In Summons Dispute IRS Entitled to Confidential Emails Between Insurance Companies and State Regulator

In US v Delaware Department of Insurance a federal district court ordered the Delaware Department of Insurance (DDOI) to turn over emails associated with micro-captive promoters.  In tax cases it is somewhat unusual that the federal government finds itself in court with state attorneys as adversaries. The case flags tension between the vast information-gathering powers of the IRS versus state and non tax specific federal law designed to provide state law with exclusive responsibility for regulating insurance companies. In this post I will briefly describe the case and highlight how federal law preempts Delaware confidentiality provisions.

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IRS had previously investigated Artex Risk Solutions, Inc. (“Artex”) and Tribeca Strategic Advisors, LLC (“Tribeca”) (which is owned by Artex) in transactions involving micro-captive insurance plans. As part of its investigation into possibly abusive micro-captive insurance transactions, IRS served an administrative summons on DDOI asking for a wide range of information relating to Artex and Tribeca. DDOI turned over thousands of pages of documents but refused to turn over client specific information.

As justification for its refusal, DDOI relied on Section 6920 of the Delaware Insurance Code, which provides for confidential treatment of materials and information that captive insurers submit to the state tax commissioner, either directly or through DDOI, as part of the application and licensing process.

In response to the IRS’s seeking client specific information, DDOI contacted the parties and asked for consent to comply with the IRS summons. A handful agreed but most did not. DDOI then sought to enforce the summons and DDOI filed a petition to quash, relying on Section 6920 of the Delaware Insurance Code.

As a general matter, when there is a conflict between a federal statute and a state statute, the state statute yields under the doctrine of preemption. The McCarran-Ferguson Act (“MFA”) creates an exception to this general rule.  The MFA generally provides that states are entitled to regulate the business of insurance and that “no Act of Congress shall be construed to invalidate, impair, or supersede any law enacted by any State for the purpose of regulating the business of insurance, or which imposes a fee or tax upon such business, unless such Act specifically relates to the business of insurance.”

MFA thus sets out a reverse preemption principle. State law cedes to federal law but not when the state law pertains to the state’s role in regulating the business of insurance. The opinion discusses the policy underlying the MFA:

“Congress was mainly concerned with the relationship between insurance ratemaking and the antitrust laws, and with the power of the States to tax insurance companies.” S.E.C. v. Nat’l Sec., Inc. , 393 U.S. 453, 458-59 (1969) (citing 91 Cong. Rec. 1087-1088). The MFA attempted “to assure that the activities of insurance companies in dealing with their policyholders would remain subject to state regulation.” Nat’l Sec., 393 U.S. at 459.

While the language in the MFA is broad, the opinion notes that It did not “purport to make the States supreme in regulating all the activities of insurance companies; its language refers not to the persons or companies who are subject to state regulation, but to laws ‘regulating the business of insurance.’ Insurance companies may do many things which are subject to paramount federal regulation; only when they are engaged in the ‘business of insurance’ does the [MFA] apply.” 

The opinion gets into some detailed discussion about how cases have applied the MFA and its reach but essentially the magistrate and ultimately the district court held that the MFA “simply does not apply – i.e., the MFA only allows for reverse preemption when the conduct at issue is the “business of insurance,” which was found missing here. “

DDOI asserted that the conduct “is more properly characterized as “receiving, maintaining and restricting dissemination of application and licensing information of captive insurers,” which it argues is fundamental to insurance regulation.”

The magistrate and district court judge disagreed, framing the state’s conduct as akin to maintaining records rather than actual regulation:

Here, the Court finds no error in the Report’s conclusion that the challenged conduct itself is fairly characterized as “record maintenance” and, more specifically, the dissemination and maintenance of information, documents, and communications maintained by the state. In the Court’s view, this is a fair characterization because it flows directly from the language of Section 6920, which is what DDOI argues protects it from complying with the Summons. Section 6920 protects from disclosure broad swathes of information, not merely application and licensing information of captive insurers (as DDOI suggests). See, e.g. , 18 Del. C. § 6920 (“ … all examination reports, preliminary examination reports, working papers, recorded information, other documents, and any copies of any of the foregoing, produced or obtained by or submitted or disclosed to the Commissioner that are related to an examination pursuant to this chapter … ”). Given the broad scope of documents and information covered by Section 6920, the Report committed no error in characterizing the conduct at issue.

I am giving somewhat short shrift to the MFA arguments that DDOI made, including a disagreement on the standard relating to how to define the business of insurance, but they will be of interest more to a small group of practitioners. Not only does the case highlight the IRS appetite to challenge captive insurance arrangements, but it also resonates n light of the recent Pandora Papers scandal. The Pandora Papers release reveals how at times states’ trust laws are designed to shield information from taxing authorities and other creditors. Many state laws, such as in the DDOI case, present formidable but not insurmountable barriers to engaged and inquisitive IRS employees. Tax havens are not only located outside the US. We will likely see government efforts to obtain information that is potentially subject to state laws that are meant to make it difficult, though not impossible, to attract the eyes of the federal government.

District Court Finds That IRS Failed to Adequately Notify Taxpayer Before it Contacted Third Party

In US v Vaught a federal district court in Idaho declined to enforce a third party summons due to the IRS’s failure to notify a taxpayer of its intent to contact a third party during the course of the audit.  

In this post I will discuss Vaught and provide some context for the summons dispute.

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In 2015 IRS began an investigation of Stanley Crow into penalties associated with his promotion of installment sale transactions. The IRS suspected the transactions were tax shelters subject to registration and disclosure requirements.  At the start of the examination it sent Crow a Publication 1, Your Rights as a Taxpayer. That publication gives generic information about the audit process, and also informs taxpayers that the IRS may contact third parties during the course of an examination.

Prior to the Taxpayer First Act, under Section 7602(c)(1), enacted as part of the Restructuring and Reform Act of 1998, IRS was required to provide a taxpayer with “reasonable notice in advance” before it contacted financial institutions, employers or other third parties.  Pre-TFA there was litigation as to what constituted reasonable advance notice. In many of the cases, the IRS argued that sending Publication 1, at the start of an exam sufficed for these purposes. 

