No, the Tax Court Did Not Repeal Attorney-Client Privilege

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.

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  1. Captain Krunk

    > “When a person puts into issue his subjective intent in deciding how to comply with the law,

    Sorry buddy, no citizen ever “puts into issue” their intent. Its relevance is a matter of legislation, like all those crimes following the template “___ with intent to ____”.

    If the law (statutory and legislative) doesn’t mention intent, then it is irrelevant to the court proceedings and cannot be “put into issue”. On the other hand if the law does mention intent, then the law is still limited by attorney-client privilege as a matter of due process, superseded only by constitutional amendment.

    1. MaroonBulldog

      This is how tax litigation really works. The IRS sends a taxpayer a notice of tax deficiency, and assesses a penalty for “negligence” in taking a return position. “Negligence” is a state of mind. If the taxpayer wishes to challenge the assessment of the penalty, the taxpayer has a two choices.
      Choice 1: file a petition in the Tax Court. In this case, the taxpayer is a petitioner (not a defendant) and, as the moving party, bears the burden of proving that the penalty was wrongfully assessed. To win, the taxpayer must persuade the Tax Court that the taxpayer was not negligent. The taxpayer puts the state of mind into issue and bears the burden of proof.
      Choice 2: pay the deficiency, as assessed, and then file a claim for a refund. Go through the IRS administrative processes. Assuming the IRS denies the refund, file a lawsuit for a tax refund in the federal district court. In this case, the taxpayer is a plaintiff (not a defendant), and, because the taxpayer is also the moving party in this case, the issues and burden of proof are the same as discussed in Choice 1. The taxpayer bears the burden of proving that the taxpayer was not negligent.
      As for the comment that “the law is still limited by attorney-client privilege as a matter of due process,” even if that proposition were sound, it wouldn’t help here. Here, the taxpayer has to prove the case, the government doesn’t have to prove anything. If disclosure of the attorney’s advice would have helped the taxpayer’s case, the taxpayer would have gladly waived the privilege and disclosed the advice. If the taxpayer is not willing to waive the privilege, the court may justly infer that the taxpayer is not truthfully claiming to have to come to the tax return position by independent research, and the taxpayer may justly lose.

      1. bh2

        “‘Negligence’ is a state of mind.”

        Unfortunately, what counts is the state of mind of the taxing authority. The income tax laws are such a tangle of vague (as in “void for vagueness”) and medieval definitions that anyone going to court is unlikely to prevail. Cheaper to just write a check — which, of course, is exactly what the law is fully intended to encourage.

        This has given rise to the “special letter” sold by the IRS to individual taxpayers as a one-time ruling having no relevancy to tax treatment of other taxpayers in similar circumstance. Basically like indulgences issued by the equally medieval Roman church or high-priced garlic picked by fairies under the light of the full moon to ward off vampires.

        “The more the laws, the more corrupt the nation.” — Tacitus

        1. MaroonBulldog

          The IRS does not have a “state of mind”. It does not have a duty to treat taxpayers consistently. It could not discharge such a duty if it did have it. One hand there does not know what the other hand is doing.

    2. MFrohike

      You are wrong. The defendant in this case put the question of his own judgment at issue by asserting it as a defense. It’s analogous to opening the door to a character attack by asserting your own good character in direct examination.

      I wonder if the lawyer in question didn’t recommend this scheme, knowing it to be of dubious legality. It’s one thing to present an argument that almost certainly will lose, it’s quite another to present one that absolutely will lose.

  2. John Glover

    Shepard concludes that “The taxpayer cannot have its cake and eat it too.”

    A taxpayer that is rich enough to buy a Son of Boss shelter and stupid enough to litigate rather than settle is precisely the kind of a-hole who thinks he can have his cake and eat it too.

    In fact, there are a lot of rich a-holes that believe that, probably because, way to often, they turn out to be right.

  3. JayTe

    So basically, he’s saying that if you use your brain and do due diligence yourself rather than wholly believing what you’re told by your lawyer, you give up client attorney privilege?!? I think his opinion is rather naive given that we all know that the government respects NO RULES when it comes to extracting money from the populace (especially given the dodgy foundations for the income tax in general – see Irwin Schiff for blatant proof) . If we revisit this in the coming years, we will see clearly that this set the beginning of the slippery slope where client attorney privilege was eroded.

    1. John Blaze

      Lee Sheppard:
      As a defense against the tax penalty, the taxpayer argued that it had done its homework, had examined the law and the facts, and had concluded that the desired tax treatment was more likely than not to survive in litigation. That is one of the defenses to the penalty; the other is reliance on the advice of a tax professional, which is the more usual route.

      The taxpayer contended that because it was not explicitly relying on advice of counsel, it had not waived attorney-client privilege for lawyers’ opinions saying that the desired tax treatment was more likely than not to prevail. The taxpayer was a partnership, representing partners participating in a shelter. The individual whose state of mind was being evaluated was the managing partner.

      The IRS essentially argued that the opinions were necessary to determine whether the managing partner had really undertaken his own evaluation of the facts and law, or was just relying on what he read in the legal opinions.

      Here the IRS argued that the taxpayer waived any privilege that might exist by raising the issue (implicitly assuming that the lawyers’ opinions were privileged in the first place). Privilege can be waived at the drop of a pin. Privilege is easily waived in tax cases (U.S. v. El Paso Co., 682 F.2d 530 (5th Cir. 1982), cert. denied, 466 U.S. 944 (1984)).

      The question is whether the taxpayer put the opinion in play. 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.

      1. Nathanael

        In this case, the ruling is wrong.

        The managing partner could have introduced his records of his independent research, asserted that he did not consult his lawyers on this matter, and accused the IRS of going on a fishing expedition. The IRS should then have to present evidence that the managing partner *did* consult his lawyers… or accuse him of being negligent by not consulting his lawyers.

        Probably the correct thing to do at that point would have been to offer to show the attorney-client communications to the judge in private, without exposure to the opposing counsel, in order to prove that the lawyer was in fact never asked about this matter.

        Of course, bad facts make bad law, and it looks like this criminal *did* consult his lawyer.

        1. MaroonBulldog

          Sorry, Nathanael, but if the managing partner offered to show the attorney advice to “prove” something, the IRS general counsel would be entitled to see it, too. The only time judges do the type of inspection you describe is to determine whether allegedly privileged material is going to be admitted or not. Once a party offers it to prove something, that party allows it to be admitted.

          1. Nathanael

            That’s not how it works in US courts.

            Not in the cases where the government claims that they’re proving cases with “State secrets” which the opposition is not allowed to see.

  4. Whine Country

    I am not a lawyer but fate has involved me in way more than my fair share of lawsuits. Everything a client tells his or her attorney is “confidential”, but it is much more difficult to establish that it is “privileged”. What is unknown to the average client is that only a very small portion of what one says to his or her attorney falls into the latter category. Best to remember what H. L. Menken once said, “A judge is a law student who marks his own examination papers.” As a practical matter, just as in the case cited in the article, it is that “judge” that makes the final determination and then gives himself a A for the answer. Of course, if you’re part of the 1%, you can appeal and find a judge who grades on a slightly different scale.

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