Newsletter -- June 1998 Issue
IN THIS ISSUE
- Treasury Implements Expanded Interest Abatement Authority
- Work Product Privilege -- When Does it Protect Accountant's Work Product?
Treasury Implements Expanded Interest Abatement Authority
Starting with returns which are filed this year, a new statutory regime applies for compelling the IRS to abate interest on tax deficiencies uncovered in an audit. In January, the Secretary of the Treasury proposed new regulations to flesh out that regime. The new statutory regime and regulations should become a potent tool to bring down excessive IRS interest charges.
Traditionally, the IRS had no power to abate interest on any overdue tax or tax deficiency uncovered in an audit. Audits often drag on for years without resolution, leaving the amount of interest sometimes to exceed by several times the amount of the tax. Recognizing this problem, in 1986, Congress inserted a provision into Internal Revenue Code Search7RH6404(e) which allowed the IRS, in its sole discretion, to abate interest for any period in which the IRS delayed in performing a "ministerial act." Interest could not be abated where the taxpayer significantly contributed to the IRS delay.
While heralded as a great victory for taxpayers, the original Search7RH6404(e) benefited few people in practice. The main problem was the definition of the term "ministerial act". The IRS took a very narrow reading of that term. A "ministerial act" was defined in regulations as a procedural or mechanical act that did not involve the exercise of judgment or discretion and that occurred during the processing of a taxpayer's case after all prerequisites to the act, such as conferences and reviews by supervisors, had taken place. Ministerial acts did not include delays occasioned by agents being assigned to work for extended periods on audits of other taxpayers or simply taking too much time to decide whether to propose an adjustment. About the only acts that the IRS viewed as ministerial were a failure by an IRS employee to implement instructions from the employee's supervisor, such as a direction to transfer a case to another district for audit or to issue a notice of deficiency.
A second defect with the original Search7RH6404(e) was the procedure for getting interest abated. If a taxpayer receives a bill for tax plus interest, usually the taxpayer has to pay the entire tax and interest and file a Form 843 refund claim with respect to the portion of the interest attributable to a delay in performing a ministerial act. The taxpayer might be able to file the Form 843 before paying the disputed interest, but nothing requires the IRS to hold off on using its mandatory collection tools while the IRS is considering the merits of the Form 843 claim.
There is no procedure for the taxpayer to be able to inquire within the IRS as to the cause of any apparent delay. Usually, the taxpayer merely asserts in the Form 843 that there was a ministerial act delay, but is not able to point to any particular act. The IRS typically responds to the Form 843 with a letter saying it finds no ministerial act delay. Such a letter can be protested to the IRS Appeals Office. Typically, the Appeals Officer merely reviews the agent's work log on the case. That log would almost never contain an entry showing the agent's failure to act on instructions from supervisors for extended periods.
Under the former IRS procedure, if the Appeals Officer disagreed with the taxpayer, the taxpayer lost and the matter ended there. There was no recourse to the courts because the statute left it to the sole discretion of the IRS to abate interest.
As part of the Taxpayer Bill of Rights 2 passed in 1996, Congress fixed some of the problems with Search7RH6404(e). First, it expanded the situations in which interest should be abated to include IRS delays in performing "managerial acts." Under Proposed Regulation Search7RH301.6404-2 issued in January, a "managerial act" is defined as an administrative act that occurs during the processing of a taxpayer's case involving the temporary or permanent loss of records or the exercise of judgment or discretion relating to management of personnel. Thus, for example, a managerial act includes not reassigning the taxpayer's case to another agent while the original agent is sent on an extended IRS training session or is out on extended sick leave.
Second, a new Search7RH6404(g) allows certain taxpayers whose net worth is not more than $2 million (if an individual) or $7 million (for all other taxpayers) to petition the United States Tax Court in the event that the IRS rejects an interest abatement request.
The judicial review mechanism applies to all requests for abatement made after July 30, 1996, regardless of the taxable year involved. Thus, the Tax Court has been receiving petitions for interest abatement for over a year. No taxpayer has yet prevailed in those cases, since the taxable years involved in those cases are those in which the taxpayer must show a delay in performing a ministerial act.
