Potential consequences of work-product privilege in tax disputes: when is litigation anticipated?

• Author: Borders, Thomas C.

Taxpayers and practitioners have trumpeted recent taxpayer victories in a series of significant work-product cases as a powerful shield for taxpayers in disputes with the Internal Revenue Service. (1) Such victories, however, may ultimately be Pyrrhic for any taxpayer litigant that fails to consider the accompanying obligation to preserve documents that may be relevant to future litigation. The opinion in the much-heralded Con Ed case (2)--a taxpayer victory--underscores the perils facing a taxpayer. The IRS used the taxpayer's asserted work-product claim as a weapon to argue that the court should sanction Con Ed because it had destroyed relevant emails while it reasonably anticipated litigation. Although Con Ed emerged unscathed, overlooking both edges of the work-product sword could prove dangerous.

The law regarding the obligation to preserve documents that may be relevant to anticipated litigation is not well-developed in the tax controversy arena. Generally, the issue when a duty to preserve arises is a fact-intensive inquiry that defies general formulations, and it can be a particularly difficult determination in the federal tax controversy arena. An audit can at times be adversarial and quite contentious, especially given the IRS's recently vigorous enforcement actions against large corporate taxpayers and upper-income individuals, particularly with respect to transactions designated as Tier I or listed transactions.

In Consolidated Edison Co. of New York v. United States, the IRS challenged the taxpayer's lease-in, lease-out (LILO) transaction effecting Con Ed's 1997 return. In planning the transaction in 1997, the taxpayer sought advice from the law firm of Sherman & Sterling, which issued opinion letters on the tax risks and changes to time tax law affecting the transaction. The taxpayer's in-house counsel also prepared a memorandum discussing the possible application of section 467 of the Internal Revenue Code to the transaction. The government filed a motion to compel production of these documents, but the taxpayer invoked work-product protection. The court ruled that these documents were not protected work-product because they were not prepared in anticipation of litigation.

At trial, the government filed a "Spoliation of Evidence Claim" against Con Ed, alleging that Con Ed had destroyed potentially relevant emails in 2000 when the company migrated its email program to a new server and failed to backup the old emails. The government argued that Con Ed anticipated litigation by 2000 and thus had a duty to preserve the emails at the time of the migration. As a sanction, the government sought "an adverse inference that the destroyed information, if now available, would have been favorable to the United States and harmful to Consolidated Edison."

The court observed that the parties had flipped their positions from the court's earlier consideration of the government's motion to compel the 1997 tax advice memoranda. There the taxpayer invoked work-product protection arguing that the memoranda at issue had been prepared in anticipation of litigation. The government countered that the memoranda were prepared for business purposes, not in anticipation of litigation, and therefore were not entitled to work-product protection. Later in regard to the separate issue whether there was spoliation, the government argued that one of the same memoranda was prepared in anticipation of litigation and the taxpayer argued the reverse. (3)

This anomalous situation illustrates the double-edged nature of a work-product claim. Nevertheless, as the court had held that there was no anticipation of litigation in 1997 for purposes of work-product protection, it consistently held that the taxpayer had not (nor should it have) reasonably anticipated...