On March 27, 2017, in U.S. v. Micro Cap KY Ins. Co. Inc.,1 the federal district court upheld a claim of attorney-client privilege in a federal income tax dispute between two doctors and the US Internal Revenue Service (the “IRS”). The taxpayers had undertaken a micro-captive insurance transaction, relying on the advice of counsel in doing so. The IRS sought to compel the disclosure of emails between the doctors and the attorney in a summons enforcement proceeding in district court. The court upheld the privilege claim even though the taxpayers had asserted in their petition in a related Tax Court case that their reliance on such advice protected them from the imposition of penalties under the “reasonable cause”2 defense.
In Micro Cap the court held that a taxpayer’s claim of a reasonable cause penalty defense in a Tax Court petition does not automatically lead to a waiver of the attorney-client privilege. In recent years, the IRS has been successful in limiting taxpayer privilege claims when the taxpayer asserts that he relied on the attorney’s advice and such reliance served as the basis for avoiding tax penalties.
The gradual erosion of protection accorded to privileged taxpayer communications reached a critical point with the Tax Court’s decision in Ad Investment 2000 Fund, LLC v. C.I.R.3 There, the Tax Court determined that the taxpayer’s assertion of a reasonable cause penalty defense caused a waiver of attorney-client privilege over six tax opinions that the taxpayer procured from outside counsel. The potential ramifications of this holding were severe—it seemingly enabled the IRS to gain access to privileged communications by simply asserting a negligence or other accuracy-related penalty against a taxpayer.4 This holding has threatened to fundamentally undermine privilege protections by placing taxpayers in the untenable position of having to decide whether to disclose privileged communications to the IRS or forfeit a penalty defense.
The context of the new case, Micro Cap, is particularly interesting because the IRS began this summons enforcement proceeding for the specific purpose of obtaining privileged communications related to a micro-captive business structure. The IRS designated micro-captive transactions as transactions of interest in Notice 2016-66. On January 31, 2017, the IRS announced that micro-captive transactions would be part of its compliance campaign initiative. To the extent the IRS’s actions in Micro Cap reflect the manner by which these campaigns will be conducted, taxpayers with campaign issues should brace themselves for contentious examinations.
II. Micro Cap Opinion
The district court in Micro Cap limited the holding of Ad Investment by holding against the “waiver-through-pleading” interpretation that, experience has shown, the IRS endorses.5 The district court specifically held that the taxpayer’s reasonable cause defense to penalties in a separate Tax Court petition did not, by itself, waive privilege over relevant documents. Rather, waiver would only result if the taxpayers “persist” in their reasonable cause defense following any subsequent IRS motion to compel production of privileged materials in the Tax Court case. Micro Cap, therefore,partially dulls the negative effect of Ad Investment, providing taxpayers with some ability to maneuver around disclosing privileged communications unless and until a court orders production of those materials.
The taxpayers in Micro Cap are two doctors who formed separate captive insurance companies to insure against risks posed in their medical practices. During the formation of those insurance companies, the doctors sought and received advice from a law firm. During a subsequent IRS audit of the insurance transactions, the IRS examiner issued a summons to the doctors, directing them to produce several categories of documents, including a series of emails between the doctors and the law firm. The doctors produced all of the documents identified in the summons with the exception of those emails, claiming they were protected by attorney-client privilege. The IRS then initiated an enforcement action, seeking full compliance with the summons.
While the summons enforcement action was docketed in district court, the doctors filed a petition with the Tax Court. In that petition, the taxpayers pled that they relied on the advice of counsel for all positions taken on their income tax returns with respect to the insurance transactions. The IRS argued that the taxpayers had waived privilege over the relevant communications through their pleadings in the Tax Court matter. The district court judge ultimately determined that this issue was untimely raised by the IRS but nonetheless proceeded to explain that the IRS’s contentions were unpersuasive on the merits.6
The district court relied heavily on the Tax Court’s holding in Ad Investment. While noting that reasonable cause defense “may result in a waiver of the attorney-client privilege in a variety of proceedings, including those before the Tax Court,” the district court held that the assertion of the defense does not in and of itself cause a privilege waiver. Waiver, instead, occurs when the taxpayers continue to maintain the defense following a court order to produce those documents:
[The assertion of a ‘reasonable cause’ defense] merely gives the Commissioner grounds to compel the production of documents subject to the attorney-client privilege. Even when such a motion to compel is well-taken, case law suggests that disclosure may not result. For example, in Ad Investment 2000, the Tax Court found that the petitioners had waived their attorney-client privilege by putting protected communications at issue, and ordered the petitioners to produce the privileged documents.However, the Tax Court simultaneously indicated that the petitioners could still protect their documents from disclosure by abandoning their ‘reasonable cause’ defense.
The persistent position qualification to waiver is found in the conclusion section of the Ad Investment opinion.7 As a practical matter, this places the burden on the IRS to move to compel the petitioner in Tax Court proceedings to produce the relevant documents. Only then can subsequent affirmative taxpayer actions result in waiver of privilege.
III. Going Forward
The district court’s opinion in Micro Cap bolsters the attorney-client privilege—which was arguably impaired by some interpretations of Ad Investment—andshould provide some relief to tax planners and taxpayers who rely on attorney advice and tax opinions in structuring their business transactions. While the district court’s opinion is arguably of limited precedential value, it should serve as a persuasive predicate for future court decisions.
1 No. 5:16-cv-00278, 2017 WL 1132904 (E.D. Ky. Mar. 27, 2017).
2 The federal district court refers to a “reasonable cause” penalty defense, though it is perhaps more appropriate to refer to it as the “reasonable cause and good faith” defense. See Treas. Reg. §1.6664-4. The defense is unavailable for transactions lacking economic substance. See I.R.C. §6664(c)(2).
3 142 T.C. 248 (2014).
4 There are other available defenses to accuracy-related penalties. For example, a return position that has a “reasonable basis” is not considered attributable to negligence. See Treas. Reg. §1.6662-3(b)(1). Taxpayers may also avoid the imposition of substantial understatement penalties by demonstrating that there is “substantial authority” for the tax treatment of the relevant item. See Treas. Reg. §1.6662-4(d)(1).
5 See U.S. v. Eaton Corp.,2012 WL 3486910, at *9 (N.D. Ohio Aug. 15, 2012) (The IRS unsuccessfully argued that “Eaton contested the adjustments made by the IRS to its tax returns by challenging the IRS’s adjustments in Tax Court (and thus placed at issue all of the documents related to its transfer pricing methodology and APA application).”).
6 There is a possibility that the district court’s decision would be dismissed as dicta, but its thoroughness and thoughtfulness should make it persuasive to any subsequent waiver matter.
7 142 T.C. at 258 (if the petitioners “persist, they sacrifice the privilege to withhold the contents of the opinions”).