Changes to the Rules of Evidence Applied in the Tax Court

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We welcome back guest blogger Joni Larson.Joni has graciously provided her insight again into the interpretation of rules at the Tax Court. This time she provides insight into the impact of recent legislation on those rules. As with her previous posts found here, here and here, she takes us into the practical world of interpreting the rules and preparing to present evidence.  She authors the book on evidentiary issues in Tax Court.  Professor Larson has moved schools since she wrote for us last and now teaches at Indiana Tech Law School.

The recently-enacted tax bill (Protecting Americans From Tax Hikes Act of 2015) includes a provision that Tax Court proceedings will be conducted in accordance with the Federal Rules of Evidence. There has been a positive response to this change.  Moreover, academic types breathed a sigh of relief.  But, to be honest, only because the change brought form into line with substance.

Before the change in the law, the Tax Court conducted trials in accordance with the rules of evidence applicable in trials without a jury in the United States District Court of the District of Columbia. The change removed the reference to the rules used in the District of Columbia.  By uncoupling the rules from one specific jurisdiction, the Tax Court can now look for guidance on application of the rules of evidence to the Circuit Court of Appeals to which the case is appealable.

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This change makes a lot of sense. When a case is appealed to a Circuit Court of Appeals, if there is an issue about whether the Tax Court properly admitted (or considered) evidence, the appellate court will rely on its own interpretation of the rules of evidence.  But this is, as a practical matter, what has been happening all along.  A practitioner would be hard-pressed to find a case in which the Tax Court or an appellate court looked to the District of Columbia for guidance on how to apply a rule of evidence.  To the contrary, there are plenty of cases in which the appellate court looked to its own interpretation to resolve an issue.

Where this law-change places the Tax Court is under the Golsen rule [Golsen v. Commissioner, 54 T.C. 742 (1970)]. And this is where it has been all along.  It is just there officially now.

Under the Golsen rule, when there is a disagreement among appellate courts, the Tax Court will follow the opinion of the Circuit Court of Appeals to which the case could be appealed.  Or if the appellate court has not yet ruled on the issue, the Tax Court can decide on its own how to interpret the rule.

Having conflicting rules at the appellate level is nothing new. The Golsen rule’s very existence is built on the fact that the appellate courts often disagree.  What the new statutory amendment does is to officially recognize that such disagreements extend to more than substantive law and that the appellate courts also can take evidentiary differences into consideration.

While evidentiary issues often take a back seat to the substantive issues, it is not unheard of for the evidentiary issue to control the outcome of the case. For example, a number of recent Tax Court opinions have addressed whether the taxpayer was entitled to claim a charitable contribution deduction for donating an easement.  The value of the easement, generally, is determined by comparing the value of the property before the grant to the value after the grant, with the decrease in value being what was given up, or the value of the easement on the property.  At trial, experts provide testimony about the before and after values.

Under Federal Rules of Evidence 702, a party offering the testimony of an expert witness must establish that the witness is qualified as an expert. The court must assess the reliability of proffered testimony before admitting it into evidence, making sure the expert testimony conforms with Daubert v. Merrell Dow Pharmaceuticals, Inc. (finding that trial courts must perform as gatekeepers, excluding unreliable expert testimony) [509 U.S. 579, 590–93 (1993)].

However, in the area of easement valuation, the reliability of some experts was not only called into question, but the experts were accused of aiding in the understatement of tax by overvaluing façade easements. Eventually, the experts entered into a settlement with the IRS, admitting to violating Circular 230 by failing to exercise due diligence in preparing the valuation reports and failing to determine the correctness of their written representations.  [News Release, IR-2014-31] While the experts were not identified, it is unlikely their clients were successful in obtaining the claimed charitable contribution deductions.

Another area of evidentiary tension is in the privileges found under Rule 501, specifically the work-product privilege. In United States v. Textron, Inc. [577 F.3d 21 (1st Cir. 2009], the IRS requested Textron’s tax accrual work papers. The papers were prepared by its lawyers (and others) to support Textron’s calculation of tax reserves for potential liabilities for further taxes. In turn, Textron claimed it did not have to provide the work papers as they were protected by the work-product privilege.

The work product privilege protects tangible documents, mental impressions, personal beliefs, and other material prepared by an attorney in anticipation of litigation or trial. The scope of protection under the work product privilege is broader than that under the attorney-client privilege. It protects documents prepared in anticipation of litigation if prepared by, or at the direction of, the party’s attorney or the party. To come within the privilege, the taxpayer must demonstrate that the document was created with reference to a specific claim, supported by concrete facts, and likely to lead to litigation. Because the privilege protects only documents prepared in anticipation of litigation, it does not protect documents prepared in the ordinary course of business or for other non-litigation purposes.

Textron was statutorily required to prepare the tax accrual work papers for financial reporting purposes. As part of its analysis, Textron had to consider prospects for litigation related to each position. Nevertheless, the First Circuit held that, because the papers were prepared for financial reasons, and not for use in litigation, they were not protected from disclosure.

The Fifth Circuit previously reached a conclusion similar to the First Circuit [United States v. El Paso, 682 F.2d 530 (5th Cir. 1982)], finding that tax work papers were not protected by the work-product privilege.

While these controversies over the protection of tax accrual work papers began in district courts, the Tax Court has previously had to grapple with the protection afforded by the work product privilege. Given the lengthy dissent in Textron and lack of guidance from most of the other appellate courts, it is unlikely that this issue has been played out. However, if a similar version of the issue reaches the Tax Court, it is now free to overtly look to the relevant appellate court for guidance on how to resolve this issue. As it will be able to do on all other evidentiary issues.

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