Attorney-client Privilege Waiver By Putting State of Mind In Issue -- Reasonableness and Good Faith (4/21/14; 4/26/14)

In AD Investment 2000 Fund LLC v. Commissioner, 142 T.C. No. 13 (2014), here, the Tax Court (Judge Halpern) held that, by putting the taxpayer's intent and good faith in issue to contest the substantial understatement penalty, the taxpayer had waived the attorney-client privilege with respect to the opinion received for this tax shelter ploy.  The opinion is short and direct and definitive for the case.  The tax shelter involved was the Son-of-BOSS shelter, which readers already know is bullshit.  

I need to state the context.  I do this in order to address also the attorney-client privilege as it arose in TIFD III, which I discussed several days ago in a different penalty context.  See GE Ducks Any Penalty for Its Bullshit Tax Shelter -- For Now (Federal Tax Crimes 4/17/14). here.

AD Investment involved the substantial understatement penalty in Section 6662(d)(1), here.  The threshold requirement for that iteration of the accuracy related penalty is that the tax involved with the position exceed a "substantial" amount, defined rather insubstantially as the greater of (i) 10% of the tax required to be shown the return or (ii) $5,000 for individuals and $10,000 for corporations.  AD Investment involved a partnership proceeding, and the existence of the threshold must await partner level proceedings where the tax is actually determined.

Assuming the threshold exists, the penalty applies to the understatement except for the portion of the understatement for which the taxpayer has either (i) substantial authority or (ii) reasonable basis and made a return disclosure of the position.  As the statute now reads, the except clause excluding a portion of the understatement does not apply to tax shelters.  For the year involved, the blanket exclusion of tax shelter items did not apply; in pertinent part, the reduction of the base subject to the penalty applied if the position had substantial authority (an objective test) and the taxpayer reasonably believed that the tax shelter position was more than likely correct (a combined subjective test requiring that the taxpayer believed it and objective test requiring that the taxpayer have reasonably believed it).  The taxpayer in AD Investment averred the presence of these two tests to avoid the penalty.

In addition, the accuracy related penalty, including the substantial understatement penalty, may be avoided if the taxpayer acted with reasonable cause and good faith.  Section 6664(c), here. This is a defense to the application of the accuracy related penalty, although as I shall note below, in some cases, its factors blend into the elements that cause the accuracy related penalty to apply in the first place.  Stobie Creek Investments, LLC v. United States, 82 Fed. Cl. 636, 708 (Fed. Cl. 2008), aff'd, 608 F.3d 1366 (Fed. Cir. 2010).

According to Judge Halpern, the key point in issue was whether the partnership reasonably believed that its position was more likely than not correct.  Under the Regulations, there are two ways to satisfy this requirement.  First, the taxpayer alone makes the determination in good faith.  Second, "The taxpayer reasonably relies in good faith on the opinion of a professional tax advisor."

Under traditional interpretation of attorney-client privilege waiver, there would be a waiver if the taxpayer sought to avoid the penalty under the second ground -- reliance on the opinion of a professional tax adviser.  The partnership -- serving the role of the taxpayer for this purpose -- studiously avoided reliance on the second ground.  Hence, the partnership urged, it had not waived the privilege: "A generalized 'good faith' defense, not specifically relying on the advice of counsel is not a waiver of the attorney-client privilege."  Judge Halpern rejected the argument.

Here is the analysis in full for waiver on the issue of whether the penalty applies, an issue which will turn whether the partnership had a reasonable belief that the position was correct.

B. Belief Requirement 

To satisfy the belief requirement by the first method (i.e., under section 1.6662-4(g)(4)(i)(A), Income Tax Regs. [here]) petitioners must show that the partnerships "analyze[d] the pertinent facts and [legal] authorities * * * and in reliance upon that analysis, reasonably * * * conclude[d] in good faith that there * * * [was] a greater than 50-percent likelihood that the tax treatment of the item * * * [would] be upheld if challenged by the Internal Revenue Service". Petitioners' averments that the partnerships satisfied the belief requirement by the first method put into dispute the partnerships' knowledge of the pertinent legal authorities. Petitioners' averments also put into contention the partnerships' understanding of those legal authorities and their application of the legal authorities (i.e., the law) to the facts. Finally, the averments put into contention the basis for the partnerships' belief that, if challenged, their tax positions would more likely than not succeed in the courts. Petitioners have thus placed the partnerships' legal knowledge, understanding, and beliefs into contention, and those are topics upon which the opinions may bear. If petitioners are to rely on the legal knowledge and understanding of someone acting for the partnerships to establish that the partnerships reasonably and in good faith believed that their claimed tax treatment of the items in question was more likely than not the proper treatment, it is only fair that respondent be allowed to inquire into the bases of that person's knowledge, understanding, and beliefs including the opinions (if considered). See, e.g., Cox, 17 F.3d 1386; Bilzerian, 926 F.2d 1285; Anderson, 444 F. Supp. 1195. 