In JB v United States, which I discussed in Ninth Circuit Rejects IRS’s Approach to Notifying Taxpayers of Third Party Contacts, the Ninth Circuit held that sending the Publication 1 was insufficient notice, though it did not categorically hold Publication 1 can never constitute “reasonable notice in advance.” The court was skeptical though stating that it was “doubtful that Publication 1 alone will ever suffice to provide reasonable notice in advance to the taxpayer, as the statute requires.”

Shortly after JB v US, TFA did away with the squishy reasonable standard and requires the IRS to provide notice to the taxpayer at least 45 days before the beginning of the period of third-party contact, which may not extend longer than one year.  In Keith’s post on the major tax procedural developments of 2019, he discusses the TFA change, and the earlier TAS legislative recommendations that highlighted the problems with the “reasonable advance notice” standard under pre TFA law.

Back to Vaught. The case involves an exam and third-party summonses that were issued in 2018 in connection with the IRS’s examination of Crow and his suspected shelter promotions activities. Two of the summonses were served on Steve Vaught and Alpha Lending, LLC, where Vaught was a key executive. Alpha had a business relationship with Crow, having served as a lender or escrow agent in the installment sales transactions Crow and his company promoted. Vaught/Alpha did not appear or produce the IRS’s requested records. The government filed a petition to enforce the summons, and Crow intervened in the case and filed a motion to quash based on an alleged violation of the advance notice requirements.

As I mention above, the summonses were issued before TFA, so the case involves the old reasonable advance notice standard. As the district court explained, in JB the Ninth Circuit added some meat to the reasonable notice standard:

[T]he Ninth Circuit held the phrase “reasonable notice in advance” means “notice reasonably calculated, under all the relevant circumstances, to apprise interested parties of the possibility that the IRS may contact third parties, and that affords interested parties a meaningful opportunity to resolve issues and volunteer information before third-party contacts are made.” 916 F.3d at 1164 (citing Flowers , 547 U.S. at 226). In so holding, the Ninth Circuit highlighted the purpose of the notice requirement is to protect the taxpayer’s reputational interest by giving the taxpayer an “opportunity to resolve issues and volunteer information before the IRS seeks information from third parties, which would be unnecessary if the relevant information is provided by the taxpayer himself.”

The JB standard requires district courts to examine the totality of the circumstances, “balancing of the interests of the State’ in administering an effective auditing system against the ‘individual interest’ in receiving notice of the potential third-party contact and an opportunity to respond.”

Crow challenged both related aspects of the notice requirement:  that the IRS did not provide pre-contact notice and also that the IRS did not provide a reasonable meaningful opportunity to resolve issues and volunteer information before third-party contacts were made.

The government argued it did provide sufficient notice, pointing to the Pub 1 it sent at the start of the exam in November of 2015 as well as supposed oral communications between IRS agents and Crow in December of 2015. At that meeting IRS revenue agents purportedly said that they said that the IRS may contact third parties during the course of the examination of Crow.

The district court found that the IRS failed to satisfy the reasonable advance notice standard, emphasizing the time between the generic notice and the actual contact IRS made with the third party:

Here, the IRS issued the Vaught Summonses in January of 2018, twenty-six months after it sent Crow Publication 1 on November 17, 2015. Similarly, in J.B., two years elapsed between the date the IRS sent Publication 1 to the taxpayers and the date the IRS sought records from a third party. As in J.B , this Court cannot find the IRS satisfied its “administrative duty” of giving Crow a meaningful opportunity to provide relevant documents involving the Alpha Companies by generally informing Crow, over two years before, that it may “talk with other persons” in the course of its investigation

As to the purported oral communication from IRS agents failing to tip the scales toward reasonable notice, the court focused on the absence of specific information concerning the nature of the needed information in the agent’s affidavit:

Neither the Government’s brief, nor Allred’s affidavit, offer any details regarding what London and Allred said about potential third-party contacts on December 16, 2015….[T]he Government does not provide any specific information regarding how the IRS purportedly notified Crow of potential third-party contacts on December 16, 2015. For instance, what did London or Allred say about third-party contacts on this date? Did they reference any specific third parties or types of businesses they may contact if Crow did not provide information himself? Did they give any hint that Crow should produce documents involving the escrow companies or lenders that SCCC used in its installment sales transactions?

Taken together the court concluded that the IRS failed to provide reasonable advance notice. As the opinion notes, IRS could have done more to act consistently with Crow’s legitimate privacy interests. To that end, the opinion discusses (at Crow’s suggestion) steps the IRS could have taken, including renewing its request for information from Crow closer in time to the contact (which was over two years from both the generic notice IRS provided and revenue agent conversation) and specifying that it would contact third parties if Crow did not provide the information it wanted. As a final measure, the court noted that FOIA-obtained IRS case notes erroneously concluded that Alpha and Vaught were not third parties for purposes of the notice requirements. This suggested perhaps that the IRS did not provide additional notice because of the mistaken belief that the contacts did not trigger notice requirements.

Conclusion

The court ultimately concluded that the violation of the advance notice requirement meant that the IRS failed to satisfy the fourth Powell summons requirement, that the IRS follow all administrative requirements in the issuance of the summons.  While Vaught involves pre TFA law, it is an important opinion in at least two respects. First, there may be summons enforcement cases still percolating under the pre TFA notice rules. Second, and perhaps more important, the opinion reflects a perspective that emphasizes that taxpayers have legitimate privacy and reputational interests. When there is the scent of shelters or allegedly improper taxpayer conduct at times IRS may fail to adequately weigh or even consider the interests of taxpayers. Vaught should serve as a reminder that privacy and reputational interests are at stake even when there is a taxpayer suspected of engaging or promoting aggressive transactions.

What are the next steps here? I have not dug into the filings but I assume that if the IRS has not received the information it could reissue the summonses, ensuring that it complies with post TFA notice requirements. Challenges to summons enforcement typically toll the SOL on assessment, so perhaps the taxpayer victory is short lived.

Sixth Circuit Weighs in On Sovereign Immunity and Exceptions to Notice in Third-Party Summons Case

When IRS issues a summons to third parties it generally has to notify the taxpayer whose records are identified. That right to notice is key, as it triggers a correlative right to bring an action in district court to challenge the summons and allows for limited judicial review of IRS’s vast information gathering powers.

