The U.S. Tax Court concludes in AD Investment 2000 Fund LLC v. Commissioner that a taxpayer’s assertion of a state of mind penalty defense waives the attorney-client privilege with respect to tax opinions provided to the taxpayer in advance of filing the taxpayer return, even if the taxpayer explicitly disclaims reliance on the tax opinions.
It is well established that there is an implied waiver of the attorney-client privilege with respect to a tax opinion letter if the taxpayer relies on the opinion letter in defense of an asserted tax penalty. In AD Investment 2000 Fund LLC v. Commissioner, 142 T.C. No. 13 (April 16, 2014), the U.S. Tax Court extended the implied waiver doctrine to apply when a taxpayer asserts a penalty defense based on the taxpayer’s belief or state of mind, even if the taxpayer explicitly disclaims reliance on the opinion.
AD Investment 2000 Fund LLC (AD Investment) involved consolidated partnership-level proceedings for tax year 2000 with respect to Son of Boss transactions. Son of Boss transactions are Internal Revenue Service (IRS) listed transactions that have been the subject of widespread litigation and a nationwide IRS settlement program. In addition to challenging the tax treatment of the underlying transactions, the IRS asserted penalties attributable to: (1) substantial understatement of income tax; (2) gross valuation misstatement; and (3) negligence or disregard of rules and regulations. The taxpayers are contesting the substantive tax adjustments and the penalty determinations.
The issue addressed by the Tax Court was whether the taxpayers were required to turn over six opinion letters received from their outside tax advisor. The taxpayers argued that the letters were privileged attorney-client communications. The IRS did not contest that the opinions were privileged communications. But the IRS contended that the taxpayers had waived privilege by asserting affirmative defenses based on the taxpayers’ belief or state of mind.
Specifically, in defense to the assertion of a substantial understatement penalty, the noncorporate taxpayers contended that even assuming that the transaction was a “tax shelter” as defined in Internal Revenue Code (IRC) section 6662(d)(2)(C), (1) there was substantial authority for their position and (2) the taxpayers “reasonably believed” that the tax treatment was more likely than not correct. See Treas. Reg. §1.6662-4(g)(4). In defense to all three of the asserted accuracy-related penalties, the taxpayers also relied on the “reasonable cause” exception under which a penalty would not be imposed if an underpayment were due to reasonable cause and the taxpayer acted in good faith. See Treas. Reg. §1.6664-4(f).
Typically, taxpayers that assert reasonable belief or reasonable cause defenses rely, at least in part, on tax opinions they have received from outside tax advisers. In such cases, the law is clear that assertion of these defenses waives privilege with respect to the tax opinion. However, in this case, although the tax opinions were received before the tax returns were filed, the taxpayers asserted that they had made their own independent analysis of the transactions. They specifically disclaimed reliance on outside counsel’s opinions.
The commissioner argued that even if there was no reliance on the tax opinions, putting the taxpayers’ state of mind in issue waived privilege because the content of the opinions was relevant to the taxpayers’ state of mind. In support of its position, the commissioner cited Johnston v. Commissioner, a 2002 Tax Court case that applied the three-factor test for implied waiver first described in Hearn v. Rhay, 68 F.R.D. 574 (E.D. Wash. 1975). Under the Hearn test, there is implied waiver if: (1) assertion of privilege was the result of an affirmative act by the party asserting privilege; (2) through the affirmative act, the asserting party put the protected information in issue by making it relevant to the case; and (3) application of the privilege would have denied vital information to the opposing party. The commissioner noted that the Hearn test has been endorsed by the U.S. Court of Appeals for the District of Columbia Circuit (D.C. Circuit).
The taxpayer responded that the Hearn test had been explicitly rejected by the Court of Appeals for the Second Circuit in Pritchard v. Cnty. Of Erie (In re City of Erie). 546 F.3d 222, 229. Under Pritchard, according to the taxpayers, attorney-client privilege is waived only if a party relies on the privileged advice to make a claim or defense. Because any appeal would lie in the Second Circuit, the taxpayers contended that the Golsen rule required applicability of the Pritchard standard. Under the Golsen rule, the Tax Court is generally required to follow the clearly established position of the circuit to which an appeal would be taken. Golsen v. Commissioner, 54 T.C. 742 (1970).
The Court’s Analysis
The court began its analysis by addressing the taxpayers’ Golsen rule argument. The court first cited IRC section 7453, which requires that Tax Court proceedings follow the rules of evidence (which incorporate common law rules of privilege) applicable to nonjury trials in the U.S. District Court for the District of Columbia. The court then rejected the taxpayers’ Golsen rule argument because it concluded that the facts before it were materially different from the facts in Pritchard. The court did not address the more fundamental question: In view of the statutory mandate that the Tax Court apply the rules of evidence applicable in the D.C. Circuit, is the Golsen rule even applicable to rulings involving privilege? The court was able to finesse this question by citing cases from the D.C. District Court and the Second Circuit (including the Pritchard case itself) in support of its analysis of implied waiver.
The court also declined to address directly the parties’ dispute over whether the Hearn or Pritchard standard should apply to the question of implied waiver. Instead, the court referred to fairness as the concept that underlies waiver considerations. The court then cited numerous cases indicating that privilege may be waived where a party puts its state of mind in issue.
Focusing first on the reasonable belief defense to the substantial understatement penalty, the court found that the taxpayers had placed into issue their knowledge and understanding of the legal authorities, and the basis for the taxpayers’ belief that, if challenged, their tax position would more likely than not succeed. It was of no import that the taxpayers did not rely on the tax opinions. The court concluded that because the taxpayers did not claim to ignore the opinions, the attorney-client privilege had been waived because the opinions were “relevant to the content and formation of their legal knowledge, understanding and beliefs.”
The court then turned to the reasonable cause exception to accuracy-related penalties, which requires a showing that there was reasonable cause for an underpayment and that the taxpayer acted in good faith. The court concluded that its reasoning concerning the relevance of the tax opinions to the taxpayers’ reasonable beliefs applied with equal force to the reasonable cause defense.
Concurrent with the enactment of new penalties applicable to reportable transactions in 2004, the reasonable belief defense to the substantial understatement penalty was eliminated for taxable tax years ending after October 22, 2004. Thus, this aspect of the opinion has limited precedential effect. However, the court’s analysis of the reasonable cause exception under the IRC section 6664(c) (1), which is generally applicable to accuracy-related penalties, will have significant continuing applicability. Presumably, the court’s rationale would also apply to the reasonable cause exception under IRC section 6664(d) (1) to the reportable transactions penalty under IRC section 6662A. It should be noted that there is no reasonable cause exception under IRC section 6664(c)(2) for transactions lacking in economic substance under IRC section 6662(b)(6).
The Tax Court’s opinion has potentially wide-ranging implications because it would apply whenever a taxpayer relies on the reasonable cause defense in IRC section 6664—regardless of whether the transaction at issue is a tax shelter—since a taxpayer’s assertion of the reasonable cause defense necessarily implicates the taxpayer’s state of mind.
Going forward, taxpayers should carefully consider whether and when to assert defenses to accuracy-related penalties that implicate their beliefs or state of mind. No waiver should occur if a taxpayer asserts the objective-based defenses in IRC section 6662(d)(2)(B) due to substantial authority for the tax position or adequate disclosure of a tax position for which there is a reasonable basis. The taxpayer, however, must carefully weigh the potential benefit of asserting a defense based on the taxpayer’s belief or state of mind against the implied waiver of privilege with respect to tax opinions and other documents and communications relating to the same subject matter.