Apparently, each partnership received the opinions well before its 2000 tax returns were due. Petitioners do not claim that those acting for the partnerships ignored the opinions. They claim only that the regulations provide an alternative pursuant to which the partnerships may satisfy the belief requirement by self-determination (without relying on professional advice). That is true. See sec. 1.6662-4(g)(4)(i), Income Tax Regs. It is, however, beside the point. The point is that, by placing the partnerships' legal knowledge and understanding into issue in an attempt to establish the partnerships' reasonable legal beliefs in good faith arrived at (a good-faith and state-of-mind defense), petitioners forfeit the partnerships' privilege protecting attorney-client communications relevant to the content and the formation of their legal knowledge, understanding, and beliefs. E.g., Cox, 17 F.3d 1386; Bilzerian, 926 F.2d 1285. Pritchard, 546 F.3d 222, is not to the contrary. The Court of Appeals there stated: "Petitioners do not claim a good faith or state of mind defense. They maintain only that their actions were lawful or that any rights violated were not clearly established. In view of the litigation circumstances, any legal advice rendered by the County Attorney's office is irrelevant to any defense so far raised by Petitioners." Id. at 229.

The Court thus said that the partnership had placed the contents of the opinion(s) in issue.

The Court then turned to whether the reasonable cause and good faith defense also supported an implied waiver.  As noted above, this is almost a no-brainer.  The Court not surprisingly applied the waiver.  The Court simply concludes:  "For the reasons set forth with respect to the belief requirement, petitioners have with respect to the section 6664(c)(1) reasonable cause exception forfeited the privilege that would otherwise apply to the opinions."

I don't think there is anything particularly exceptional about these holdings that the attorney-client privilege had been waived.  It is true that the Court made the decision more authoritative by issuing it as a T.C. rather than a TCM opinion.  But, it was not a reviewed opinion which it surely would have been had there been any substantial controversy about it.

Now, let's look at the TIFD III case.  See GE Ducks Any Penalty for Its Bullshit Tax Shelter -- For Now (Federal Tax Crimes 4/17/14). here.  As TIFD III worked its way to the Court of Appeals twice, the Government asserted the substantial understatement penalty.  The Government was successful in that assertion through the second appeal, but by the time the case again reached the district court on remand, the Government had realized that, because the payments to the lender were deductible interest, the key 10% threshold was not met.  So, on remand, the Government asserted the negligence penalty.

The taxpayers in both of these cases refused to waive the privilege.  Unlike the Tax Court in AD Investment, the district court in TIFD III said that the taxpayer's reliance or nonreliance on any opinion(s) it received was irrelevant to the negligence issue.  The Court interpreted the negligence issue to be wholly objective, not requiring resort to a taxpayer's intent or state of mind.  Here is the cut and paste:

The government's position in this case can fairly be described as "mind boggling." See Holmes, 85 F.3d at 963 n.7. It does not seriously argue that no authorities supported TIFD's tax position. At oral argument, the government declined to respond to TIFD's many proffered authorities because "it's too late, and it doesn't matter." Mot. Hr'g Tr. 32-33, Dec. 3, 2012 (doc. # 168). According to the government, TIFD must present evidence that it actually, subjectively relied on those precedents when it determined its tax liability. The government essentially asks me to draw an adverse inference from the fact that TIFD did not waive the attorney-client privilege with respect to the tax advice it received, but instead attempted to win based on the state of the law alone. But that interpretation defies both common sense and the larger structure of the regulations governing penalties. In general, a review for reasonableness is an objective assessment, one that does not consider an individual's actual state of mind. Section 1.6662-3 reflects this accepted standard, ascribing "reasonable basis" to the tax position, not the taxpayer. Treas. Reg. § 1.6662-3(b)(1) ("A return position that has a reasonable basis . . . is not attributable to negligence."); see also Didonato v. C.I.R., 105 T.C.M. (CCH) 1067 (T.C. 2013) (noting that "petitioners could not avail themselves of the defense under section 6662(d)(2)(B)(ii) because they have failed to provide authority that could provide a reasonable basis for their return position" (emphasis added)); I.R.S. Chief Couns. Mem. at 3 (Feb. 26, 2010) (looking to the section 6662 accuracy-related penalty for guidance and finding that "[a] taxpayer's state of mind has no bearing on meeting the reasonable basis standard" contained in I.R.C. § 6676). 

