The Reasonable-Basis Defense: Waiver of Attorney-Client Privilege?

This Holland & Knight alert is not focused on the structured trust advantaged repackaged securities (STARS) transaction or the economic substance doctrine, which were the primary issues before the U.S. Court of Appeals for the Eighth Circuit and the lower court in Wells Fargo & Co. v. United States. This alert concerns the standard applied in determining the taxpayer's reasonable-basis defense to a negligence penalty. As the adage goes – bad facts make bad law.

In Wells Fargo, the Eighth Circuit phrased the issue as follows:

The parties dispute whether the reasonable-basis defense requires evidence that a taxpayer actually relied on relevant legal authority which supports its return position. Wells Fargo argues that its return position was objectively reasonable under the relevant legal authorities. Accordingly, it contends that it is irrelevant whether it actually relied upon those authorities in forming its return position. The government, however, asserts that a taxpayer cannot "base" its return position on the relevant authorities without showing that it actually relied on those authorities. Because Wells Fargo did not submit any evidence that it subjectively based its return position on legal authority, the government submits that the district court correctly applied the negligence penalty. (Emphasis Added).

Objective or Subjective Test

The question is whether the reasonable-basis defense is determined using an objective or subjective test. The Eighth Circuit agreed with the government that the reasonable-basis defense is determined based on a subjective test.¹ Under Wells Fargo, the taxpayer cannot rely on a tax opinion or an advisor's conclusion that more likely than not, the taxpayer's return position is reasonable. Rather for purposes of establishing a reasonable-basis defense, the taxpayer must demonstrate that it reviewed and understood the opinion and/or authority (i.e., demonstrate a subjective understanding), and actually relied on such opinions or authority. Taken to its logical extreme, the facts and circumstance as well as the advice and legal authorities relied upon by the taxpayer will be at issue. Simply stated, the attorney-client privilege will be waived as to the subject matter – an issue the Eighth Circuit recognized but viewed as unconvincing in light of its construction of Treas. Reg. § § 1.6662-4(g)(1)(i).

Consider also the case of AD Investment 2000 Fund LLC, et al. v. Commissioner, 142 T.C. 248 (2014), where the U.S. Tax Court found that by pleading reasonable cause and reliance on counsel, a taxpayer forfeits any attorney-client privilege that would otherwise apply to the legal opinion. See "IRS, Practitioners Disagree On Privilege Case's Importance," Tax Notes, Sept. 29, 2014. The taxpayer is left with the dangerous proposition of disclosing previously privileged documents if it pleads reasonable cause, and under Wells Fargo, the privileged conversations that it had with counsel will be waived.

Now consider the Eighth Circuit's position with a common fact pattern involving foreign accounts. A taxpayer is subject to willful Report of Foreign Bank and Financial Account (FBAR) penalties under Title 31 and underreported income and Internal Revenue Code (IRC) § 6662(a) negligence penalties under Title 26. In the FBAR case, the Internal Revenue Service (IRS) need only prove willfulness under an objective recklessness standard² rather than under the Cheek subjective standard. Cheek v. United States, 498 U.S. 192 (1991). Yet, under the Wells Fargo standard for purposes of establishing a reasonable cause defense³ the taxpayer must meet a subjective test even though the term willfulness is never mentioned in IRC § 6662. Simply stated, with respect to foreign reporting requirements, the government views willfulness as objective and reasonable cause as subjective despite the fact that both implicate a state of mind.

Conclusion

With the upcoming tsunami of cases arising from the IRS offshore projects, it should be expected that the IRS will allege fraud, and in the alternative, negligence additions to tax. Under Wells Fargo and AD Investment, the existence of a legal opinion as a basis for reasonable cause will no longer be viewed as shield. Rather, the attorney or advisor may become the government's primary witness against the taxpayer – and that is concerning.

Notes

¹ In TIFD III-E Inc. v. United States, 8 F. Supp. 3d 142, 151 (D. Conn. 2014) rev'd on other grounds, 604 F. App'x. 69 (2d Cir. 2015), the court rejected the government's position that evidence of taxpayer's subjective or actual reliance was necessary. The Eighth Circuit is the first court of appeals to accept the IRS' position as to the subjective test.

² See Bedrosian v. United States, 912 F.3d 144, 152 (3d Cir. 2018); Kimble v. United States, 141 Fed. Cl. 373, 385 (2018), appeal docketed, No. 19-1590 (Fed. Cir. Feb. 26, 2019); United States v. McBride, 908 F. Supp. 2d 1186 (D. Utah 2012); United States v. Dadurian, No. 18-81276-RLR, 2019 WL 2577921 (S.D. Fla. June 24, 2019).

³ It is the IRS position that in an FBAR cases there is no reasonable cause defense to a willful FBAR violation. See United States v. Dadurian, No. 18-81276-RLR, 2019 WL 2577921, at *4-*5 (S.D. Fla. June 24, 2019).

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.