IRS Won Some / Lost Some on Privilege Assertions in Summons Enforcement (8/20/12)

In United States v. Eaton, 2012 U.S. Dist. LEXIS 115003 (ND OH 2012), here, the IRS was not pleased with the taxpayer's assertion of privilege in a contentious audit.  In an earlier blog today on the sister blog site, Federal Tax Crimes blog, in discussing the John Doe Summons, I discussed the administrative summons and the minimal showing the IRS must make to obtain a court enforcement order.  See The IRS Administrative Summons as Pretext to Avoid the Need for a John Doe Summons (8/20/12), here.  I won't repeat that discussion here, for it overlaps with what I do discuss.

I should just stick to the opinion, but I do link to an earlier article that suggests that the ongoing to and fro between Eaton and the IRS has been quite adversarial (adversarial on steroids).  See Patrick Temple-West, Eaton, IRS tangle over cross-border pricing pacts (Reuters 6/17/12), here.  The IRS had, for the first time in four years, canceled APAs, Advanced Pricing Agreements between the IRS and the taxpayer as to transfer pricing mothologies, and then, after extensive investigation, issued a notice of deficiency.  The article discusses the filing of a Tax Court petition in response to the notice of deficiency.  But, apparently toward the end of the audit rancor, the IRS issued those summonses which it sought to enforce.  Hence the case I discuss in this blog.

In the summons dispute, the Court's statement of the Background for the case consists almost entirely of Eaton's complaints, in effect, that the the IRS had abused its information gathering tools in a vendetta against Eaton:

The examination of Eaton's 2005 and 2006 tax returns has lasted more than four years, and Eaton asserts that the examination has been extensive in scope. In particular, Eaton asserts that its employees and outside advisors have spent more than 30,000 hours addressing various information requests issued  to Eaton by the IRS in connection with the examination. Eaton asserts that it has responded to more than 240 Information Document Requests (the IRS's standard means of communicating written requests for information) by providing written, narrative answers to the IRS's information document requests and producing more than 10,000 pages of documents and "massive amounts of electronic information." In addition, in connection with its investigation, the IRS has conducted a total of 12 site visits to Eaton facilities in the United States, Puerto Rico, and the Dominican Republic, two full days of transcribed interviews each with Eaton's Senior Vice President-Taxes and its Vice President-Federal Tax Strategy, interviews of "multiple third parties engaged in business with Eaton's relevant operations, and eight days of transcribed interviews with a former employee of Eaton's Tax Department, John Semanchik (and in addition is currently seeking an unspecified number of additional interview days with Mr. Semanchik in a separate enforcement proceeding recently filed in the Western District of Pennsylvania). n1
   n1 Eaton also asserts that, "in practical terms," the 2005 and 2006 examination ended on December 19, 2011 (just four business days after the summons response date in Case Nos. 24, 26, and 27), when the IRS issued Eaton a Notice of Deficiency asserting tax deficiencies related to Eaton's 2005 and 2006 tax years. Eaton contends the IRS was aware when it served its summonses that Eaton intended to challenge in court any adjustments made by the IRS to its transfer pricing. In fact, on February 29, 2012, Eaton filed a petition with the United States Tax Court challenging the IRS's Notice of Deficiency, Eaton Corp.  v. Commissioner, Case No. 5576-12 (T.C. filed February 29, 2012).

It is not clear whether the Court was buying into Eaton's assertions or just stating them.  (I suspect the IRS has a different view of the assertions.)  By the end of the opinion, however, it is clear that the Court did buy in and even felt Eaton's pain (but not enough to give Eaton a win when it had not done enough).

The Court then offers a straight-forward statement of the law regarding summons enforcement under the caption "Legal Standard" (which I quote without quotation marks (except for the Code quotes) and most citations for easier readability):

In order to ensure the proper determination of tax liability, Congress has endowed the IRS with expansive information-gathering authority.  Section 7602 of the Internal Revenue Code, 26 U.S.C. § 7602, is the centerpiece of that congressional design. Under Section 7602, the Commissioner of the IRS is authorized, "[f]or the purpose of ascertaining the correctness of any return . . ., [t]o examine any books, papers, records, or other data which may be relevant or material to such inquiry" and "[t]o summon the person liable for tax or required to perform the act, or any officer or employee of such person . . . to appear before the Secretary at a time and place named in the summons and to produce such books, papers, records, or other data, and to give such testimony, under oath, as may be relevant or material of such inquiry." 26 U.S.C. § 7602(a)(1) and (2). 