It may come as a surprise that not all summonses the IRS issues result in notice to the taxpayer. Section 7609(c)(2) excludes five categories of summonses. I discuss this extensively in Chapter 13 of Saltzman and Book IRS Practice and Procedure. Gaetano v US, a recent Sixth Circuit case, discusses the nature of the exclusion and its relationship to subject matter jurisdiction, standing and sovereign immunity. It also highlights inconsistent approaches that courts have taken to characterizing the exceptions, and concludes that the 7609(c)(2) notice exceptions relate to the court’s underlying jurisdiction to hear challenges to the summons.

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Gaetano involves an IRS criminal tax investigation into the taxpayers’ Michigan-based cannabis dispensary business. IRS sought the records pertaining to the Gaetanos from Portal 42, a software company that provides the cannabis industry with point-of-sale systems. Those systems allow businesses to track customer sales data or delete the data remotely with a “kill switch.”

The opinion discusses how an IRS CID agent interviewed the owners of Portal 42 and then served a summons ordering that the owners “give testimony and produce various records “and other data relating to the tax liability or the collection of the tax liability or for the purpose of inquiring into any offense connected with the administration or enforcement of the internal revenue laws concerning [the Gaetanos] for the periods shown.”

The IRS did not notify the Gaetanos, but within two weeks of the service of the summons on Portal 42, the taxpayers filed a petition to quash, alleging that IRS should have given them notice and alleging that the summons was issued in bad faith.

The district court, adopting the magistrate judge’s key holding, dismissed the Gaetanos’ petition to quash, and concluded that they did not have standing under 7609(c)(2)(E).

The (E) exception to notice applies when the summons issued by an IRS criminal investigator in connection with an IRS criminal investigation and the summoned party is not a third-party recordkeeper. Portal 42 was not a third-party recordkeeper (that is statutorily defined in 7603(b)(2)).

There was a dispute about whether the summons was issued in connection a criminal investigation. The Gaetanos’ main argument was that the summons was deficient because it failed to specify the tax periods that the IRS was criminally investigating, but the opinion held that the statute only required that the summons identify the tax periods which IRS sought information.

The Sixth Circuit opinion affirms the district court but in so doing explores and clarifies the import of the five exceptions to notice in Section 7609(c)(2).  As the opinion notes, courts have viewed the exceptions as either “limitations on statutory standing or (as the Government argues) exceptions to [Section 7609’s] sovereign immunity waiver.”

The opinion nicely collects cases that have viewed the exceptions to notice as triggering standing limits or sovereign immunity waivers.

The lower court opinion, in dismissing the challenge for lack of subject matter jurisdiction, was not clear if the dismissal relied exclusively on standing or was also based on the sovereign immunity waiver. The Sixth Circuit viewed this issue as a matter of first impression, and while the result in this case did not hinge on the difference, the opinion discusses why the difference matters, including most importantly that 1) the government cannot waive sovereign immunity and 2) a court can bring that jurisdictional issue up at any stage of litigation.

As we have discussed numerous times, the Supreme Court’s case law on whether a statute confers jurisdictional status has evolved over time. As the opinion notes, the “Supreme Court, however, has cautioned that a statutory condition — even one attached to a waiver of the United States’ sovereign immunity — is not accorded jurisdictional status unless “Congress has ‘clearly state[d]’ as much.” United States v. Kwai Fun Wong, 575 U.S. 402, 409, 418-20 (2015) (citation omitted).

Gaetano analogizes the language in the 7609(c) exceptions as similar to the Federal Tort Claims Act, where the Court has found that the exceptions suspend the whole statute, leaving the “bar of sovereign immunity” and hence concluding that the (c)(2) exceptions are jurisdictional.

The opinion has one more wrinkle. While typically a plaintiff bears the burden of proving that there is a waiver of sovereign immunity, Gaetano holds that the government has the burden for establishing that the exception applies when the petition to quash is not facially within one of the exceptions:

The basic rationale for treating sovereign immunity exceptions as affirmative defenses is that a plaintiff should not be required to prove a negative for each enumerated exception, and the government will generally possess the relevant facts to prove that a particular exception does apply. 

That burden for the government is pretty low, and the CID agent’s affidavit was sufficient to connect the summons to a criminal investigation. That the CID agent may have not fully complied with the IRM (including specifying all time periods involved in the investigation) and “goes to the merits of whether a summons should be enforced or quashed. We cannot proceed to the Powell test when 7609 does not confer jurisdiction over this action.”

No Notice to Taxpayer Required When Summons Issued to Aid in Tax Collection

Who can bring a petition to quash a summons that the IRS has issued when it is trying to get information that would allow it to collect on an assessed tax? This is the issue in Marra v US a recent case out of the district court in Washington. In Marra, the IRS issued a summons to the taxpayer’s Chapter 7 bankruptcy trustee as part of the IRS’s efforts to find ways to collect on Marra’s $ 4 plus million assessment. The revenue officer had reason to believe the trustee had compiled information that would help the IRS track down sources to satisfy the tax debt (note the bankruptcy court had recently revoked Marra’s discharge).

Marra did not want the trustee to turn over any information, claiming the sought after documents were privileged. He filed a petition to quash the summons, and the government filed a motion to dismiss the petition to quash the summons due to its belief that the court did not have subject matter jurisdiction.

I will briefly describe the issue and outcome.

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First some background. As a starting point, I note that I cover the complex summons notice rules in some detail in Chapter 13 of Saltzman and Book. Here is the nutshell version.

If the IRS issues a summons to a bank or other entity for a third party’s records, the IRS must determine whether either the taxpayer or the third party is entitled to notice of the summons.  That is important because the statutory scheme sets out that only a person required to receive notice when the IRS serves a summons can bring a proceeding to quash a summons.

There are the exceptions to the general rule that the IRS must give notice to third parties. Under Section 7609(c) he general rule is inapplicable when an IRS summons is “issued in aid of the collection of — (i) an assessment made or judgment rendered against the person with respect to whose liability the summons is issued or (ii) the liability … of any transferee or fiduciary of any person referred to in clause (i).”

The in “aid of the collection language” is broad, and read literally it would swallow the general notice rule. Courts have limited its application. A key case in this development is Viewtech v US, a Ninth Circuit opinion from 2011. There the court that applied the “issued in aid of the collection” exception and held that “a third party should receive notice that the IRS has summonsed the third party’s records unless the third party was the assessed taxpayer, a fiduciary or transferee of the taxpayer, or the assessed taxpayer had some legal interest or title in the object of the summons.”

