Attorney-client privilege waived under common law

The Tax Court recently concluded that, when the taxpayers in the case asserted that they had reasonable cause and acted in good faith as a defense to penalties assessed by the IRS, they forfeited their privilege protecting attorney-client communications.

In this case (Ad Investment 2000 Fund, LLC, v. Commissioner, 142 TC No. 13, April 16, 2014), the IRS asserted that the taxpayers engaged in transactions designed to create artificial tax losses. The IRS also assessed penalties attributable to:

  • A substantial understatement of income tax;
  • A gross valuation misstatement; and/or
  • Negligence or disregard of rules and regulations.

Anticipating the taxpayers’ argument that the penalties should not apply because they acted with reasonable cause and in good faith, the IRS asked the court to compel production of six tax opinion letters the taxpayers had obtained from their law firm.

The taxpayers objected to the disclosure on the grounds that the letters were privileged attorney-client communications. The IRS argued that the taxpayers waived any privilege under the common-law doctrine of implied waiver by relying on affirmative defenses to the penalties that turn on the taxpayers’ beliefs or state of mind. The taxpayers contended that they had developed their reasonable belief by analyzing the pertinent facts and authorities and not by any reliance on advice from their attorneys.

The court concluded that, by putting the taxpayers’ legal knowledge and understanding into contention to establish good-faith and state-of-mind defenses, the taxpayers forfeited the privilege protecting attorney-client communications relevant to the content and formation of their legal knowledge, understanding and beliefs.

The court reasoned that the taxpayers must show that they analyzed the pertinent facts and legal authorities and, in reliance upon that analysis, reasonably concluded in good faith that there was a greater than 50 percent likelihood that the tax treatment would be upheld if challenged. This put into contention their knowledge of the pertinent legal authorities, their understanding of those legal authorities and their application of the legal authorities to the facts.

The court noted that the taxpayers received the opinions well before their tax returns were due and they did not claim that they ignored the opinions. If the opinions formed the basis for the taxpayers’ beliefs, the court concluded that it is only fair to allow the IRS to review those opinions.