The courts are authorized to enforce this summons power. Proceedings seeking enforcement of an IRS summons are intended to be summary in nature. The decision of whether to enforce an IRS summons is governed by the analytical framework set forth by the Supreme Court in United States v. Powell, 379 U.S. 48 (1964). Under this analytical framework, the government must first establish a prima facie case for enforcement by demonstrating that: (1) the investigation has a legitimate purpose; (2) the information summoned is relevant to that purpose; (3) the documents sought are not already in the IRS's possession; and (4) the procedural steps required by the tax code have been followed. The requisite showing is generally made by the submission of the affidavit of the agent who issued the summons and who is seeking enforcement.  

Once the government has made this prima facie showing, the burden shifts to the party being summoned to either disprove the elements of the prima facie case or demonstrate that judicial enforcement of the summons would otherwise constitute an abuse of the court's process. In this regard, the Supreme Court has held that the obligation imposed by a tax summons remains "subject to the traditional privileges and limitations," including the attorney-client privilege and the work product doctrine. Upjohn Co. v. United States, 449 U.S. 383, 398 (1981). Further, the Internal Revenue Code, 26 U.S.C. § 7525 ("IRC § 7525"), establishes a third privilege, the so-called "tax advisor's" or "tax practitioner's," privilege, which may limit the IRS's right to obtain information and documents by way of a summons. IRC § 7525 extends "the same common law protections of confidentiality which apply to a communication between a taxpayer and an attorney . . . to a communication between a taxpayer and any federally authorized tax practitioner." 

The party asserting a privilege bears the burden of establishing the existence of the privilege.

All of this seems fairly straight-forward generalisms and variations of it are used in many, perhaps most, summons enforcement cases.

Applying the generalisms to the facts is where the parties and the court earn their keep.  So, the court then moved to the facts.  The Court addressed the summonses which fell into broad categories:

12 MC 24 [LESSON - WHEN ASSERTING PRIVILEGE, DO IT RIGHT WITH A PRIVILEGE LOG, OTHERWISE TAXPAYER LOSES THE PRIVILEGE FIGHT]

The first summons, presented in Case No. 12 MC 24, sought the background documents for the APA of which the IRS complained.  The Court explained the context

Eaton applied for and obtained "Advance Pricing Agreements" (APAs) — which are binding contracts with the IRS — relating to the transfer pricing of its Breaker Products for 2005 and 2006 and other tax years. Eaton asserts that its attorneys and tax advisors conducted the interviews referenced in the 12 MC 24 summons (on February 12, 2002, March 7, 2005 and February 27, 2006) for the purpose of obtaining factual information needed to advise Eaton with respect to its defense of its transfer pricing and preparation of applications for APAs for the 2001 through 2010 tax years. 

Eaton refused to provide the interview notes, asserting the attorney-client privilege, the work product privilege and the tax practitioner privilege in Section 7525.  The IRS asserted that Eaton had not established the privileges it asserted.  Specifically, the IRS noted that Eaton had not provided a privilege log which offers some opportunity for the IRS and, ultimately, a court to make a preliminary determination of the propriety of the assertion of privilege.  Eaton did not explain why it had not submitted a privilege log, but made generalized allegations of the persons involved (who were attorneys and tax advisors whose role might support some of the alleged privileges).  (By way of note, one of the attorneys was Joseph Goeke who is has been for some time now a judge on the United States Tax Court.)  On that basis, Eaton urged that no privilege log was required because the privileged nature of the interviews should be evident from the persons participating and their roles, so that a privilege log would have provided no useful information.  The Court rejected Eaton's argument: 

The Court does not agree with Eaton. While the IRS summons identifies what documents are sought, the summons does not indicate what responsive documents in Eaton's possession exist. Furthermore, it cannot be determined from Eaton's objection and Hennis's declaration whether there are "only one or a few items" that are being withheld on the basis of the privilege, or, whether there are many items being withheld. Rule 26 requires Eaton to provide the IRS with enough information about  [*21] the documents withheld in order to enable the IRS to "assess the claim" of privilege. Eaton's objection and Hennis's declaration (both generally asserting that the interview notes sought pertain to interviews conducted by Eaton's legal and tax advisors for the purpose of developing the factual background in connection with legal and tax advice rendered to Eaton in adversarial administrative proceedings with the IRS) are insufficient in this regard.

The Court then summarily distinguished the cases upon which Eaton relied and ordered enforcement of the summons.

It gets worse for the IRS.