In other words, if the other person was the assessed taxpayer or had a close legal interest to the taxpayer, then the IRS does not have to notify that other person when it is trying to get information that would help it collect against that taxpayer’s liability. That rule makes sense, at least to me, as a taxpayer who has an assessed liability has had sufficient notice of the IRS’s interest in collecting the outstanding tax, and presumably would have had ample opportunity to work something out with a revenue officer. 

Back to Marra. In light of the Viewtech standard, and that the IRS was seeking records that pertained to Marra himself, the district court concluded he was not required to receive notice and thus had no right to bring a petition to quash. 

Speidell v US is Latest Rebuke to Challenge to IRS Ability to Investigate Legal Marijuana Businesses

Section 280E disallows deductions for business activities concerning controlled substances which are illegal under federal law. State law increasingly allows the selling of marijuana for medicinal and recreational purposes. Federal law classifies marijuana as an illegal controlled substance. This tension between state and federal law means that taxpayers engaged in the legal selling of marijuana are unable to deduct expenses that would otherwise be deductible for federal income tax purposes. This leads to the bogarting of the ability to pay principle, and effectively penalizes taxpayers who operate legal state law marijuana businesses.

Over the last few years as part of civil tax audits IRS has investigated a number of dispensary taxpayers. At times IRS used its vast summons powers to gather information from third parties like financial institutions and state marijuana regulatory bodies. In many of these cases, the dispensaries and their individual owners have challenged those efforts, in part by arguing that the IRS could use the information to assist in the possible prosecution for violations of federal law. The courts, applying the Supreme Court’s Powell factors, have rejected challenges and found that IRS had a legitimate purpose in seeking the information from the businesses themselves and from third parties. The courts have generally held that was no abuse of process or bad faith because there was no evidence that the IRS was seeking the information to place the dispensaries and their owners in jeopardy of federal criminal investigations.

The latest case that upheld the IRS’s summons’ power over state law marijuana dispensaries is Speidell v US out of the Tenth Circuit, which has taken the lead on these cases given Colorado’s budding and booming marijuana business. The case breaks no new ground, but is a useful reminder that the IRS has broad latitude to use its summons power, and, despite the inequity in Section 280E, challenges to IRS audits of these businesses face an uphill struggle. 

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As a refresher, under Powell the IRS must establish (1) that the investigation will be conducted pursuant to a legitimate purpose, (2) that the inquiry may be relevant to the purpose,'(3) that the information sought is not already within the IRS’s possession, and (4) that the administrative steps required by the Internal Revenue Code have been followed.

As the Speidell opinion notes the district court held that (1) the IRS had a legitimate purpose in issuing the summonses because there was no pending criminal investigation (2) the information sought was not already in the IRS’s possession (3) the IRS followed the required administrative steps; and (4) there was no showing of an abuse of process or bad faith because the summonses had a valid purpose, did not violate the Fourth Amendment’s right to privacy or Colorado law. 

In Speidell, the circuit court addressed some wrinkles that distinguish the case from prior marijuana business challenges to IRS investigations. In rejecting the challenge the district court had treated the government’s response to the petitions to quash the summonses as a motion to dismiss; it should have treated the government’s efforts as a motion for summary judgment.  The Tenth Circuit held that the distinction made no substantive difference, nor did the lower court’s citation of the 1985 Tenth Circuit opinion Balanced Financial Management that referred to the burden in establishing the Powell factors as “slight.”  On appeal, the plaintiffs argued that the lower court and recent similar Tenth Circuit opinions in Standing Akimbo v US and High Desert v US failed to apply the Supreme Court’s 2014 decision in US v Clarke, which recalibrated the standards that parties must satisfy to challenge the Powell factors.  In failing to apply Clarke or treat the government’s actions as a summary judgment motion, the appellants argued that the lower court improperly sided with the government.

The Speidell court disagreed: 

The Appellants argue that the rules announced in our 1985 Balanced Financial Management decision, which rules impose a “slight” burden on the IRS and a “heavy” burden on the taxpayer, are incompatible with normal summary judgment standards and the Supreme Court’s 2014 ruling in Clarke. Although Standing Akimbo does not directly address this issue, the panel in that case was clearly aware of Clarke and continued to apply Balanced Financial Management principles. See Standing Akimbo, 955 F.3d at 1154–55, 1157, 1160–61, 1163, 1166 (citing both Clarke and Balanced Financial Management). High Desert embraces a similar analysis. See 917 F.3d at 1181–84, 1187, 1191, 1194 (same). In any event, we need not decide whether this point in Standing Akimbo and High Desert is dictum or a holding. As discussed below, even if we eschew descriptions like “slight” and “heavy” and apply traditional summary judgment standards, the Appellants simply have not submitted proof sufficient to create a genuine dispute of material fact. The Appellants thus fall short even if we assume arguendo that Balanced Financial Management has been displaced by Federal Rule of Civil Procedure 56 and Clarke

The opinion discusses further the relationship between its precedent and Clarke, noting that Clarke at its core emphasizes the need for credible evidence. Bare allegations of improper purpose under pre or post Clarke law are insufficient for evidentiary hearings at the summons enforcement stage. Even if there was some gap between the precise language in pre-Clarke Tenth Circuit law and the standard for all courts to apply following ClarkeSpeidell held that any tension between the two was “indirect” and Clarke did not overturn its precedent. 

Conclusion

There is more to the opinion, including an interesting discussion of the lower court’s treatment of one of the individual owner’s untimely petition to quash the summons, principles of sovereign immunity, and the relationship of the constitution’s Supremacy Clause to the legitimacy of the IRS investigation.  At one level, the opinion highlights the difficulties parties face when fighting IRS and its vast summons powers. At another level, however, the opinion flags the need for Congress to update the federal tax laws to reflect the growing importance of the legal marijuana business. Help for these businesses is unlikely to come in summons enforcement cases; it will come in legislation that carves out the 280E prohibitions from the sale of substances that are allowed under state law. A recent Politico article Why the Next Congress is Unlikely to Legalize Marijuana suggests that this may not be high on the agenda next year, with the Senate the main stumbling block. 