The amendment of Search7RH6404(e) to allow abatements where there is a delay in performing a managerial act takes effect only for taxable years beginning after July 30, 1996. Returns for those taxable years are only now being filed. It will take several years for those returns to be audited and several more years for sufficient interest on any tax deficiencies on those returns to build up to the point where a taxpayer brings an interest abatement case to the Tax Court. As a result, it may be another four or five years before a body of case law begins to delimit the scope of managerial act abatements.
One shortcoming of the proposed regulations is their failure to deal with the question of how a taxpayer can uncover managerial act delays in the absence of any ability to do discovery of the IRS. Freedom of Information Act requests may help if the goal is to uncover documents, but it is probable that the causes of most delays are not put in writing. Only interviews of agents and supervisors will uncover most delays. It is not clear whether the IRS will be willing to allow taxpayers to speak to agents and supervisors about delays after the audit is concluded.
The Tax Court Rules of Practice and Procedure allow for discovery of parties. It may be that for those taxpayers who can bring an action to Tax Court, the Tax Court rules can be used to depose agents and supervisors.
One partial practical solution to this problem is that when an agent requests an extension of the statute of limitations, the taxpayer condition his signing of the extension on receiving a letter from the agent detailing the reasons why the normal three years allowed for an audit was not enough. Once again, however, it is unclear at this time how the IRS as an institution will respond to such requests.
It is hard to fault the new proposed regulations for their definition of "managerial act". The definition appears consistent with language in the pertinent Congressional Committee Reports. What is really needed, however, is a still broader class of acts which will require interest abatement. There also appears to be no good policy reason for denying access to courts to wealthy taxpayers. The IRS should not be allowed to abuse a taxpayer simply because he or she is wealthy.
For all of the statute's deficiencies, however, practitioners should be aware that there is now at least some practical chance of getting interest abated in future audits. Thus, it will be incumbent on practitioners to track IRS delays during audits in addition to dealing with substantive issues.
Work Product Privilege -- When Does it Protect Accountant's Work Product?
In an unusual, much-discussed, and potentially significant case, the United States Court of Appeals for the Second Circuit held in a 2 to 1 decision that a 58-page memorandum prepared by the taxpayer's accounting firm, Arthur Andersen & Co., could qualify for the work product privilege if certain conditions were met. United States v. Adlman, 134 F.3d 1194 (Feb. 13, 1998).
The Federal work product privilege, which is embodied in Federal Rule of Civil Procedure 26(b)(3), protects against the discovery by an opposing party of documents prepared in anticipation of litigation or for trial by a party or by its representative, including its attorney, consultant, surety or agent, unless the opposing party shows a substantial need for the material and that it is unable to obtain the equivalent of the material by other means without undue hardship. However, even if a showing of undue hardship is made, the court must protect against disclosure of the mental impressions, conclusions, opinions, or legal theories of an attorney or other representative of a party concerning the litigation.
It is clear from the foregoing that the work product privilege is not limited to documents which reflect the mental impressions, conclusions, opinions or theories of an attorney. The privilege extends to documents prepared by a party, or any agent or representative of a party, including the party's accountant, provided that the documents are prepared in anticipation of litigation. Thus, the Second Circuit's opinion does not break new ground in applying the work product privilege to accountants. However, the opinion addresses the less clear question of when a document is prepared in anticipation of litigation.
The memorandum prepared by Arthur Andersen dealt with a proposed merger of the client's subsidiaries which would trigger a large tax loss and give rise to a carryback refund claim. The memorandum detailed the likely IRS challenges to the tax treatment of the proposed merger and to the related tax refund claim that would be filed after the merger. The document contained possible legal theories and strategies for the taxpayer to adopt, recommended preferred methods of structuring the merger transaction, and made predictions about the likely outcome of litigation.
The taxpayer went ahead with the restructuring, claimed the resulting $289 million loss, and carried back the loss, thereby generating a $35 million refund claim.
