Anyclo International is a clothing manufacturer that markets its clothing to the United States. It hired Cha to market its products to the New York metropolitan area. Cha and Anyclo decided that Anyclo should have a branch office in the US, so they decided to form a corporation in New York that would be wholly owned by Anyclo. Anyclo wired Cha $10,000 for seed money to start the office, and Cha told Anyclo that he had successfully incorporated the business as a New York corporation. According to the complaint, Cha submitted fictitious documents to Anyclo in order to show operating costs and requested reimbursement for such expenses. Additionally, the complaint alleges that Cha skimmed (or otherwise withheld) money received from purchasers before sending the funds to Anyclo headquarters.

On March 26, 2019, Daniel Cho (the defendant’s CPA) was subpoenaed. The subpoena commanded the production of “[a]ll communications (electronic and otherwise) with [the defendants] as it relates to Anyclo USA, Inc. and/or Mojo Moto, LLC. Copies of all documents prepared for the benefit of [the same].” Counsel for the defendants moved to quash the portion of the subpoena that would require the disclosure of the personal tax returns of the individual defendants. In the motion to quash, defense counsel argued that the “court should not authorize disclosure solely because the credibility of the defendants may be impeached. A defendant’s credibility is at issue in almost any case. If the Court accepts that the tax returns could adversely affect credibility, then in almost every case a party’s tax information would be discoverable. This would . . . constitute an unreasonable intrusion into a defendant’s privacy.” Defense counsel also explained that “the Plaintiff’s own records can be the source of its prima facie proof of loss.”

In its response to the motion to quash, Plaintiff’s counsel noted that the defense’s theory is, at least partially, based on the entitlement of the Defendant to certain monies as compensation. According to the Plaintiff’s counsel: “Given that YS Cha’s entire defense in this matter is based upon an accounting of his personal income and business expenses, his tax returns are clearly relevant. . . . Indeed the individual tax returns of the Defendants will show how they classified these payments contemporaneously with the parties’ dealings. The entire crux of this matter is whether the monies received, transferred, and/or withheld by Defendants are stolen funds, rental payments, income, salary, reimbursements, or otherwise.”

This sequence of events set up the question for the United States District Court: When can production of a party’s tax return(s) be compelled under the rules of discovery?

Generally, the Federal Rules of Civil Procedure allow parties to “obtain discovery regarding any nonprivileged matter that is relevant to any party’s claim or defense and proportional to the needs of the case, considering the importance of the issues at stake in the action, the amount in controversy, the parties’ relative access to the relevant information, the parties’ resources, the importance of the discovery in resolving the issues, and whether the burden or expense of the proposed discovery outweighs its likely benefit.” FRCP 26(b)(1). The information sought does not need to be admissible to be discoverable. Id.

However, this broad discovery rule stands in stark contrast to IRC § 6103, which places limits on the disclosure of returns and return information. This section notes that such returns and return information “shall be confidential.” The section goes on to list the specific exceptions for when the government (or certain people who received the tax return from the IRS) can disclose such returns. However, of course, there is a difference between confidentiality and privilege.  Hanks v. Zenner, 2000 U.S. Dist. LEXIS 13201, *8 (W.D. La.) (“Although tax returns are not privileged documents, courts have been reluctant to order their routine disclosure as a part of discovery.”).  If tax returns were privileged, rather than merely confidential, they could not be compelled to be turned over. Moreover, IRC § 6103 proscribes only governmental disclosures of a tax return; in Anyclo, the plaintiff has requested that the taxpayer disclose his own return. 

Yet, despite the technical inapplicability of IRC § 6103 and the non-privileged nature of tax returns, courts are still reluctant to order their disclosure. The idea behind the reluctance is that unless confidentiality is guaranteed, taxpayers are less likely to accurately report all of their taxable income or to claim all legally available tax benefits. De Masi v. Weiss, 669 F.2d 114, 120 (3d Cir. 1982) (citing Payne v. Howard,75 F.R.D 465, 469 (D.D.C. 1977)).

