Courts Split on Tax Shelter Exception to Practitioner Privilege

In the long-running Countryside Limited Partnership case, the Tax Court ruled against a government documents discovery request, saying the government had not met its burden of proof for showing the documents were in connection with the promotion of a tax shelter. Thus the government was unable to overcome the federally authorized tax practitioner privilege of IRC § 7525. Prior litigation (see “Tax Matters: Step Right Up,” JofA, April 08, page 74), concerned the underlying basis-shifting transaction. The recent ruling concerned whether minutes of meetings that included tax advice given by a federally authorized tax practitioner were in connection with the promotion of a tax shelter and thereby subject to the tax shelter exception to the tax practitioner privilege.

A similar question was raised in Valero Energy, in which an appellate court was asked to review a district court’s order to release certain documents. The documents contained advice from an accounting firm on transactions related to a corporate acquisition (for earlier coverage, see “Tax Matters: ‘Significant Purpose’ of Tax Avoidance Trumps Document Privilege,” JofA, Dec. 08, page 92).

In 2000, as part of its litigation with Countryside, the IRS asked the Tax Court to compel Countryside to produce a series of 16 documents, all titled “Estate Planning Meeting Minutes” (the minutes), that constituted a cumulative chronicle of communications, in part confidential, from clients, including Countryside, to their attorneys for legal advice; to Timothy Egan, a federally authorized tax practitioner, for tax advice; or from those individuals back to their clients. Countryside argued that because the documents contained advice given to it by a federally authorized tax practitioner they were protected by the tax practitioner privilege under IRC § 7525.

Section 7525(a) provides that tax advice by a tax practitioner to a client in noncriminal tax matters or proceedings is privileged in a manner similar to the attorney- client privilege. Section 7525(b) exempts from privilege written communication in connection with the promotion of a tax shelter. The exception has four requirements: (1) written communication (2) in promotion of (3) a corporation’s participation in (4) any tax shelter. In this case, the court looked specifically at the promotion requirement.

Since the term “promotion” is not defined in the Code and is ambiguous, the court examined congressional intent, which it said appeared to target sales of plans and schemes to avoid tax and not a routine relationship between a tax practitioner and a client. The records showed that the practitioner (Egan) had a long-standing relationship with Countryside. He charged a fixed fee for his tax compliance services and an hourly fee for other work. He was not entitled to fees based on tax savings or a fixed amount for specific advice. His employer did not benefit from the transaction except to the extent he billed the taxpayer for the hours worked. These facts describe a tax practitioner giving basic tax advice as part of a routine relationship with a client and not promoting a tax shelter, the court said. Since the notes did not contain advice given in the promotion of a tax shelter, the court ruled that they were protected by the section 7525 privilege.

At issue in Valero were documents prepared by accounting firm Arthur Andersen LLP in 2001 related to Valero’s acquisition of a Canadian company, Ultramar Diamond Shamrock, which resulted in large foreign currency losses to the oil company. Valero appealed a decision by the District Court for the Northern District of Illinois, arguing that the court’s interpretation of “promotion” for purposes of the exception was too broad. The Seventh Circuit affirmed the district court’s decision that many of the documents were subject to summons since they were prepared not for federal tax advice, as the privilege requires, but for general business and accounting advice, even though they discussed federal tax topics. The Seventh Circuit distinguished from privileged tax advice “information gathered to facilitate the filing of a tax return,” which it said was not privileged. The court also ordered a set of documents released because they were written communications made in connection with the promotion of a tax shelter and therefore fell under the privilege exception.

The appellate court also concluded that the shelter exception to the privilege was not ambiguous simply because the word “promotion” was not defined in the Code. Based on the entire provision, the court concluded that promotion includes any advocacy of a plan with a significant purpose to avoid income tax. It is not, as Valero argued, limited to prepackaged shelter products but can include an “individualized tax reduction plan” as Valero termed Arthur Andersen’s advice, the Seventh Circuit said.

  Countryside Limited Partnership v. Commissioner, 132 TC no. 17

  Valero Energy Corp. v. U.S., docket no. 08-3473 (7th Cir.)

By Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accounting and director, MTA Program, Culverhouse School of Accounting, University of Alabama, Tuscaloosa.