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Tax Court Order Indicates That E-Discovery and Predictive Coding Are Here to Stay

On July 13, 2016, Judge Buch of the US Tax Court denied an Internal Revenue Service (IRS) motion to compel the production of electronically stored information (ESI) by Dynamo Holdings Limited Partnership and Beekman Vista, Inc., which was not delivered as part of a discovery response based on the mutually agreed-upon use of “predictive coding.” Predictive coding is an electronic discovery method that permits an efficient and effective approach when reviewing for relevance a large amount of data and documents. It is a relatively new discovery method that is gaining acceptance by courts around the country as an alternative to the costly and laborious physical review of data and documents. Judge Buch previously authorized the use of predictive coding in Dynamo Holdings, Ltd. vs. Commissioner, 143 T.C. No. 9 (2014).

The IRS and the taxpayers had agreed that the taxpayers would run a search for terms determined by the IRS on the potentially relevant documents. The taxpayers provided the IRS with samples of randomly selected documents from the universe of potentially relevant documents, from which the IRS identified the relevant documents. These selections were used to create a predictive coding model, which a computer can use to identify conceptually similar documents.  The IRS also selected a “recall rate” of 95 percent. A search method’s recall rate is the percentage of all relevant documents in the search universe that are retrieved by that search method. The higher the recall rate, the fewer relevant but retrieved documents there will be. The taxpayers then delivered to the IRS all of the documents retrieved using the predictive coding model that were not privileged. More documents were identified in the initial search for terms than were identified using the predictive coding model. The IRS filed a motion to compel production of the documents identified in the initial terms search that were not produced.

The Tax Court denied the IRS’s motion, explaining that document review results are never perfect. The court stated that the IRS was seeking a perfect response, but that the Tax Court Rules and the Federal Rules of Civil Procedure require only that the responding party make a “reasonable inquiry” when making a discovery response. The court explained that “when the responding party is signing the response to a discovery demand, he is not certifying that he turned over everything, he is certifying that he made a reasonable inquiry and to the best of his knowledge, his response is complete.”  The use of predictive coding does not change this standard, and the court held that the taxpayers satisfied the reasonable inquiry standard when they responded using predictive coding.

Practice Note: Due to the amount of data and documents generated by taxpayers in the normal course of business, discovery of ESI can be extremely burdensome and expensive for taxpayers.  Nonetheless, it has become commonplace to see discovery requests for ESI.  Although there is a substantial amount of guidance on this subject in other courts, the Tax Court has issued [...]

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Tax Court Clarifies the Rules and Grants IRS’s Motion to Compel Nonconsensual Depositions

On July 8, 2016, Judge Buch of the US Tax Court (Tax Court) granted the Internal Revenue Services (IRS) motion to compel depositions of six individuals in Dynamo Holdings Ltd. P’ship v. Commissioner.  That case involves the question of whether certain transfers between related entities are disguised gifts or loans.  The IRS has been attempting to take sworn testimony of individuals relating to its examination of Dynamo for several years, which was part of the Supreme Court’s opinion in United States v. Clarke, 135 S.Ct. 2361 (2014).  That summons’s enforcement action is still proceeding. (See United States v. Clarke, lead case: 15-11663).  As a subject of the ongoing discovery disputes, the IRS filed a motion to compel the depositions of six witnesses from Dynamo in the Tax Court. We have previously discussed the Tax Court’s prior opinion in this case regarding the use of predictive coding in responding to the IRS’s discovery requests for electronically stored information.

The Tax Court recognized its longstanding position that nonconsensual depositions are an extraordinary method of discovery.  In ruling on the motion to compel depositions, the court explained the two requirements necessary under the Tax Court Rules of Practice and Procedure (Tax Court Rules) to consider such a motion and three factors to consider in deciding whether to grant such a motion.  To request nonconsensual depositions, the movant must show:  (1) the testimony that the movant seeks to obtain through the depositions is discoverable under Rule 70(b) of the Tax Court Rules; and (2) the testimony sought practicably cannot be obtained through informal consultation or communication, interrogatories, requests for production of documents, or consensual depositions.

If the movant can establish the two requirements, the court will weigh the movant’s:  (1) basis for the deposition; (2) purposes of the depositions other than having a substitute for cross-examination; and (3) prior opportunities to obtain the information sought through the depositions.

Judge Buch found that the two requirements were met because the testimony sought was central to this case, and the IRS could only obtain the information through the examinations, which four of the six witnesses refused to attend.  Additionally, he found that all three factors weighed in favor of compelling the depositions because the information was directly related to the witnesses’ knowledge, which was hard to access through other means, and the IRS has not had a chance to obtain the information because of the witnesses’ refusals to appear when summoned.

Practice Note:  Historically, depositions in the Tax Court were rare.  Since the Tax Court Rules were amended in recent years, this discovery practice has increased dramatically.  In the last five years we have seen the IRS increasingly and routinely request depositions.  This discovery tool, although not at the level that is experienced in district court, is one of the IRS’s new techniques to solidify the taxpayer’s position prior to trial.  We expect this practice to continue for the foreseeable future.  What does this mean to taxpayers?  The costs of litigating in Tax [...]

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