Attorney-client privilege may seem sacrosanct, but it is not the bulwark against discovery that both attorneys and clients have come to expect.
Four recent decisions reveal that the IRS is more aggressively seeking discovery of potentially privileged information, including from attorneys and tax practitioners, and meeting with mixed success: Taylor Lohmeyer Law Firm PLLC v. United States, Gaetano v. United States, In re Search Warrant Issued June 13, 2019, and United States v. Microsoft Corp. These cases illustrate how courts may navigate the tension between enforcement of the tax laws and well-established privilege protections.
Several decades ago, the U.S. Supreme Court explained that “[t]he attorney-client privilege is the oldest of the privileges for confidential communications known to the common law,” and “[i]ts purpose is to encourage full and frank communication between attorneys and their clients and thereby promote broader public interests in the observance of law and administration of justice.” Upjohn Co. v. United States. Under federal common law, attorney-client privilege protects confidential communications between the client and his or her attorney, or the attorney’s representative, that were “made for the purpose of facilitating the rendition of professional legal services to the client.” Proposed Fed. R. Evid. 503(b); see also In re Bieter Co. “With respect to tax advice,” the federally authorized tax practitioner privilege extends this privilege to “a communication between a taxpayer and any federally authorized tax practitioner to the extent the communication would be considered a privileged communication if it were between a taxpayer and an attorney.” tax code Section 7525(a)(1). The work product protection safeguards work product created in anticipation of and preparation for litigation by or at the direction of counsel, particularly where the work product reveals an attorney’s mental impressions.
There are, of course, exceptions to the attorney-client and work product privileges, including the crime-fraud exception, which applies (1) if the client was in the process of committing or planning a fraud or crime, and (2) the communications were made in furtherance of the fraud or crime, see
In re Grand Jury Investigation, as well as the exception to the tax practitioner privilege for communications involving the promotion of tax shelters, Section 7525(b).
Taylor Lohmeyer Law Firm PLLC v. United States (2019)
In Taylor Lohmeyer Law Firm PLLC v. United States, the IRS served a John Doe summons on Taylor Lohmeyer Law Firm PLLC, an estate planning firm, in an effort to discover the identities and other information of clients that the IRS suspected concealed taxable income abroad between 1995 and 2017. A John Doe summons pursuant to Section 7609(f) may be issued with respect to an unknown party provided that the IRS establishes certain statutory requirements, including that “there is a reasonable basis for believing that such person or group or class of persons may fail or may have failed to comply with any provision of any internal revenue law” and the information to be discovered “is not readily available from other sources.” The John Doe summons in Taylor was largely based on an earlier investigation of one of the law firm’s clients, who used the law firm to set up offshore accounts and admitted to $2 million in unpaid tax liability from 1996 to 2000. The law firm estimated that 32,000 pages of documents were responsive to the summons and petitioned to quash it. The IRS filed a counter-petition to enforce the summons.
The U.S. District Court in the Western District of Texas declined to quash the summons and instead enforced it. It held that at an enforcement hearing, the government has only a “slight” and “minimal” burden to enforce a John Doe summons, while the challenger’s burden to quash it is “heavy.” The court decided that the government’s low burden was satisfied with a single affidavit from an IRS agent. It emphasized that the agent relied on “an interview with [a] former partner of the firm, [who] estimated that he structured offshore entities for tax purposes for 20 to 30 clients between the 1990s and early 2000s,” which permitted the agent to infer from one client’s admission that the law firm had helped other clients avoid tax liability.
The court rejected all of the law firm’s attempts to meet its “heavy” burden to quash the summons, including the argument that the information the summons sought—names and other information related to the firm’s clients—was protected by the attorney-client privilege. The argument failed largely because the law firm asserted a blanket privilege, rather than asserting it on a document-by-document basis. In rejecting the blanket assertion, the court held that a client’s identity was privileged only in a very narrow set of circumstances, which turned on whether “disclosure of the client’s identity by his attorney would have supplied the last link in an existing chain of incriminating evidence likely to lead to the client’s indictment.”
The Taylor decision provides a warning that, despite privilege protections, law firms may still be the target of potentially burdensome and intrusive John Doe summonses. The case suggests that the attorney-client and work product doctrines may not provide blanket protections for a law firm even where the IRS seeks a large number of documents and the law firm is in the business of providing legal counsel. Nonetheless, although undoubtedly burdensome, the law firm may still invoke privilege protections with respect to each document, provided that the firm produces a corresponding privilege log. The Taylor case is currently on appeal to the Fifth Circuit, which may weigh in on the lower court’s reasoning and conclusions.
Gaetano v. United States (2019)
In Gaetano v. United States, the plaintiffs (the Gaetanos) ran a cannabis dispensary and engaged an attorney, Gregory Goodman, to assist in its operation. The attorney-client relationship ended poorly. After the IRS contacted Goodman by letter during an audit of the Gaetanos’ tax returns, Goodman tried to extort the Gaetanos for his silence and eventually retaliated by assisting the IRS. During Goodman’s voluntary conversation with the IRS, the agent instructed him not to share privileged information and confirmed that he understood what privileged communications were. The Gaetanos subsequently sued the IRS to prevent it from obtaining privileged information from Goodman and to require it to destroy any privileged information already obtained.