US v Sanmina: Attorney Client Privilege and Work Product Protections

US v Sanmina involves a long running discovery dispute. At issue is whether a taxpayer’s disclosing two memoranda created by in house tax counsel led to the waiver of various privilege claims. The Ninth Circuit held that Sanmina did not expressly waive work-product protection merely by providing the memos to outside counsel but it impliedly waived the privilege when it subsequently used the counsel report to support a worthless stock deduction that IRS was reviewing in audit. The important opinion highlights waiver in the context of both attorney client privilege and work-product protection. 

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Facts and Procedural Background

I have previously discussed the discovery dispute here and here. On its 2009 tax return, Sanmina had claimed about a half billion in a worthless stock deduction in one of its subsidiaries. The purportedly worthless subsidiary had two related party receivables with an approximate $113 million book value. Notwithstanding the healthy book value, Sanmina claimed that the FMV of the receivables was zero.

IRS examined Sanmina’s tax return and sent an information document request for documents that supported the deduction. Sanmina gave to IRS a valuation report from DLA Piper (DLA Report), its outside counsel. That report (not surprisingly) supported the taxpayer’s view that the receivables had no fair market value.

Included in the DLA Report was a footnote that referenced but did not describe internal memos that Sanmina’s in house tax counsel had prepared, one in 2006 and the other in 2009.

IRS asked for those two in house memos; Sanmina resisted, leading the IRS to summons them and bring an enforcement action when Sanmina did not comply.

In 2015, the district court held that both in house memos were protected by attorney client and work product privilege and that the “mere mention” of the memos in the DLA Report did not amount to the party’s waiving the privilege.

The government appealed, and in 2017 the 9th Circuit remanded the case “for the district court to review the 2006 and 2009 memos in camera to determine whether the documents requested by the government are privileged to any degree” and “retain[ed] jurisdiction over this appeal.” 

After some more procedural wrangling the 9th Circuit modified its remand, leaving the district court to decide (1) whether the memoranda are privileged in the first instance and (2) whether such privilege was waived. 

On remand the district court reviewed the documents in camera and in a more detailed discussion explained that the memoranda are protected by the attorney-client privilege and attorney work-product doctrine but also found that the privileges were “waived when Sanmina disclosed the memoranda to DLA Piper to obtain an opinion on value, then turned over the valuation report to the IRS.” 

Sanmina appealed that finding, and while both parties for purposes of the appeal agreed that the documents were covered by the attorney client privilege and work product protection they disagreed as to whether Sanmina’s disclosing either the in house memos to DLA Piper or the DLA Report to the IRS resulted in a waiver of either the attorney client privilege or work product doctrine.

Ninth Circuit Agrees With Lower Court on Existence of Privilege But Not on Work Product Waiver

With that by way of background, we can address the main takeaways from the most recent opinion. A starting point to the opinion is the 9th Circuit’s reminder that, because the parties agreed that the memos were subject to both attorney client privilege and work product protection, to order disclosure the court had to find that there was waiver of both privileges. 

The Court Finds that There Was a Waiver of the Attorney Client Privilege When Sanmina Gave the Memos to DLA Piper

This is a key part of the opinion. In reaching its conclusion that there was a waiver, the opinion notes that there are several ways to waive the attorney client privilege, including by express and implied waiver. An express waiver occurs when a party voluntarily discloses documents to third parties. 

Even in the absence of an express waiver, a court can find an implied waiver when a party puts the lawyer’s performance at issue during the course of litigation. As the opinion notes, implied waiver rests on a fairness principle, which

is often expressed in terms of preventing a party from using the privilege as both a shield and a sword. . . . In practical terms, this means that parties in litigation may not abuse the privilege by asserting claims the opposing party cannot adequately dispute unless it has access to the privileged materials. 

Closely related to implied waiver is subject matter waiver, where “voluntary disclosure of the content of a privileged attorney communication constitutes waiver of the privilege as to all other such communications on the same subject.” 

The district court had found that Sanmina’s providing the two in-house memos to DLA Piper amounted to an express waiver, based on its finding that Sanmina had sought non legal advice from DLA as to the valuation of the stock rather than legal advice.  

Whether a party engaging tax counsel is seeking legal advice or non legal advice comes up in a variety of contexts. Even assuming one can cleanly draw a line where tax advice crosses to legal advice, an engagement such as the one with DLA Piper often spans multiple purposes, especially when the tax position is intertwined with valuation issues. The 9th Circuit addressed the subtleties of that inquiry, and noted that courts both within and outside the circuit have approached a “dual-purpose” inquiry differently, with some courts looking to see if the primary purpose of the relationship was for legal advice and others having “transported the ‘because of’ test from the work-product context, and looked to “the totality of the circumstances” to determine “the extent to which the communication solicits or provides legal advice or functions to facilitate the solicitation or provision of legal advice.” 

After acknowledging that there was no decided path in the Ninth Circuit to resolve the issue, the opinion was able to sidestep it, essentially concluding that it could find no clear error with the lower court’s finding that Sanmina’s engagement with DLA had a non legal purpose:

Despite some evidence that Sanmina may have had a “dual purpose” for sharing the Attorney Memos to DLA Piper, the district court’s finding that Sanmina’s purpose was to obtain a non-legal valuation analysis from DLA Piper, rather than legal advice, was not clearly erroneous because it was not “illogical, implausible, or without support in the record.” 

Waiver for Attorney Client Privilege Differs From Waiver of Work Product Protection

After deciding that there was an express waiver for attorney-client privilege purposes, the opinion disagrees with the lower court’s approach that had essentially analyzed waiver with respect to attorney-client privilege and work product in the same way. As the opinion notes, because there was no dispute that the in house memos were both attorney-client communications and protected attorney work product, to order disclosure the court had to find that Sanmina waived both privileges. 

That allowed the panel to discuss how express waiver differs in the context of attorney work-product, with the circumstances warranting an express waiver in the work product context more narrow. The key is that unlike in attorney client privilege waiver analysis, in work product cases it is not sufficient to disclose to a third party; that third party must also be an adversary. The Sanmina opinion explored the distinction: 

[T]he overwhelming majority of our sister circuits have espoused or acknowledged the general principle that the voluntary disclosure of work product waives the protection only when such disclosure is made to an adversary or is otherwise inconsistent with the purpose of work-product doctrine—to protect the adversarial process. 

