Work product protection and attorney-client privilege in an IRS audit

In Veolia Environnement North America Operations Inc., a U.S. district court reviewed the scope of the work product rule and the attorney-client privilege in the context of an IRS audit.

The dispute arose out of an IRS audit of a $4.5 billion deduction for worthless stock claimed by Veolia Environnement North America Operations Inc. on its 2006 federal income tax return. Veolia had purchased a subsidiary corporation in 1999 and concluded that the stock in the subsidiary was worthless. It retained legal counsel and other experts to devise and implement a strategy by which it could claim a deduction for the worthless stock under Sec. 165(g). As part of its evaluation, Veolia and its legal counsel hired two valuation firms to examine the insolvency of the subsidiary. After consulting with its legal counsel and experts and obtaining a private letter ruling (IRS Letter Ruling 200710004), Veolia converted its subsidiary corporation into a limited liability company to claim the $4.5 billion worthless stock deduction on its 2006 tax return.

Anticipating an audit, Veolia enrolled in the IRS’s Pre-Filing Agreement (PFA) program and provided the IRS written reports from its insolvency experts as support for its claim that the subsidiary’s stock was worthless. The IRS issued summonses for a variety of documents in Veolia’s possession relating to the worthless stock deduction and the underlying transaction. Veolia delivered thousands of pages of documents in response to the summonses but withheld certain documents, claiming that the documents were privileged under (1) work product protection under Federal Rules of Civil Procedure Rule 26(b)(3); (2) the attorney-client privilege; and/or (3) the tax practitioner privilege under Sec. 7525(a)(1). The IRS filed a motion to enforce the summonses and compel the production of the withheld documents.

Under the work product rule, a party to federal litigation “may not discover documents … that are prepared in anticipation of litigation or for trial by or for another party or its representative” (Fed. R. Civ. P. 26(b)(3)(A)). Such protection, however, is limited to documents actually prepared in anticipation of litigation and does not apply to materials prepared “in the ordinary course of business.” Further, the party seeking work product protection must demonstrate that it subjectively intended for the work product to be used in litigation and that the anticipation of litigation was objectively reasonable.

The IRS questioned whether the documents for which Veolia sought work product protection were prepared in anticipation of litigation or in the taxpayer’s ordinary course of business, since its business activities included acquiring, managing, and divesting operating subsidiary companies. The court held that Veolia met its burden of proving that it anticipated litigation before preparing the documents in question. The taxpayer obtained valuation reports, sought a private letter ruling, and participated in the PFA program because of the prospect of litigation with the IRS. The court concluded that Veolia’s expectation of litigation was objectively reasonable, given the size of the deduction and the fact that the taxpayer was already under audit for prior years. Importantly, the court also concluded that the fact that the taxpayer undertook such transactions in the ordinary course of its business “does not deprive the Taxpayer of the opportunity to meet its burden to show that it anticipated litigation would arise from these particular transactions.” There was no evidence that the transaction under review was undertaken for any purpose other than to recognize a $4.5 billion loss on its tax return and litigate with the IRS over its deductibility.

The court also addressed whether certain materials furnished to the valuation experts to assist in their preparation of appraisal reports must be disclosed by the taxpayer to the IRS. At issue were documents containing communications of fact or data provided to the valuation experts by persons or entities other than Veolia’s legal counsel. The court concluded that Rule 26(b)(4)(C) protects communications only between a party’s attorney and its testifying expert but that data provided to the expert by sources other than the party’s attorney are not protected by the rule and must be disclosed. The court ordered Veolia to produce any materials containing facts or data considered by the valuation experts in forming their opinions “even if such facts or data were provided by [another third-party expert] or anyone else or any entity other than the Taxpayer and Taxpayer’s attorneys.”

Although the court made no specific ruling on the production of any of the disputed documents based on the taxpayer’s assertion of the attorney-client privilege, the court did note that the proper assertion of this privilege must include a showing that the communication in question was made for the purpose of obtaining or providing legal assistance. Nonlegal business advice offered by attorneys is not covered by either the attorney-client privilege or the tax practitioner-client privilege. Under Sec. 7525(a)(1), communications between a taxpayer and a federally authorized tax practitioner for the purpose of obtaining tax advice generally are accorded the same protection in noncriminal proceedings as communications between a taxpayer and an attorney, to the extent that they would be privileged communications between the taxpayer and the attorney.

Finally, the court briefly addressed whether the attorney-client privilege is waived when the withheld materials are widely distributed among individuals who work for the taxpayer or entities related to the taxpayer. The court concluded that the taxpayer had common interests with the related entities with which it shared the communications and that sharing the communications with individuals employed by these entities was necessary to obtain or act upon the legal or tax advice sought by the taxpayer. Thus, the court found no waiver of the privilege had occurred.

  Veolia Environnement North America Operations Inc., No. 13-mc-03-LPS (D. Del. 10/25/13)

By Gary Sanders, J.D., clinical instructor of business law and accounting, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.