The government moved to dismiss, arguing that the court had no jurisdiction pursuant to the Anti-Injunction Act (AIA), Section 7421(a), which bars “suits … for the purpose of restraining the assessment or collection of any tax.” The Gaetanos invoked an exception to the AIA, based upon purported violations of their Sixth Amendment right to counsel, Fifth Amendment due process rights, and the court’s common law power to enjoin intrusions into the attorney-client relationship. All failed.
The Sixth Circuit first held that the Gaetanos’ Sixth Amendment rights were not violated because the Sixth Amendment does not attach until a prosecution is commenced. With respect to the Fifth Amendment claim, the court held that “the attorney-client privilege cannot by itself provide the basis for a due process claim” because it was created by common law, not the Constitution. The court acknowledged that other courts have recognized that a “pervasive and prejudicial” government intrusion into an attorney-client relationship can threaten due process. In distinguishing those cases, the Sixth Circuit underscored its “skepticism about the continued vitality of the ‘outrageous government conduct’ defense.” Nonetheless, the court did not go so far as to hold that due process claims based on the “deliberate-intrusion concept” fail as a matter of law, but instead held that the Gaetanos had not made out the claim because the IRS did not solicit privileged communications from Goodman (he voluntarily shared supposedly non-privileged information). Further, there was no showing of prejudice because the Gaetanos “offer[ed] no explanation why the ordinary remedy—suppressing privileged evidence—would fail to protect them.”
The court also declined to enjoin the intrusion into the attorney-client relationship under the common law. It reasoned that the power was not available in the context before it, although it is available “as a shield against compelled disclosure of protected information, … to quash subpoenas … and it can supply the basis for protective orders.” Specifically, the court held that “[j]udges have no ‘roving commission to police voluntary, out-of-court communications.”
Thus, the court held that there was no evidence that the government had done anything wrong; to the contrary, the government took steps to ensure that Goodman did not share privileged communications. Finally, the court held that the Gaetanos failed to show that there was an inadequate remedy at law because they still “may invoke the privilege if the government uses privileged information against them in a criminal proceeding,” and they may still have recourse against Goodman, including professional sanctions, state civil claims, and criminal charges.
The Gaetano decision underscores that the availability of the attorney-client privilege as a sword is limited, particularly where the source of information voluntarily cooperates with the government. Where the IRS has not engaged in unlawful conduct and voluntarily receives potentially privileged communications, a court might not intervene to prevent the IRS from reviewing those communications. As a result, taxpayers have to be strategic about how they invoke attorney-client privilege protections.
Here, the court held that the privilege did not overcome the AIA bar on the Gaetanos’ suit against the IRS; however, there were other avenues the Gaetanos could have pursued to protect their communications with Goodman, including an action against the former lawyer himself. Moreover, as the Sixth Circuit alluded to, the case may have come out differently had Goodman declined to voluntarily share information with the IRS and the government was instead forced to serve a subpoena that the Gaetanos could have sought to quash.
In re Search Warrant Issued June 13, 2019 (2019)
In In re Search Warrant, the government—including the Department of Justice, the Drug Enforcement Agency, and the IRS—executed a search warrant at a law firm’s Baltimore office in connection with a criminal investigation. A partner at the law firm (Lawyer A) represented a defendant (Client A), who was also a Maryland lawyer suspected of helping drug dealers launder money, among other things. The relationship between Lawyer A and Client A triggered the crime-fraud exception, and the government opened an investigation of Lawyer A in light of Lawyer A’s suspected misconduct.
In issuing the search warrant, a magistrate judge approved a plan for reviewing the seized documents, including a privilege and responsiveness review by a filter team of government attorneys and non-attorneys. Because only 116 out of 52,000 emails were sent to or from Client A or contained Client A’s surname, it was possible that most of the seized materials related to clients that were not the subject of any government investigation and even some that were the subject of unrelated government investigations. The law firm moved for a temporary restraining order and injunction. The lower court denied the law firm’s motion, holding that there was no showing that the law firm would suffer “irreparable harm,” as required before issuing an injunction.
The Fourth Circuit reversed. It held, among other things, that the lower court abused its discretion for a number of reasons, and specifically for “disregarding the foundational principles that serve to protect attorney-client relationships.” The Fourth Circuit discussed extensively the importance of the attorney-client and work product protections. In particular, it highlighted the importance of such privileges in fostering candid conversations to promote observance of the law and effectively prepare and present a client’s defense. It noted that, in not finding irreparable harm, “the court failed to recognize that an adverse party’s review of privilege materials seriously injures the privilege holder.”
