Privileged Taxes? The Gray Area for Protecting Tax Advice in Estate Planning

It is no question that the current tax code is complex. Taxpayers—including settlors or trustees of a trust, individuals, and businesses—therefore frequently obtain legal and financial advice regarding how to structure businesses or transactions to minimize tax liability. But what happens when the IRS demands to see that advice?

THE IRS’S POWER TO DEMAND INFORMATION

The IRS has broad summons powers it can use to examine any documents or compel testimony from a taxpayer.1 That power extends to the taxpayer’s representative or a third party with potentially relevant information. The IRS routinely directs summonses to attorneys, accountants, and trustees, in addition to the taxpayers themselves. Those summonses often seek “all documents” relating to a particular transaction or filing. If the subject of a summons refuses to turn over the documents or testify as requested, the IRS can file a petition in federal court to enforce the summons.

Courts generally impose a minimal burden on the IRS, only requiring the IRS to show (1) the investigation will be conducted for a legitimate purpose, (2) the inquiry is relevant to the investigation’s purpose, (3) the IRS does not already possess the information, and (4) all administrative steps required by the IRS Code have been followed.2 If the IRS meets that burden, then the taxpayer must establish a reason why the IRS is not entitled to the information it seeks.

THE ATTORNEY-CLIENT PRIVILEGE AND THE WORK PRODUCT DOCTRINE

One reason the IRS may not be entitled to information sought in a summons is if an evidentiary privilege applies. The courts widely recognize two evidentiary privileges: the work product doctrine and the attorney-client privilege. The work product doctrine—which generally prevents the disclosure of one side’s legal theory, mental impressions, and strategy—is broad, but it only applies once litigation is reasonably anticipated. Usually, taxpayers seek tax advice before anticipating litigation, so the work product doctrine does not apply.

The attorney-client privilege protects all confidential communications between a client and an attorney for the purpose of providing legal advice. Unlike the work product doctrine, the attorney-client privilege applies regardless of whether litigation is imminent. Documents shared with third parties, such as other parties to a transaction, are unlikely to be privileged. An exception is that the attorney-client privilege can include third parties—such as accountants—when their expertise is necessary for effective consultation between the attorney and client.3 Note, however, that lawyers retaining a third-party expert should carefully document the engagement and its purpose, particularly if the taxpayer has previously used the services of that third party.

TO WAIVE OR NOT TO WAIVE

Importantly, the attorney-client privilege can be waived, particularly if a taxpayer raises a defense that he or she relied on legal advice. For example, if the IRS assesses an accuracy-related penalty against a taxpayer, the taxpayer can avoid the penalty if he or she shows that there was reasonable cause for, and he or she acted in good faith with respect to, the alleged underpayment.4

 

Raising a “reasonable cause and good faith” defense based on a legal opinion permits the IRS to obtain otherwise privileged attorney-client communications relating to the defense.5 The taxpayer can choose to waive the privilege and disclose the privileged communications, particularly if those communications firmly establish the taxpayer’s reasonable belief and good faith. The IRS, however, may then be entitled to all communications relating to whether the taxpayer’s belief was more than likely reasonable. A recent 2017 case in the Eastern District of Kentucky showed how, in some circumstances, the taxpayer can also choose to abandon the defense rather than waive the privilege.6

Applying the attorney-client privilege is fact-intensive and determined case by case. When responding to an assessment of an accuracy-based penalty, a taxpayer waiving the attorney-client privilege can facilitate cooperation and an amicable resolution with the IRS. Waiving the privilege can also help a taxpayer prove the intent behind a transaction or establish a “reasonable cause and good faith” defense. Conversely, improper assertion of this defense can inadvertently waive the attorney-client privilege. Even an intentional waiver of the privilege can lead to broader disclosure than originally intended.

Before waiving the privilege or raising a defense based on reliance on legal advice, a taxpayer should always consult an experienced litigation attorney knowledgeable about privilege issues.