In framing the issue the court looks to United States v. Deloitte LLP, 610 F.3d 129, 140 (D.C. Cir. 2010): 

Addressing whether Deloitte was a “potential adversary” to Dow, the D.C. Circuit framed the relevant question as “not whether Deloitte could be Dow’s adversary in any conceivable future litigation, but whether Deloitte could be Dow’s adversary in the sort of litigation the [work-product documents] address.” Id. at 140. In concluding “that the answer must be no,” the court noted that, in preparing the work product, “Dow anticipated a dispute with the IRS, not a dispute with Deloitte,” and the work product concerned tax implications that “would not likely be relevant in any dispute Dow might have with Deloitte.” Id

While it was easy for the Sanmina opinion to conclude that DLA Piper was not an adversary (after all it engaged DLA to help with its tax reporting), the opinion notes that courts have expanded the inquiry to see if the work product could be considered disclosed because the actions substantially increased the chances that an adversary would obtain the documents.

The opinion helpfully situates this latter inquiry as part of a “conduit” analysis. In other words, a party cannot avoid a finding that there was an express waiver of the attorney work product doctrine if it was reasonable to expect that the third party would not keep the documents confidential and disclosure to the third party increased the odds that an adversary would get access to the documents. Leaning on the DC Circuit, the court frames the conduit inquiry as follows:

As to the “conduit to an adversary” analysis, the D.C. Circuit noted that its prior applications of the “maintenance of secrecy” standard have generally involved “two discrete inquiries in assessing whether disclosure constitutes waiver.” The first inquiry is “whether the disclosing party has engaged in self-interested selective disclosure by revealing its work product to some adversaries but not to others.If so, “[s]uch conduct militates in favor of waiver” based on fairness concerns. The second inquiry is “whether the disclosing party had a reasonable basis for believing that the recipient would keep the disclosed material confidential.” 

The government argued that DLA should be viewed as a conduit because the DLA Report “was intended for disclosure to interested tax authorities” and any “expectation of confidentiality was therefore absent.”  

In the Ninth Circuit’s view the government take on the conduit analysis was lacking because it failed to focus on the underlying in house counsel documents: 

The relevant inquiry, however, is not whether Sanmina expected confidentiality over the DLA Piper Report. It is whether Sanmina “had a reasonable basis for believing that [DLA Piper] would keep the [Attorney Memos] confidential” In the process of producing its valuation analysis. Deloitte, 610 F.3d at 141. That Sanmina shared the Attorney Memos with DLA Piper to obtain a valuation report for the IRS does not necessarily mean that Sanmina knew or should have known that the resulting DLA Piper Report would disclose or make reference to its attorney work product. If anything, Sanmina’s enlistment of DLA Piper’s assistance in anticipation of litigation with the IRS indicates a “common litigation interest” between Sanmina and DLA Piper insofar as the Attorney Memos are concerned. 

What About the Disclosure of the DLA Report to the IRS?

The above discussion focuses on Sanmina’s possible waiver arising from its providing the in house memos to DLA Piper. A separate issue is whether Sanmina’s turning over the DLA Report to the IRS itself constituted a waiver of the work product protection. This issue turns on whether the DLA Report, which identifies and cites to the existence of the memos in a footnote but does not describe their contents, is enough to conclude that there is waiver of work product protection over the identified documents. 

The opinion notes that the position that disclosure requires some elaboration on the content of documents is both intuitive and supported by case law. Yet that was not enough for the court to conclude that there was no waiver. To fully analyze the issue, the opinion draws on the differences between express and implied waivers:

As we have recognized in the attorney-client privilege context, there is a difference between express and implied waivers. This framework is also applicable in the context of work-product protection, where an express waiver generally occurs by disclosure to an adversary, while an implied waiver occurs by disclosure or conduct that is inconsistent with the maintenance of secrecy against an adversary. 

Drilling down deeper into the issue, the court sets out the relevant task for the court: 

Thus, the focal point of our waiver inquiry is whether, under the totality of the circumstances, Sanmina acted in such a way that is inconsistent with the maintenance of secrecy against its adversary in regard to the Attorney Memos. More broadly, we must ask whether and to what extent fairness mandates the disclosure of the Attorney Memos in this case.

The key consideration is the relationship between the party seeking to maintain the confidentiality and the overall adversary process. On this last point the opinion highlights that Sanmina could have chosen to substantiate its worthless stock deductions with documents or evidence that did not reference the attorney memos, but it chose to reveal their existence when it gave the IRS the DLA Report:

Assuming that Sanmina reasonably expected confidentiality over the Attorney Memos when sharing them with DLA Piper, this expectation became far less reasonable once Sanmina decided to disclose to the IRS a valuation report that explicitly cited the memoranda as a basis for its conclusions. In doing so, Sanmina increased the possibility that the IRS, its adversary in this matter, might obtain its protected work product, and thereby engaged in conduct inconsistent with the purposes of the privilege.

After finding that the actions amounted to waiver, the court then refined its analysis even further, noting that the next step is to focus on the scope of the waiver “which must be ‘closely tailored . . . to the needs of the opposing party’ and limited to what is necessary to rectify any unfair advantage gained by Sanmina from its conduct.” 

That led the court to distinguish between differing parts of the in house counsel memos: 

Based on Sanmina’s overall conduct, Sanmina has implicitly waived protection over any factual or non-opinion work product in the Attorney Memos that serve as foundational material for the DLA Piper Report. However, the IRS provides no reason why the scope of this implied waiver should encompass the opinion work product contained in the Attorney Memos. Besides its general argument the Attorney Memos are needed to understand the DLA Piper Report, the IRS does not explain why the “mental impressions, conclusions, opinions or legal theories” of Sanmina’s in-house attorneys are specifically at issue or critical to its assessment of the deduction’s legal validity. Hickman v. Taylor, 329 U.S. 495, 508 (1947). 

As such, the court held that the IRS was not entitled to parts of the in house memos that contained the internal lawyers’ discussion of the legal issue, as that “may potentially undermine the adversary process by allowing the IRS the opportunity to litigate ‘on wits borrowed from the adversary’ in a future legal dispute with Sanmina. Hickman, 329 U.S. at 516 (Jackson, J., concurring). 

Conclusion

The opinion closes by ordering disclosure of the factual portion of the lawyers’ memos, all to be accomplished by a remand that will require the district court to determine which portions of the memos involve factual work product.  Sanmina will still be able to keep from the IRS its lawyers’ mental impressions, opinions, and legal theories.  As Jack Townsend has discussed in a recent blog post, the opinion highlights the difference between factual and opinion work product, and it remains difficult to force disclosure of true legal analysis. The devil, however, is in the details, and the district court will have to carefully distinguish between fact and legal analysis. Perhaps that too will lead to more litigation—all of course as predicate to a possible challenge to the merits of the deduction. 

