Taxes & Privacy, OHMY!

In this Internet age of ubiquitous Facebook, Twitter, and more, surely some things are meant to be, well, private. How much you make and what tax deductions you claim are probably more sacrosanct than your sex life. And yet the Supreme Court has recently decided not to review a case dramatically impacting taxpayers and privacy rights.

The decision is United States v. Textron, 577 F.3d 21 (1st Cir. 2009), cert. denied May 24, 2010. There's no dispute that if you are a U.S. citizen or permanent resident you must disclose and pay tax on your worldwide income. But what your advisors can be required to say - and precisely what backup documents you can be forced to disclose - are big-stakes questions.

Traditionally, all tax lawyers understood that documents to be used in the event of tax litigation (documents relating to the strength or weakness of a tax position) are covered by work-product privilege. They may be covered by attorney-client privilege too, but work-product privilege is important, a central precept of tax planning for generations. If you have attorney-client privilege, why do you care?

In the rough-and-tumble of business, many taxpayers show their tax memos and calculations to their accountants and consultants as well as their lawyers. That waives attorney-client privilege unless the taxpayer has ensured that the accountants and consultants are hired by the lawyers, not by the client directly. The idea of having the lawyer hire them is to import attorney-client privilege to all communications. It makes sense to do that if tax litigation is imminent or if you are hyper-sensitive to attorney-client privilege, as you might be with a potential criminal tax case. But it can be cumbersome otherwise, and most clients, especially businesses, don't want to go through this hassle.

Where there are large tax dollars at stake, the Internal Revenue Service pushes hard to get disclosure of any and all documents. That's what the Textron case was all about. Textron, a defense contractor, had many memos and calculations dealing with the likelihood of achieving particular tax results on audit of its complex tax positions.

The IRS pushed hard for disclosure, but Textron refused and went to court. Textron argued it was well-settled that the work-product doctrine protected these items. The federal district court agreed.

Aggressive and undaunted, the IRS appealed to the 1st Circuit Court of Appeals. The 1st Circuit affirmed the district court, upholding the work-product privilege. After all, these documents were about exactly what ended up happening - the IRS attacking tax positions and arguing for more tax. That made them well within established work-product purviews.

But the IRS then asked for en banc review of the case. The 1st Circuit granted en banc review and then reversed itself! Declining to shield the documents from the IRS, the 1st Circuit found that they were not prepared specifically for use in litigation. That meant they were not protected. In a ruling laced with strong policy overtones, the 1st Circuit admonished that collecting taxes was in the national interest and was no game.

Tax lawyers can justifiably be called myopic. Yet it is not hyperbole to say that Textron was a huge victory for the IRS, even bordering on frightening. Moreover, the fact that the Supreme Court has declined to review the case means the IRS view prevails. Technically, the case is binding only in the 1st Circuit. Yet many tax practitioners expect the IRS to assert Textron nationally. That means more care, at least in tax cases, is required.

Beyond tax matters, does Textron signal a general weakening of the work-product doctrine? The answer is almost certainly yes, and that is unfortunate. The new standard enunciated in Textron seems to focus on the degree of specificity with which something sought to be protected under the work-product doctrine is prepared. It is no longer enough for a document to be prepared in anticipation of litigation.

Now it seems, it must be explicitly "prepared for" litigation and specifically "for use" in litigation. These seemingly simple words and subtle nuances may yield decidedly non-subtle differences in result. In the past, work-product protection was generally available when documents were prepared because of the possibility of litigation, even though there may have been other purposes as well. As long as the document would not have been prepared no matter what, it was probably protected.

Now, Textron says work papers must be "prepared for" - not "because of" - litigation. And a specific litigating intent seems required. Like Robert Frost's two diverging roads in the woods, this may make all the difference.

What lawyers and clients can do about this isn't clear. It may help if all of your notes and documents are prominently legended at the time they are created with "work-product" protections. It may also help if you are able to show that you are preparing these documents for the specific use of anticipated litigation. Such steps may be self-serving, but they are not vacuous.

Even better would be more rigorous attention to attorney-client privilege. Indeed, in the tax world, Textron will lead to more accountants being hired and supervised by tax lawyers. Attorney-client privilege, after all, still seems alive and well. Be careful out there.

Robert W. Wood is a tax lawyer with Wood & Porter in San Francisco. (www.woodporter.com) The author of several tax books, including "Taxation of Damage Awards & Settlement Payments" (4th Ed. 2009 www.taxinstitute.com), he can be reached at wood@woodporter.com. <!-- Taxes & Privacy, OHMY! -->