Inadvertent Waiver of the Tax Practitioner Privilege: Salem Financial, Inc.

Practice & Procedures

A decision by the Court of Federal Claims last year has important implications for tax practitioners who represent taxpayers before the IRS. In Salem Financial, Inc., 102 Fed. Cl. 793 (2012), the taxpayer claimed the tax practitioner and work product privileges in an attempt to avoid turning over to the government documents related to advice it had received on the tax treatment of certain transactions. However, the court ruled that the taxpayer had waived both the tax practitioner privilege and the work product privilege because it had disclosed some of the tax advice to an outside auditor, whose advice the taxpayer relied on to defend against the imposition of penalties.

Tax Practitioner and Work Product Privilege

Sec. 7525 provides the tax practitioner privilege, which protects communications between taxpayers and federally authorized tax practitioners from disclosure of tax advice during litigation. The privilege, which may be asserted in noncriminal tax proceedings in federal court, is an extension of the attorney-client privilege to tax advice provided by nonattorney tax practitioners. As a result, the applicability of the privilege is determined by the body of federal law that deals with the attorney-client privilege.

Similarly, the work product privilege, found in Rule 26(b)(3) of the Federal Rules of Civil Procedure, protects from disclosure materials that were gathered or prepared in preparation for litigation. Potentially, the privilege can extend to documents prepared years before an examination or other proceeding was begun or a return filed, such as to analyses of the likelihood that a tax position would be upheld upon IRS examination, as long as they were prepared in anticipation of litigation.

Waiver of Privilege

Tax practitioners must be mindful that the tax practitioner privilege and the work product privilege can be waived not only in the course of litigation but also prior to litigation, during audits and appeals, if the taxpayer discloses the substance of the advice. Complicating the matter is that it may be beneficial to the taxpayer to waive the tax practitioner privilege. For instance, successfully defending against the accuracy-related penalty in Sec. 6662 may require providing the IRS privileged information about tax advice the taxpayer received.

Since establishing that a taxpayer relied in good faith on tax advice received from a qualified tax practitioner can prevent the imposition of substantial penalties, it may seem prudent to disclose at least a portion of the advice received to the tax examiner or the Appeals officer during the audit or appeals process. However, an important rule about privilege is that waiver applies broadly, not only to portions of communications that are actually disclosed, but also to all potentially privileged communications that involve the same subject matter.

As important as it may seem to assert reliance on professional advice as a defense in certain circumstances, doing so has the potential to substantially impair the taxpayer’s ability to defend against the finding of a deficiency if the case is later litigated. Accordingly, strategic decisions may need to be made early in the audit and appeals process regarding the potential consequences, both favorable and unfavorable, that may result from disclosing information and waiving the privilege. Because the substance of tax advice could be relevant to a number of issues, such as the taxpayer’s motivations for entering into a particular transaction, whether the privilege has been waived or continues to be available through discovery and trial can be important, and even determinative, in later litigation.

Court of Claims Ruling

In Salem Financial, the taxpayer asserted the work product and tax practitioner privileges to prevent the court from ordering it to disclose documents regarding tax advice it received from accounting firms about the tax treatment of certain transactions. The taxpayer sought to distinguish between advice it received before entering into the transactions, which it disclosed to defend against the imposition of penalties and, therefore, waived its privilege, and advice it received after the transactions, for which it wanted the privilege to remain intact.

The court found that the waiver applied broadly to both the pretransaction and post-transaction advice because it involved the same subject matter. In accordance with the principle found in case law—that a party should not be allowed to assert the tax practitioner privilege to disclose only advice favorable to its position, while concurrently shielding advice concerning the same subject matter that is unfavorable—the court required the taxpayer to provide most of the documentation the IRS requested.