The IRS sought to obtain a copy of the 58-page memorandum by issuing a summons during an audit of the taxpayer's income tax returns. The IRS argued that the document could not have been prepared in anticipation of litigation because not only was there no pending or threatened litigation, but the business transaction had not even taken place. The taxpayer argued that because of the substantial amounts involved, the nature of the legal issues, the fact that the taxpayer was audited every year and that it would file a substantial refund claim if the transaction occurred, there was a virtual certainty that litigation would ensue if the transactions outlined in the memorandum were effectuated. Therefore, the memorandum should be considered to be have been prepared in anticipation of litigation.
The District Court denied protection from disclosure under the work product doctrine because the primary purpose for the memorandum was to decide whether or not to go through with the multimillion dollar transaction and not to prepare for litigation. The Second Circuit Court of Appeals, however, ruled that a document should not be denied the work product privilege merely because it was prepared to assist in a business decision rather than to assist in the conduct of a specific litigation. The court held that documents should be deemed prepared in anticipation of litigation, and thus be within the scope of the work product privilege, if "in light of the nature of the document and the factual situation in the particular case, the document can fairly be said to have been prepared or obtained because of the prospect of litigation". A document which is created because of the prospect of litigation and which analyzes the likely outcome of that litigation, does not lose work product protection merely because it is created in order to assist the party in making a business decision.
The Second Circuit did not actually determine whether or not the 58-page memorandum was prepared "because of the prospect of litigation". The Circuit Court remanded the case to the District Court to consider whether the document can fairly be said to have been prepared because of the prospect of litigation. The Circuit Court noted that the taxpayer had the prospect of litigation in mind when it directed Arthur Andersen to prepare the memorandum. However, whether the memorandum was prepared because of that expected litigation turns on whether it would have been prepared in substantially similar form irrespective of the expected litigation with the IRS. The Circuit Court instructed the District Court that if substantially the same memorandum would have been prepared in any event as part of the ordinary course of business in undertaking the corporate restructuring, then the memorandum was not prepared because of the expected litigation and it would not be entitled to the work product privilege. On the other hand, if the memorandum would not have been prepared but for the taxpayer's anticipation of litigation with the IRS over the losses generated by the restructuring, then the memorandum is protected by work product privilege.
The dissenting opinion characterized the majority opinion as expanding the work product privilege to protect documents not prepared in anticipation of litigation but instead prepared in order to permit the client to determine whether to undertake a business transaction. The dissent noted that there would be no litigation unless the transaction is undertaken. The dissent also points out that a party is not without means to protect the legal analysis and conclusions from disclosure, since the party could engage an attorney and be protected by the attorney-client privilege.
The majority opinion appears to be saying that it will not deny the work product privilege to the accountant's legal analysis, conclusions and mental impressions simply because there is no actual litigation or even an actual audit of the taxpayer's return. However, it will not grant work product privilege simply because litigation is possible or even likely. The court says the first question to be asked is whether the document was prepared in the ordinary course of business; e.g., is it the usual course of business for the client to seek the advice of its accountants or others in advance with regard to the tax consequences of major transactions? The Court did not give guidance on what constitutes the ordinary course of business in this context. One important fact might be how often in the past an accountant or attorney had been asked by the party to prepare an analysis of the tax consequences of its proposed business transactions.
The client who normally comes to his accountant for analysis of the tax consequences of a proposed business transaction might be hard pressed to justify the work product privilege, since it would be argued that the memorandum was prepared in the ordinary course of business.
If the accountant prepares a memorandum with regards to a transaction that has already occurred, but before the tax return has been prepared, it could be argued that the memorandum was prepared to assist in reporting the transaction on the tax return and not because of anticipated litigation.
In sum, the work product privilege will not automatically apply to an accountant's legal analysis merely because there is a likelihood that the taxpayer will be audited and that litigation with the IRS is likely. The concern expressed by the dissent that the majority opinion will substantially broaden the scope of the work product privilege may well be misplaced.