United States: Tax Court Order Reaffirms That State Of Mind Defense Waives Attorney-Client Privilege

In Eaton Corp. v. Commissioner, No. 5576-12 (2015), Special Trial Judge Daniel A. Guy, Jr. reinforced the U.S. Tax Court's controversial opinion from AD Investment 2000 Fund LLC v. Commissioner, 142 T.C. 248 (2014), which held that a taxpayer implicitly waives its attorney-client privilege simply by asserting a reasonable belief defense to accuracy-related penalties.

AD Investment

In AD Investment, the Tax Court left many tax practitioners surprised and dismayed when it held that taxpayers asserting good-faith defenses to accuracy-related penalties had waived the attorney-client privilege by putting their state of mind at issue. The case involved two partnerships engaging in what the Internal Revenue Service (IRS) described as Son-of-Boss tax shelter transactions designed to create artificial tax losses. Based on these transactions, the IRS adjusted partnership items and determined that various section 6662 accuracy-related penalties should apply to any resulting underpayments of tax.

The partnerships defended against the penalties by claiming two commonly pled affirmative defenses under section 6664: the reasonable belief defense and the reasonable cause/good faith defense. Although the taxpayers had received six opinion letters regarding the transaction from the law firm Brown & Wood LLP, they did not claim that their "reasonable belief" and "good faith" centered on that professional advice. Instead, they stated that they had relied on their own self-determination, and thus they claimed that those tax opinions were not relevant to their defenses and should therefore be protected by the attorney-client privilege.

In an opinion by Judge James S. Halpern that stunned the tax bar, the Tax Court held that the taxpayers had implicitly waived the attorney-client privilege by raising the reasonable belief defense. Judge Halpern wrote that the taxpayers' defense "placed the partnerships' legal knowledge, understanding, and beliefs into contention, and those are topics upon which the opinions may bear." He further opined that if the partnerships had relied on the legal knowledge of their lawyers in forming their reasonable and good faith belief that the tax treatment of the items in question was more likely than not the proper treatment, then "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)." Thus, Judge Halpern ordered production of the once privileged documents.

Eaton Corp.

Many tax lawyers were cautiously optimistic that the Tax Court's ruling would be limited to the area of tax shelters, where courts may be less inclined to allow the attorney-client privilege. These hopes were dashed by the order in Eaton Corp., which revolved around the IRS's motion to compel the production of certain documents held by the taxpayer. These documents comprised internal e-mails, memos and data compilations exchanged between the taxpayer and the taxpayer's legal counsel at Mayer Brown LLP, and tax practitioners at PricewaterhouseCoopers and KPMG. The documents were generated in support of the taxpayer's negotiation of an advanced pricing agreement (APA) with the IRS.

Special Trial Judge Daniel A. Guy, Jr. first rejected the IRS's argument that these documents weren't at all privileged. Finding that the documents under review were prepared because of the prospect of litigation and that the communications in question were intended to be confidential, the court concluded that the documents were theoretically protected from discovery based on the attorney-client and tax practitioner privileges, as well as under the work product doctrine.

Next, the judge turned to the question of whether the taxpayer had implicitly waived those privileges by asserting the reasonable cause/good faith defense. The taxpayer tried to differentiate its facts from those of AD Investment by arguing that the AD Investment court had only properly analyzed the reasonable belief defense and not the reasonable cause/good faith defense that was being utilized in the taxpayer's case. Here, however, the judge agreed with the IRS that AD Investment was controlling, concluding that the taxpayer's "reasonable cause/good faith defense puts into contention the subjective intent and state of mind of those who acted for [the taxpayer] and [taxpayer]'s good-faith efforts to comply with the tax law." Thus, the judge stated, "it would be unfair to deprive [the IRS] of knowledge of the legal and tax advice that [taxpayer] received in the course of requesting and negotiating the APA." Accordingly, the court held that by raising the reasonable cause/good faith defense, the taxpayer had waived its right to proclaim the documents privileged.


It is disheartening that the protections offered by the attorney client privilege are eroding. It remains to be seen whether and to what extent the full Tax Court will continue to apply AD Investment. In the meantime, taxpayers should weigh their options and closely evaluate alternatives before invoking a 6664 state of mind defense to an accuracy-related penalty.

Tax Court Order Reaffirms That State Of Mind Defense Waives Attorney-Client Privilege

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