When a court considers whether to compel disclosure of a tax return, it conducts a balancing test. On one side, the court weighs the privacy interest of the individual whose returns are in question. On the other side, the court is “required to balance a number of factors, including plaintiff’s need for the information, its materiality, and its relevance.” Id. Unfortunately, balancing tests are rarely easy to understand and generally cannot be applied in a mechanical fashion. This impediment is yet another reason why discovery costs so many resources, particularly money and time.

Because there are not many reported cases to establish the procedure when a tax return is sought, we turn to how the United States District Court for the Eastern District of Pennsylvania handled the issue. This case is not properly considered to be a seminal case with regard to the issue, but it provides a bit of guidance in the absence of well-established case law. In it, the court begins its analysis with two questions: (1) is the tax return relevant to the subject matter of the action; and (2) is there a compelling need for the return because the information is not otherwise readily obtainable. Jackson v. Unisys, Inc., 2009 U.S. Dist. LEXIS 121716, *4-5 (E.D.P.A. 2009). “The party seeking the discovery at issue bears the burden of establishing its relevance . . . while the party resisting discovery bears the burden of establishing other sources for the information.” EEOC v. Princeton Healthcare Sys., 2012 U.S. Dist. LEXIS 65115, *61-62 (D.N.J. 2012) (citing Jackson v. Unisys, Inc., 2009 U.S. Dist. LEXIS 121716 (E.D.P.A. 2009).  Even if it is demonstrated that the tax returns contain some relevant information, they “are protectable from discovery as confidential documents if the party seeking protection demonstrates good cause to uphold its expectation of confidentiality, as well as the availability of reliable financial information from other sources.” Farmers & Merchants Nat’l Bank v. San Clemente Fin. Group Sec., 174 F.R.D. 572, 585 (D.N.J. 1997). Accordingly, “[w]here the taxpayer has placed . . . financial information into dispute, the tax returns may contain relevant information. The probative value of such information must be weighed against the policy of confidentiality of tax return information, taking into account the alternative sources from which reliable financial information may be obtained.” Id. (internal citations omitted).  

Once relevancy of the tax return is established, the court will turn to the question of whether there is a compelling need for the return. “Good cause for the production of income tax returns is not shown when the movant has the information sought or can obtain it with little difficulty through other methods.” EEOC at *62 (citing Blakey v. Continental Airlines, 1997 U.S. Dist. LEXIS 22067 (D.N.J. 1997)). One way a subpoena for a tax return might be defeated on this element is by providing other documents, such as copies of W2s or 1099s, to the party seeking the subpoena. This can allow reconstruction of tax returns with less sensitive information (e.g., no social security numbers of children, no non-relevant income, etc.).

Overall, the party seeking to obtain the tax return is facing an uphill battle. Courts are quite reluctant to grant the request if there is any feasible way of obtaining the information needed that does not require the disclosure. In Anyclo, however, the Court held that “Defendants’ tax returns are relevant” because “the contemporaneous treatment of monies allegedly paid to support [Anyclo’s branch office’s] business operations on Defendants’ individual tax returns may support or undermine each parties’ contentions.” Anyclo, slip op. at 5.Further, the court found that “it does not appear . . . that the same information discoverable in Defendants’ individual tax returns is discoverable by other means.” Id. Accordingly, the court denied the defense motion to quash.

So, what is the lesson to learn from this case? In short, it is that tax returns are protected from discovery but not immune from it if one can prove (1) relevancy and (2) a compelling need. Of course, the procedural protection afforded to tax returns is given on the back side (a subpoena has to be challenged). Perhaps it would be better to provide this protection at the front end and require a motion to be made to the court beforehand (much like a request for a mental or physical examination under Rule 35). Such a requirement would help protect unsophisticated litigants from intrusive discovery. Yet, that is not the rule. If you have the resources to challenge a subpoena, you might very well win, but there is no absolute guarantee of protection.