challenged.
Mind you, this is the opposite of the argument that many people use when caught out trying to use tax gimmicks. The more common approach is to say you relied on the advice of experts. Why didn’t the taxpayer go that route? As Sheppard notes, many times the tax opinions that taxpayers rely on are canned, general ones; they didn’t bother getting an opinion specific to their situation. Trying to argue that the boilerplate documents have any bearing on your particular situation isn’t just useless; they can actually damage the taxpayer’s case.
So how did attorney-client privilege play into the argument that the taxpayer had done his own homework and supposedly had an informed basis for believing Son of BOSS would pass the smell test? The taxpayer asserted that because it had not relied on the advice of counsel in making up his mind about the shelter, he hadn’t waived attorney-client privilege. The IRS said that was hogwash, that to determine whether the taxpayer had made his own determination, independent of counsel, the court needed to see what counsel had said.
As Sheppard explains, the ruling the tax court made wasn’t pathbreaking; the relevant precedent is over 20 years old:
The court held that the taxpayer had impliedly waived privilege when opening the issue of the managing partner’s state of mind. Fairness demanded that the IRS be allowed to see evidence of how the managing partner came by his asserted knowledge of the applicable law and the chances of success in litigation.
Here is the sentence that got the libertarians’ undies in a twist: “When a person puts into issue his subjective intent in deciding how to comply with the law, he may forfeit the privilege afforded attorney-client communications.”
This sentence does not state a new legal rule. The doctrine of “at issue” implied waiver is settled law when the party claiming privilege has put his subjective state of mind at issue. The case law is very clear, and especially clear in the Second Circuit, where appeal in AD Investment 2000 lies.
The Tax Court judge relied on a Second Circuit case from two decades ago (United States v. Bilzerian, 926 F.2d 1285 (2d Cir. 1991)).
“The attorney-client privilege cannot at once be used as a shield and a sword,” the Second Circuit stated in Bilzerian, emphasizing the unfairness to the opponent of making claims that cannot be proved except by admission of material for which privilege is then asserted.
A party “may not use the privilege to prejudice his opponent’s case or to disclose some selected communications for self-serving purposes,” the Bilzerian court stated. Courts frequently find implied waiver when the material for which protection is sought is the only source of evidence for the state of mind of the party claiming privilege.
By asserting a penalty defense that required a particular subjective state of mind, the taxpayer in AD Investment 2000 put the issue in court, and could not deny the IRS access to relevant evidence that might prove or disprove that intent. Bilzerian is directly on point. The taxpayer cannot have its cake and eat it too.
The lesson to keep in mind is that it’s easy to waive attorney-client privilege, particularly in tax cases, which are about money, not life and limb. And if you use aggressive tax shelters and they don’t pan out, it might be better to man up and pay the IRS than running the risk of paying even more all in via a protracted legal battle.