Work-Product Doctrine Protects Accountant’s Tax Advice

In Schaeffler, the Second Circuit held that the taxpayer did not waive the attorney-client privilege by sharing documents with a consortium of banks with which the taxpayer had a common legal interest. Sec. 7525 extends the attorney-client privilege to authorized federal tax practitioners and their clients for the provision of tax advice. The circuit court opinion vacated a district court decision denying the privilege and remanded the case to the lower court to determine which documents were covered by the privilege (Schaeffler, 806 F.3d 34 (2d Cir. 2015), vacating and remanding 22 F. Supp. 3d 319 (S.D.N.Y. 2014)).

In addition, the appellate court ruled that these shared documents, which were summonsed by the IRS, were protected under the work product doctrine since the documents were prepared in anticipation of litigation. In civil proceedings (as opposed to criminal ones), the work product doctrine protects materials prepared in anticipation of litigation from discovery by opposing counsel. This decision represents a reaffirmation of the work product doctrine established in Adlman, 134 F.3d 1194 (2d Cir. 1998), and provides a broader interpretation of what constitutes “anticipation of litigation” in the work product context.

Facts

The taxpayer in Schaeffler was an individual who lived in Dallas, who controlled 80% of the Schaeffler Group, an automotive and industrial parts supplier incorporated in Germany. In 2008, Schaeffler decided to engage in a foreign transaction through the Schaeffler Group in which he would acquire a minority interest in another German company. However, under German law, tender offers seeking less than all of a company’s shares are prohibited.

To acquire only a minority interest, German law required a partial offer to be accomplished by offering a price that is estimated to result in the desired number of shares being tendered. To finance the acquisition, Schaeffler, through the Schaeffler Group, entered into an €11 billion loan agreement with a consortium of banks. In mid-2008, after the offer was made and two days before the acceptance period expired, the stock market collapsed and the economic crisis worsened. German law prevented the Schaeffler Group from withdrawing the offer and, because of the economic collapse, far more shareholders tendered their shares than had been anticipated. As a result, the Schaeffler Group ended up controlling approximately 90% of the German company, not the minority interest it was seeking.

The acquisition endangered the Schaeffler Group’s solvency and ability to meet its financial obligations to the consortium. To alleviate this problem, the Schaeffler Group and the consortium entered into a refinancing arrangement. Since Schaeffler was a U.S. citizen and owned 80% of the Schaeffler Group, this refinancing arrangement would be subject to IRS scrutiny and would substantially affect his U.S. personal federal tax liability. Consequently, he retained both a law firm and an accounting firm to advise him on the tax consequences of the foreign transactions, including the debt restructuring and the possibility of future tax litigation. Schaeffler provided the documents on this tax advice to the consortium because of their shared financial interest.

Proceedings

As predicted, the IRS proceeded with an audit of Schaeffler and the Schaeffler Group (called the taxpayers, here) and summonsed all documents the accountant created, including, but not limited to, legal opinions, analyses, and appraisals that were provided to parties other than the taxpayers. The IRS did not summons the documents the taxpayers’ attorneys created. The taxpayers provided several thousand documents to the IRS but attempted to quash the IRS’s demand for legal opinions, such as one memorandum from their accountants that identified, analyzed, and/or discussed potential U.S. tax consequences of the refinancing and restructuring, possible IRS challenges to the Schaeffler Group’s tax treatment of the transactions, and the relevant statutory provisions, Treasury regulations, judicial decisions, and IRS rulings.

The District Court for the Southern District of New York denied Schaeffler’s attempt to assert attorney-client privilege concerning the accountant-prepared memo by holding that, because Schaeffler shared the document with the consortium, he waived his attorney-client privilege. The district court also held that the “joint defense privilege” exception to the waiver did not apply since the consortium lacked a common legal interest with the taxpayers. The district court found that the taxpayers and consortium only shared a common economic interest but not the requisite common legal interest.

The district court also rejected the taxpayers’ claim that the memo prepared by the accountant was protected under the work product doctrine because the district court found it was not prepared in “anticipation of litigation.” The district court also held that the work product doctrine was not waived when the taxpayers shared the memo with the consortium. But the district court found that the memo prepared by the accountant did not specifically address future litigation by discussing particular actions that should be taken during the litigation process, nor did it discuss any settlement strategies. Since Schaeffler was a rational business person, he would have sought out the accountant’s advice even if he had not been concerned about potential future litigation. In other words, the memo was prepared primarily for business purposes, not in anticipation of litigation, and therefore that the work product doctrine did not apply to it.

Second Circuit’s decision

The Second Circuit overruled the district court, reasoning that the attorney-client privilege is generally waived by a taxpayer through voluntary disclosure of the communication to another party as was the case when the taxpayers shared the information with the consortium. Nonetheless, the privilege is not waived if both parties are engaged in a common legal enterprise, and both parties do not have to be currently engaged in ongoing legal procedures. According to the Second Circuit, the taxpayers and the consortium all had an interest in the refinancing and restructuring of the debt and had a common interest in ensuring that U.S. tax law was applied in a certain way. Therefore, the parties not only had a common commercial interest, but also a common legal interest, which meant the attorney-client privilege was not waived when the taxpayers shared the memo with the consortium.

In applying the work product doctrine, the appellate court cited Adlman, as the governing precedent. Adlman first interpreted the phrase “in anticipation of litigation.” According to the Adlman court, “a document created because of anticipated litigation, which tends to reveal mental impressions, conclusions, opinions or theories concerning the litigation, does not lose work-product protection merely because it is intended to assist in the making of a business decision influenced by the likely outcome of the anticipated litigation” (134 F.3d at 1195). In other words, a document can have both a legal and a business purpose. Therefore, a document does not need to be prepared primarily or exclusively for ongoing, pending, or anticipated litigation to satisfy the work product doctrine.

In Schaeffler, the Second Circuit disagreed with the district court on many points in its interpretation of the work product doctrine, but probably the biggest disagreement was with the district court’s holding that tax analyses and opinions contained in documents created to assist in large and complex transactions with uncertain tax outcomes could never have work product protection. The appellate court determined that this was contrary to the Adlman decision. Its decision supports the application of the work product doctrine in cases where the size, complexity, and tax ambiguity of a transaction during its planning stages suggests an IRS audit is likely.

In closing, the Schaeffler decision broadened the interpretation of the phrase “in anticipation of litigation” to include documents created in the planning stages of large and complex transactions where the size and complexity of a transaction increase the probability of heightened IRS scrutiny.

Richard Ray is an assistant professor in the College of Business at California State University in Chico, Calif.