Practitioner-client and work product doctrines preclude IRS summons

The Second Circuit overruled a district court, holding that documents prepared by an accounting firm for a taxpayer were protected by the work product doctrine and practitioner-client privilege, the latter of which was not waived by the documents’ disclosure to the taxpayer’s creditors.

Facts: Georg Schaeffler, the majority owner of a German group of companies, the Schaeffler Group, sought to restructure the group and refinance loans a consortium of banks had pledged for the group’s stock tender offer (binding under German law) to indirectly acquire a German company. The tender offer proved ill-fated by economic events, and the acquisition threatened the group’s solvency. Given the complexity of the restructuring and refinancing transaction (and the fact that his prior tax years were under IRS audit), Schaeffler anticipated IRS scrutiny of the transaction and retained a major accounting firm and a private law firm for tax and legal advice.

As expected, the IRS began an audit and summonsed all documents prepared by the accounting firm relating to the restructuring that were supplied to third parties. Schaeffler filed an action in the District Court for the Southern District of New York to quash the summons. That court denied the petition (Schaeffler, 22 F. Supp. 3d 319 (S.D.N.Y. 2014)).

Issues: The Sec. 7525 tax practitioner privilege protects certain communications between a client and its federally authorized tax adviser intended to be kept confidential. A party that shares otherwise privileged communications with an outsider is deemed to have waived that privilege. However, the privilege is not waived by disclosure to a party that shares a common legal interest or is engaged in a common legal enterprise with the holder of the privilege.

The IRS argued that the privilege was waived when the documents were shared with the banks because their common interest with the taxpayer involved a business purpose, not a shared legal interest. The district court agreed, noting that the common-interest rule has not applied where the parties did not devise a common legal strategy or contemplate becoming co-parties in litigation, even if possible litigation threatened their joint business or economic interests, as was the case here.

The work product doctrine under Rule 26(b)(3) of the Federal Rules of Civil Procedure protects documents prepared in anticipation of litigation but not if prepared in the ordinary course of business or essentially the same form irrespective of the litigation. Protection is waived when disclosure is to an adversary or materially increases the likelihood of disclosure to an adversary. Here the banks were unlikely to be or become adversaries toward the taxpayer, and the parties’ common business interests and confidentiality agreements made further disclosure unlikely, so the district court held that work product protection would not have been waived—if it had existed. The court analyzed whether the documents would have been prepared in essentially similar form if litigation had not been anticipated (Adlman, 134 F.3d 1194 (2d Cir. 1998)). Under this test, the district court held the protection was unavailable, since Schaeffler likely would have obtained the advice in the absence of any threat of audit or litigation, to conduct the transaction in a tax-efficient manner while complying with the tax law.

Holding: The Second Circuit held that the interests of Schaeffler and the banks were sufficiently legal in nature and shared to preserve the practitioner-client privilege, finding that Schaeffler’s efforts to avoid insolvency and a default on the consortium’s financing hinged on resolution of his tax issues. The consortium’s agreement with Schaeffler entailed a “common legal strategy” that included the consortium’s promise to subordinate its debt to Schaeffler’s personal tax liabilities, the court noted.

Additionally, the materials summonsed were protected by the work product doctrine, the court held, because they were prepared in anticipation of litigation with the IRS. The court held that actual litigation involving both parties was not a prerequisite and applied the doctrine where the tax advice addressed urgent circumstances arising from the need for a refinancing and restructuring and necessarily was geared toward an anticipated audit and litigation.

The Second Circuit accordingly vacated and remanded the district court’s order.

• Schaeffler, No. 14-1965 (2d Cir. 11/10/15)

—By Maria M. Pirrone, CPA, LL.M., assistant professor of taxation, St. John’s University, New York City.