The IRS regulations do contain a safe harbor provision that examines a taxpayer's conduct and its subjective belief, allowing the taxpayer to avoid a penalty if it had "reasonable cause . . . and acted in good faith." Treas Reg. § 1.6664-4. In determining whether the reasonable cause and good faith defense applies, the most important factor generally is "the extent of the taxpayer's effort to assess the taxpayer's proper tax liability." Id. Under section 1.6664-4, "[r]eliance on an information return, professional advice, or other facts . . . constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith." Id. (emphasis added). But section 1.6664-4 is not the provision upon which TIFD relies. The IRS included no such language in section 1.6662-3, and there is no reason to believe that it intended the "reasonable basis" standard to include a similar subjective component. 

Of course, one way to bolster a case for a reasonable basis could be to show that a taxpayer relied on the independent advice of counsel. Such was the strategy in the case cited by the government, Stobie Creek Investments, LLC v. United States, 82 Fed. Cl. 636 (Fed. Cl. 2008), aff'd, 608 F.3d 1366 (Fed. Cir. 2010). Factual differences aside (Stobie Creek involved an opinion issued by a conflicted attorney and a transaction that lacked economic substance), that case does not support the proposition that there must be actual, subjective reliance by a taxpayer hoping to avoid a negligence penalty. Whether a taxpayer's subjective reliance on certain authorities or on the advice of counsel was reasonable need not enter the equation until its position appears unreasonable to the objective observer. Here, the taxpayer's conduct appeared more than reasonable to me, it appeared correct. In such a case, the taxpayer's subjective belief simply is not relevant. 

Finally, even if TIFD's conduct or state of mind were at issue here, the record reflects a cautious effort to create equity, not debt, and the company cannot be faulted for failing to correctly predict the ultimate outcome of this case. Corporate representatives reviewed proposals from seven respected investment firms before deciding on a plan. They evaluated those proposals based on one central criterion – that GECC amass no additional debt, for doing so would trigger a financial catastrophe for the company. After a series of revisions, vetted by Babcock & Brown and at the very least GECC's inside legal team, the company offered the Dutch Banks an ownership stake in the partnership. In short, there was nothing negligent or haphazard about the decision to enter into the Castle Harbour transaction or to treat the Banks' participation as a partnership interest rather than a loan. Accordingly, the negligence penalty is not applicable in this case.

I am not sure that the general analyses of the two cases are consistent.  To the extent that they aren't, I think Judge Halpern's is the better reasoning.

I also think that even the judge in TIFD III realized that his analysis was weak; hence he felt compelled at the end to say that, even if he were wrong, the taxpayer before him was pure as snow with regard to intent.  If that is true, how could he really assess intent without the opinions for the context of the intent he found so pure?

In fairness, I don't know whether the Government had attempted to get the opinions.  If the Government did and the district court refused to order disclosure of the opinions, then the district court should not have made the finding of intent without the key evidence he denied to the Government because he had allowed key evidence to be withheld.  In this regard, as the case progressed earlier, it was a substantial understatement case and likely would have been subject to the same analysis as AD Investment.

Addendum 4/26/14:

Lee Sheppard has a flowery discussion of AD Investment in Lee A. Sheppard, Tax Court Addresses Privilege in Shelter Penalties, 143 Tax Notes 407 (Apr. 28, 2014), so readers having access to that article might want to read it.

For a shorter, more straightforward presentation of her views, see Lee A. Sheppard, The Tax Court Didn't Repeal Attorney-Client Privilege (Forbes 4/20/14), here.  I can't resist excerpting a part that shows Lee's inimical writing style:

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.”

And her conclusion:

Why wouldn’t the taxpayer just hand over the opinion to the court? Many tax shelter opinions were canned opinions with assumed facts that were not based on any client information. A canned opinion does not impress a judge, and may have the opposite effect of showing the flimsiness of the taxpayer’s argument. 

The mere existence of the lawyer’s opinion was supposed to help the taxpayer’s case by giving it a justification to avoid tax penalties. As long as no one read the opinion–least of all a judge. Sounds backwards, but many tax shelter opinions were not worth the paper they were printed on, and turned out to be more damaging than helpful to taxpayers’ cases. 

Guilt and innocence are not relevant concepts in this case. AD Investment 2000 is not a criminal case. No one is going to jail. This is about a fine in addition to tax. The taxpayer here is just paying a penalty for being in a tax shelter for which there was no legal basis. Money. That’s all. 

Presumably that is why GE did not want to turn over its tax opinions in TIFD III.