The U.S. Court of Federal Claims held that a taxpayer had to produce documents requested by the IRS containing information about its tax reserve for uncertain tax positions reported in its financial statements and other information concerning tax advice. According to the court, since the taxpayer had relied on the advice of its external financial auditor as a defense against IRS penalties, the taxpayer waived any work product protection for its tax reserve information. Similarly, by relying on an accounting firm’s tax advice as a defense against IRS penalties, it waived any tax practitioner privilege concerning other potentially contradictory tax advice.
Information prepared in anticipation of litigation may be withheld from the other litigant under the work product privilege. In addition, Sec. 7525(a) gives protection to communications between a taxpayer and a tax practitioner similar to attorney-client privilege. Either privilege may be waived by a litigant; however, a waiver applies to any work product and any communication related to the same subject matter.
Salem Financial Inc.’s predecessor-in-interest, Branch Investments LLC, had from 2002 to 2007 engaged in a transaction known as structured trust advantaged repackaged securities (STARS) by which it claimed various tax credits and deductions. In 2010, the IRS issued a notice of deficiency assessing penalties and interest of approximately $885 million, which the taxpayer paid on the same day. One month later, Salem filed suit in the Court of Federal Claims, seeking to recover approximately $688 million. During the case’s discovery phase, Salem refused to give documents related to its tax reserve estimates for uncertain tax positions (FASB Interpretation no. 48, now incorporated into FASB Accounting Standards Codification Topic 740, Income Taxes) to the IRS and documents containing advice from a major accounting firm after the closing of the STARS transaction. The IRS filed a motion to compel Salem to produce the documents.
The court held that Salem had waived any work product protection related to the STARS-specific tax reserve documents when it used the advice of its external auditor concerning those reserves as a defense against IRS penalties. Salem argued, based in part on the external auditor’s conclusion that reliance on the opinions of another accounting firm and a law firm was reasonable, that it had reasonable cause for its position on STARS and no penalties should be assessed. Salem then argued the external auditor’s tax reserve analysis and analysis of the STARS transactions were two separate subject matters, waiving privilege for the STARS analysis but asserting privilege for the tax reserve analysis. The court disagreed, stating it was likely that the STARS analysis influenced the tax reserve analysis, and therefore the two were parts of the same subject matter. Thus, Salem had waived its work product protection for any documents related to the tax reserves on the financial statements, the court held.
The court also held that Salem waived any tax practitioner privilege attaching to the post-closing STARS documents, due to Salem’s intended use of the other accounting firm’s pre-closing advice as a defense against penalties. According to the court, the “pre- and post-closing advice appears to relate to the same subject matter,” and Salem could not disclose the firm’s advice encouraging the initial use of the STARS transaction as a defense against penalties while at the same time attempting to withhold its later advice to quit using STARS.
By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota–Duluth.
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