12 MC 25 [LESSON - SAME LESSON, EXCEPT TAXPAYER CAN WIN WHEN IT DOES IT RIGHT]

The summons in case 12 MC 25 sought production of 12 categories of documents.  Eaton provided documents within the scope of the summons, except for 61 documents totaling 133 pages withheld under similar privilege assertions.  Eaton produce a privilege log for the documents withheld, along with an officers certiification that the descriptions in the log were consistent with the documents withheld.  Because of the apparent distrust, the IRS was not satisfied and sought enforcement where it hoped the district court would at least conduct a third party review of the claims for the documents.  The IRS also hoped that Eaton's claims about the adequacy of the functional analysis had effectively waived the privileges asserted.

The Court declined to enforce this summons, finding the privilege log and declaration of the officer sufficient without needing to inspect the documents, finding "The IRS has not set forth any persuasive reason to doubt the veracity of Hennis's assertions or privilege claims as to the documents on Eaton's privilege log."  Specifically, the Court rejected the IRS's positions (1) that documents prepared for an administrative proceedings could not be work product; (2) that inside employees could not qualify for the tax practitioner privilege; (3) that Eaton had not provided sufficient detail in the privilege log and (4) the IRS had not established waiver because "The IRS has not persuasively demonstrated that Eaton has affirmatively raised claims that can only be disproven through disclosure of privileged documents."

12 MC 27 [LESSON - SAME LESSON ON DOING IT RIGHT]

This summons sought additional documents for which privilege was asserted with supporting privilege log and statement of an officer.  For the same reasons, the Court refused to enforce the summons.

12 MC 26

This summons sought to produce performance evaluations of a Tax Department employee involved in the APA process and its implementation and interpretation.  The Court was skeptical as to the relevance of performance evaluations to transfer pricing methodology.

The IRS has not persuasively demonstrated the relevance of Mr. Semanchik's performance evaluations. The declarations of Agent Babija and Mr. Gearhart on which the IRS relies, stating that other performance evaluations for Mr. Semanchik indicate that Mr. Semanchik professes knowledge about the tax issues under investigation, do not indicate that Mr. Semanchik's performance evaluations actually contain any substantive information as to Mr. Semanchik's "knowledge." Significantly, the IRS does not dispute Eaton's assertion in its opposition brief that the IRS has failed to identify any relevant information obtained from the IRS's review of other performance evaluations for Mr. Semanchik. 

On the other hand, Eaton has persuasively demonstrated that the IRS's position is purely speculative that the performance evaluations sought "are likely to contain information" about Eaton's transfer  [*43] pricing. The IRS has come forward with no reason to indicate that the performance evaluations sought contain relevant substantive information. Furthermore, as Eaton persuasively argues, there is no need for the IRS to pursue such a speculative avenue of discovery to learn of Mr. Semanchik's "knowledge" (by seeking Mr. Semanchik's performance evaluations) because the IRS has had the opportunity during its extensive investigation to interview Mr. Semanchik personally (for eight days) about his knowledge, and the IRS obtained the non-privileged materials contained in Mr. Semanchik's files and binders in connection with other discovery requests.

So, there you have it, the bottom line lessons established in this and other cases are:

1.  Taxpayers rarely win when the fight is just about whether the summons meets the minimal Powell standard.

2.  Taxpayers can win when the fight is about whether the assertion of privilege is proper and properly preserved.

3.  But, taxpayers need to meet the minimal predicate for good privilege assertions -- a privilege log properly attested.

4.  Practical lesson: Don't piss off the IRS.  You may win some battles.  But the goal is to win the war even at the expense of some battles (opening of the kimono).

For a related article, see Kim Dixon, IRS wields summons to pry info out of wealthy, companies (Retuers 4/17/12), here.  Some excerpts from the article with the order re-arranged for purposes, I think, of clarity:

The IRS typically starts out seeking information from a taxpayer by issuing an information document request. 

If a taxpayer refuses to comply, the agency can issue an administrative summons. If the target still resists, the IRS can take the matter to the Justice Department, which can provide a court order to enforce the summons. A target that still refuses to cooperate may face sanctions for criminal or civil contempt. 

* * * * 

The power of the summons, an order to hand over books, records or other data relevant to an agency investigation, is that it carries the threat of court enforcement. It inhibits negotiations that typically take place between taxpayers and agents, and it shows the IRS is playing hardball.
The jump in summons litigation reflects not only more frequent use of summonses, but also an effort by the agency to speed processing of investigations, lawyers said. In addition, they said, the IRS now has the ability to demand more types of documents about potentially aggressive tax practices. 

* * * * 

Solid data on the number of summonses issued by the IRS was not available. Nor was information on how many times the agency threatened taxpayers with summonses without following through. 

"My hunch is there are way more summonses issued and cases ultimately settled before ever becoming summons litigation," said Miriam Fisher, an attorney at Latham and Watkins and a former Department of Justice tax lawyer.