Clients’ Identities and the IRS Summons Power

The recent Fifth Circuit case of Taylor Lohmeyer v U.S. explores the limits of the attorney-client privilege in the context of the IRS using its John Doe summons powers seeking the identity of a law firm’s clients the firm represented with respect to offshore transactions. The case provides a useful opportunity to explore the general rule that the attorney client privilege does not extend to client identity and fee arrangements, as well as a limited exception that would allow the privilege to exist when disclosure of the client identity would effectively disclose the nature of the client communication. 

In this post, I will summarize the circuit court opinion, as well as highlight briefs addressing the law firm’s request for a rehearing en banc.

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Taylor Lohmeyer involves the IRS’s serving a John Doe summons on the law firm seeking the identity of “John Does”, who were U.S. taxpayers

who, at any time during the years ended December 31, 1995[,] through December 31, 2017, used the services of [the Firm] … to acquire, establish, maintain, operate, or control (1) any foreign financial account or other asset; (2) any foreign corporation, company, trust, foundation or other legal entity; or (3) any foreign or domestic financial account or other asset in the name of such foreign entity.

According to a declaration by an IRS revenue agent, the IRS sought the information because it was familiar with a taxpayer who used the firm’s services in an effort to avoid US income tax:

[The prior IRS] investigation “revealed that Taxpayer-1 hired [the Firm] for tax planning, which [the Firm] accomplished by (1) establishing foreign accounts and entities, and (2) executing subsequent transactions relating to said foreign accounts and entities”. Additionally, “[f]rom 1995 to 2009, Taxpayer-1 engaged [the Firm] to form 8 offshore entities in the Isle of Man and in the British Virgin Islands” and “established at least 5 offshore accounts so [Taxpayer-1] could assign income to them and, thus, avoid U.S. income tax on the earnings”. “In June 2017, [however,] Taxpayer-1 and his wife executed a closing agreement with the IRS in which they admitted that Taxpayer-1 … earned unreported income of over $5 million for the 1996 through 2000 tax years, resulting in an unpaid income tax liability of over $2 [m]illion.”

In seeking to quash the summons, the law firm argued that the identity of its clients was protected by the attorney client privilege because the identifying information itself was tantamount to disclosing confidential client communication.

In finding that the exception did not apply and rejecting the law firm’s petition to quash, the Fifth Circuit relied on general precedent that explored the exception in cases that did not involve the IRS, as well as the few cases exploring the exception in the context of IRS investigations. The Fifth Circuit framed the discussion by noting that the few cases that have allowed shielding clients’ identity do so by not expanding the reach of the attorney-client privilege; the cases emphasize that the exception is a subset of the privilege itself. As such a client’s identity is shielded “only where revelation of such information would disclose other privileged communications such as the confidential motive for retention”. Citing In re Grand Jury Subpoena for Attorney Representing Criminal Defendant Reyes-Requena, 913 F.2d 1118, 1124 (5th Cir. 1990), the opinion emphasized that:

the privilege “protect[s] the client’s identity and fee arrangements in such circumstances not because they might be incriminating but because they are connected inextricably with a privileged communication—the confidential purpose for which [the client] sought legal advice”. Reyes-Requena II, 926 F.2d at 1431 (emphasis added).

The firm argued that the IRS’s request for client identities was “connected inextricably” with the purpose for which its clients sought advice. In rejecting that argument, the opinion explored the Third Circuit case of United States v. Liebman, 742 F.2d 807  (3d Cir. 1984). In Liebman, the Third Circuit sought the identity of a law firm’s clients.  The IRS had issued a John Doe summons to the firm seeking the identity all clients who paid fees over a three-year period in connection with the acquisition of certain tax shelters.

The Third Circuit held that the identity of the clients was protected by the attorney client privilege:

If appellants were required to identify their clients as requested, that identity, when combined with the substance of the communication as to deductibility that is already known, would provide all there is to know about a confidential communication between the taxpayer-client and the attorney. Disclosure of the identity of the client would breach the attorney-client privilege to which that communication is entitled

Liebman and Taylor Lohmeyer are facially similar. One key difference though was that the affidavit of the revenue agent in Liebman tipped the IRS’s hand and revealed that the IRS itself linked the identity of the clients with the specific legal advice that the firm itself gave to the clients:

The affidavit of the IRS agent supporting the request for the summons not only identifies the subject matter of the attorney-client communication, but also describes its substance. That is, the affidavit does more than identify the communications as relating to the deductibility of legal fees paid to Liebman & Flaster in connection with the acquisition of a real estate partnership interest, App. at 116a-121a. It goes on to reveal the content of the communication, namely that “taxpayers … were advised by Liebman & Flaster that the fee was deductible for income tax purposes.” App. at 117a. Thus, this case falls within the situation where “so much of the actual communication had already been established, that to disclose the client’s name would disclose the essence of a confidential communication ….” See United States v. Jeffers, 532 F.2d 1101, 1115 (7th Cir. 1976) (and cases cited therein).

The Fifth Circuit in Taylor Lohmeyer highlighted this distinction. Unlike in Liebman, 

the “agent’s declaration did not state the Government knows the substance of the legal advice the Firm provided the Does. …Rather, it outlined evidence providing a “reasonable basis”, as required by 26 U.S.C. §7609(f), “for concluding that the clients of [the Firm] are of interest to the [IRS] because of the [Firm’s] services directed at concealing its clients’ beneficial ownership of offshore assets”. The 2018 declaration also made clear that “the IRS is pursuing an investigation to develop information about other unknown clients of [the Firm] who may have failed to comply with the internal revenue laws by availing themselves of similar services to those that [the Firm] provided to Taxpayer-1”. (Emphasis added.)

Following the adverse circuit court opinion, the Taylor Lohmeyer firm has filed a petition for an en banc rehearing. The American College of Tax Counsel Board of Regents submitted an amicus brief in support of the petition (disclosure: Keith and I are members of the ACTC but did not participate in the amicus filing). 