While the Fourth Circuit’s opinion is a reminder about the importance of privilege, it nonetheless leaves open the possibility that the government may discover information from law firms pursuant to the crime-fraud exception or with a proper review protocol in place to address privilege issues. Nonetheless, the Fourth Circuit strongly articulated the importance of attorney-client and work product protections, and the importance of the judiciary in fulfilling its role to protect from executive overreach. Thus, the opinion underscores that the government’s enforcement powers are not without limits. Moreover, it illustrates the importance of invoking privilege swiftly to secure its protections.
United States v. Microsoft Corp. (2020)
In United States v. Microsoft, the government issued summonses to Microsoft and KPMG LLP, an accounting firm while investigating Microsoft’s cost-sharing arrangements with its Puerto Rican subsidiary in connection with certain intellectual property. KPMG had advised Microsoft on the arrangement. The government argued that the arrangement was designed to avoid income tax liability. In responding to the summonses, Microsoft withheld certain responsive documents and argued that they were protected by the attorney-client privilege, work product doctrine, and/or the tax practitioner privilege under Section 7525. The IRS challenged the privilege designations.
Based upon its in camera review, the U.S. District Court in the Western District of Washington held that nearly all of the documents were not protected and ordered them to be produced. In reaching this conclusion, the court walked through each of the grounds for protection. The court’s determination that most of the withheld documents were not protected by the attorney-client or work product protections turned on a document-by-document analysis finding that the primary purpose of the advice reflected was business, not legal. The court likewise determined that work product protection did not apply because the disputed documents “were not created in anticipation of litigation. Rather, Microsoft anticipated litigation because of the documents it created.” Microsoft also asserted the tax practitioner privilege over the vast majority of the contested documents. Similarly, the court’s decision that the tax practitioner privilege did not apply was based on finding that the primary purpose of the document was “to assist in implementing a business transaction,” rather than to provide tax or legal advice. The court rejected the argument that “merely because [Microsoft] has pursued business transactions requiring ongoing and complex tax, legal, and business advice,” all details provided to KPMG were protected.
But perhaps the most significant portion of the Microsoft opinion is the court’s conclusion that the tax practitioner privilege did not apply because “a significant purpose, if not the sole purpose, of Microsoft’s transactions was to avoid or evade federal income tax.” As such, the court found that the communications fell within the tax shelter exception to the federally authorized tax practitioner privilege set forth in Section 7525(b). The court concluded that neither Microsoft nor the record provided a business purpose for its cost-sharing arrangement besides evading taxes. The court rejected the business justification Microsoft raised—that the cost-sharing arrangement “replace[d] annual disputes over its licensing and royalty scheme”—because that explanation appeared to have “no real impact on how customers were served.”
The Microsoft decision could be read as expanding the tax shelter exception to the tax practitioner privilege (notably, there is no such exception to the attorney-client privilege or work product protection) to include otherwise legitimate business decisions to minimize taxes. In reaching its conclusion, the Microsoft court ignored the broader business justification for Microsoft’s cost-sharing arrangement: its business purpose for holding the intellectual property in the first place and the fact that it has a right to decide which subsidiary will own that property. While time may show whether the Microsoft opinion remains an outlier or if other courts adopt its approach, the decision may signal a change that is already underway globally, particularly in Europe: a shift in public perception to viewing tax optimization as impermissible.
To minimize the risk of an outcome like Microsoft, companies should take precautions in seeking advice from accountants by avoiding the discussion of tax benefits in a vacuum and by including language that places a tax discussion within the broader business context. They should also consider engaging accountants through outside counsel utilizing a Kovel arrangement so that the lawyers’ and accountants’ collaborative communications would be protected by the attorney-client privilege or work product protection, in addition to the tax practitioner privilege. Further, accounting firms should understand the risks of appearing as if they are advocating for decisions solely on the basis of the resulting tax benefit.
All four cases illustrate different methods the IRS can employ to discover potentially privileged information from taxpayers, attorneys, and tax practitioners despite well-established privilege protections. Whether by a John Doe summons, a search warrant, voluntary interviews, or more traditional discovery, the result is the same: the IRS may discover client information from lawyers and federally authorized tax practitioners. Still, the procedural vehicle and strategy the government uses to discover information may impact the success of challenges to such efforts. Challenges to an already-issued John Doe summons (Taylor) and voluntarily obtained privileged information (Gaetano) may be tough for taxpayers to win. However, when the government reaches far beyond the target of the investigation, a court may be more willing to enforce privilege protections (In re Search Warrant). As such, the scope of the IRS’s attempted discovery and appearance of fairness may play a role in how courts rule.
Finally, these cases, particularly Microsoft, reinforce the importance of being thoughtful about how lawyers and tax practitioners phrase written communications with clients, internal communications within law firms and accounting firms, and their own notes. The attorney-client, work product, and tax practitioner protections are not absolute; communications may fall into the IRS’s hands whether through application of an exception to privilege, or voluntary or inadvertent waiver. This is especially important now, as the IRS appears to be becoming more aggressive in seeking potentially privileged information, including client information, from attorneys and tax practitioners.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Kat Gregor is a tax partner and co-founder of the tax controversy group, Elizabeth Smith is counsel, and Monica Mleczko is an associate at Ropes & Gray LLP.