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Saturday, April 19, 2014


Written and oral communications between a client and his or her attorney are generally privileged. This includes communications regarding taxes.

In a recent Tax Court case, an example of “the exception swallowing up the rule” arose. The case threatens to void the attorney-client privilege in a great swath of tax cases that are litigated where the taxpayer asserts a reasonable cause defense to a penalty.

In the subject case, the taxpayer was threatened with a substantial underpayment of income tax penalty. In defense of that threat, the taxpayer claimed the reasonable cause exception for the penalty under Code §6664(c). That Section applies to the portion of an underpayment “if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion (emphasis added).”

By asserting that defense, the government claimed that that taxpayer had waived the attorney-client privilege. The government could thus access communications between the taxpayer and his attorney that related to the tax issue, because that is relevant to whether the taxpayer acted in ‘good faith.’ More specifically, the government was seeking access to written tax opinions that would otherwise have been privileged.

The Tax Court agreed with the government, finding that the required inquiry into ‘good faith’ makes the reasonable cause exception a ‘state-of-mind’ exception. Thus, a review of the knowledge and thinking of the taxpayer as to the law is relevant. Further, knowledge and statements communicated by the attorneys to the taxpayer relating to the reporting of the tax item are directly relevant to such an inquiry. Thus, by asserting the penalty exception, the taxpayer waived the attorney-client privilege.

The reach of this exception is broad, since it presumably will apply to all accuracy related penalties, including fraud penalties, when the reasonable cause exception is asserted by the taxpayer. Thus, taxpayers and their tax attorneys do have the benefit of the attorney-client privilege, but a taxpayer that wants to assert the privilege may have to sacrifice any claim to any state-of-mind penalty exception, including the reasonable cause exception, if it wants to maintain the privilege. Since reasonable cause is a common and important penalty defense, the impact of this case will be very significant (forcing a choice between an exception to penalty argument vs. protecting privileged communications).

The exception should not result in a waiver of all attorney-client communications – only those relevant to the taxpayer’s state of mind and knowledge of the applicable law when filing its tax return.

A similar case and result occurred in a District Court bankruptcy proceeding relating to tax issues, in In Re: G-I Holdings, et al., 92 AFTR2d 2003-6451 (DC NJ), 07/17/2003. See also New Phoenix Sunrise Corp. v. Comm., 106 AFTR 2d 2010-7116 (CA6 2010) for another similar result.

I leave it to the litigators whether there is any method to bifurcate the tax determination phase of a proceeding from the penalty phase, so that the privileged items need not be disclosed unless the taxpayer lost the tax determination phase. This was attempted in the In Re: G-I Holdings case cited above. It was not rejected out-of-hand, but was ultimately denied because the court determined that the taxpayer had already waived the privilege by asserting the reasonable cause defense to penalties in discovery responses and thus it was too late to salvage it.

AD Investment 2000 Fund LLC, Community Media, Inc., 142 TC No. 13 (2014)

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