In submitting its petition, the Taylor Lohmeyer firm emphasized that the panel failed to explore fully circuit precedent, especially United States v. Jones, 517 F.2d 666 (5th Cir. 1975), which it believed supported the privilege applying even in the absence of a declaration that did not definitively tie the request to the firm’s substantive legal advice. The ACTC brief’s main substantive point emphasizes that the summons request should be thought of as covered by the exception flagged in Liebman because the summons is “premised upon the IRS’s purportedly knowing the motive of clients in engaging Taylor Lohmeyer.” (page 11). The ACTC brief states that “[b]ecause the summons at issue requires the Firm to provide documents that connect specific clients with specific advice provided by the Firm, compliance with the summons effectively requires testimony by the Firm regarding that advice.”

In essence both briefs minimize the importance of explicit substantive tax issue that the agent identified in his declaration in support of the summons in Liebman and ask the court to consider the context of the request in Taylor Lohmeyer, which in their view inexorably links the request to the substance of the advice. 

Some Concluding Thoughts

There is more to the briefs, including a detailed discussion of circuit precedent in the petition and the ACTC’s distinguishing of the Seventh Circuit’s United States v. BDO Seidmananother case the Fifth Circuit relied on, and a policy argument alleging that an undisturbed Taylor Lohmeyer opinion will “impose a discernible chill over the attorney-client relationship between taxpayers and tax counsel.” But the key part of the briefs is the point that courts should consider the overall context of the IRS request and not limit the privilege to circumstances when an agent says aloud in a declaration what was driving the request for the client identities.

My colleague Jack Townsend blogged this case when the Fifth Circuit issued its opinion this past spring, and we are discussing it in the next update to the Saltzman and Book treatise (Jack is a contributing author). As he noted in his blog, in Taylor Lohmeyer the IRS request for information “was not connected to ‘identified specific, substantive legal advice the IRS considered improper;’ rather, the request asked for documents of clients for whom the Firm established, maintained, operated or controlled certain foreign accounts, assets or entities, without limitation to any specific advice the Firm rendered, so that it was ‘less than clear . . . as to what motive, or other communication of [legal] advice, can be inferred from that information alone.’

The ACTC suggests that even without the agent’s declaration explicitly referring to the legal advice the law firm purportedly provided the request itself implicates the legal advice in such a way that the identity itself should be protected. This approach, if accepted, would extend the exception in tax cases in a way that other courts have not embraced, at least not in cases that solely focus on the tax consequences of the unknown clients. 

I Do Not Have What You Want: The Affirmative Defense of Non-possession In Summons Enforcement Proceedings

I am prepping to teach tax procedure in Villanova’s Graduate Tax Program.  Most of the students in our program are full time tax professionals, both accountants and lawyers. Few of the students in the GTP specialize in tax procedure, so I try to teach the course with an eye toward what practitioners may find useful. One topic that generates intense interest is the IRS’s broad power to seek access to a taxpayer’s books and records, including its power to issue an administrative summons to compel a taxpayer to turn over records or documents. There have been lots of interesting developments in the summons world in the last few years. An area that generates lots of litigation, and occupies a large chunk of the material in the summons chapter in the Saltzman and Book IRS Practice and Procedure, is the various affirmative defenses that can be raised when fighting an IRS enforcement proceeding in district court.

A defense that has occasionally succeeded is that the summoned party claims and establishes that they do not have what the IRS is seeking. After IRS establishes a prima facie case that a court should order enforcement, a summoned party can establish non-possession of documents as an affirmative defense.  I previously wrote about this issue, and discussed the difficulty in proving non-possession in Summons Enforcement For Undisclosed Offshore Accounts: The I Don’t Have Em Defense Is Not an Easy One to Win.  The recent case of United States v Santoso  in a federal district court in Maryland is a nice example of a successful non-possession defense.

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In Santoso, the US was seeking three categories of documents: (1) ownership of entities and structures, (2) non-taxable sources of income, and (3) professionals that Santoso had engaged. After the IRS initially established a prima facie showing that the petition should be enforced, and a determination that Santoso had submitted sufficient evidence of non-possession to warrant a hearing, the court had an evidentiary hearing to allow for the possibility that she could meet the burden of proving that she did not have what the IRS sought.

The caselaw in this area establishes that to succeed in using this affirmative defense the party must demonstrate not only that she does not possess the documents, but also that she has taken reasonable steps to obtain them if they are within her control. Moreover, conclusory statements or self-serving testimony alone is not going to get over the hurdle. 

In finding that Santoso met her burden and established non-possession the opinion notes the following:

  1. She submitted two sworn statements and testified under oath about both her non-possession and efforts to track down what the IRS wanted; 
  2. She established that she obtained bank statements, hospital bills and tuition records, as well as reviewed emails that spanned a decade, as part of her effort to find responsive documents; 
  3. She authorized her attorney Andrew Feldman to contact people and entities who potentially had documents that might be responsive;
  4.  She provided testimony and documentary evidence establishing Feldman’s efforts, all of which resulted in no further documents, especially with respect to the taxpayer’s late mother and her estate documents.

 The latter two points seemed to matter a great deal in this case, as the opinion discusses in some detail the correspondence between Santoso’s attorney and the third parties. The correspondence between the attorneys and third parties, some of which was met by responses stating that the parties did not want to get involved or did not have information that was requested, showed to the judge a good faith effort to comply with the summons.  

The government argued that she could have done more to conduct a diligent search and that there were likely other records that related to transfers that the IRS believed that she received from her mother’s estate that were in her constructive control. As to the latter point, the court noted that she testified that she did not inherit anything from her mother’s estate, which suggested that she had no right to compel production of documents pertaining to the estate. In concluding that her search and efforts were diligent enough, the court noted that while the efforts were unsuccessful, it appeared to the judge that she was “sincere” in trying to obtain information the government sought:

While there may always be additional steps that could be taken, the actions taken by Santoso and her attorney, as described above, can hardly be considered inaction. Moreover, although there is a relative dearth of authority regarding what a taxpayer must do to show that she has taken “all reasonable steps” to identify and obtain documents, what has been established is that she must make more than a pro forma demand and cursory search for records….The actions taken by Santoso and Feldman are certainly more than that.

Conclusion

It is not easy to establish non-possession as an affirmative defense. It is helpful when one can demonstrate a significant amount of time and money spent trying to get what the IRS is seeking. This case should be in the practitioner’s toolkit.