reasonable cause defense

In Estate of Levine v. Commissioner, the US Tax Court (Tax Court) rejected an Internal Revenue Service (IRS) attempt to expand upon the privilege waiver principles set forth in AD Inv. 2000 Fund LLC v. Commissioner. As background, the Tax Court held in AD Investments that asserting a good-faith and reasonable-cause defense to penalties places a taxpayer’s state of mind at issue and can waive attorney-client privilege. We have previously covered how some courts have narrowly applied AD Investments.

In Estate of Levine, the IRS served a subpoena seeking all documents that an estate’s return preparer and his law firm had in their files for a more-than-ten-year period, beginning several years before the estate return was filed and ending more than four years after a notice of deficiency (i.e., which led to the Tax Court case) was issued. The law firm prepared the estate plan and the estate tax return in issue. The law firm represented the estate during the audit, and after the notice of deficiency was issued, the law firm was engaged to represent the estate in “pending litigation with the IRS.”  
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Courts continue to strike down the Internal Revenue Service (IRS) as it continues to test the bounds of the attorney-client privilege and work product doctrine through the issuance of improper summonses. In the last several years, the IRS has filed numerous summons enforcement proceedings related to the production of documents generally protected by the attorney-client privilege, tax-practitioner privilege, and/or work product doctrine. These summonses include overt requests for “tax advice” and “tax analysis,” which several courts have refused to enforce. For example, see Schaeffler v. United States, 806 F.3d 34 (2d Cir. 2015).

Once again, in United States v. Micro Cap KY Insurance Co., Inc. (Eastern District of Kentucky), a federal district court rejected the IRS’s arguments and refused to enforce an inappropriate summons. The opinion is available here. The IRS filed this enforcement proceeding seeking to compel the production of confidential communications between taxpayers and the lawyers that assisted them in forming a captive insurance company. After conducting an in camera review (where the judge privately reviewed the documents without admitting them in the record), the judge found the taxpayers had properly invoked privilege since each document “predominately involve[d] legal advice within the retention of [] counsel.”

The court also rejected the government’s argument that the attorney-client privilege was waived by raising a reasonable cause and reliance on counsel defense to penalties in the taxpayers’ case filed in Tax Court. Because the government’s argument was untimely, it was waived and rejected outright. The court, however, proceeded to explain how the argument also failed on its merits.
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The Internal Revenue Code (Code) contains various provisions regarding the imposition of penalties and additions to tax. The accuracy-related penalty under section 6662(a), which imposes a penalty equal to 20 percent of the amount of any understatement of tax, is commonly asserted on the grounds that the taxpayer was negligent, disregarded rules or regulations, or