Protecting against the disclosure of trade secrets to independent experts and third-party fact witnesses during an Internal Revenue Service audit.

• Author: O'Brien, James M.

Protecting Against the Disclosure of Trade Secrets to Independent Experts and Third-Party Fact Witnesses During an Internal Revenue Service Audit

1. Introduction

   During a coordinated examination of a large corporation, the Internal Revenue Service typically deploys a team of revenue agents, international examiners, engineers, or economists, who possess broad statutory authority to collect facts regarding the taxpayer's property and business. (1) This authority generally is exercised informally through the agents' issuance of Information Document Requests (IDRs). (2). If the taxpayer fails to provide the requested information on an informal basis, however, the IRS can issue an administrative summons to examine "any books, papers, records or other data" or to take testimony of any person which may be relevant or material to the audit inquiry. (3).

   It is not uncommon during the audit of highly factual issues for the agents to request information that the taxpayer considers to be confidential trade secrets. For example, an IRS engineer might request access to detailed product cost data, product blueprints, and similar technical data to examine the taxpayer's intercompany pricing or allocation of consideration among intangibles in an asset acquisition. In response, the taxpayer might provide the IRS with copies of the relevant documents or with an opportunity to interview one of its engineers.

   The Internal Revenue Code of 1986, as amended, provides certain safeguards to the taxpayer with respect to confidential information disclosed to the IRS during an examination. Specifically, section 6103 (4) provides that "return information" shall be confidential and disclosed by the IRS only in accordance with the statute. A taxpayer is entitled to civil damages for an unauthorized disclosure of return information. (5) Certain willful, unauthorized disclosures are crimes under the Code. (6)

   The statutory safeguards applicable to trade secrets are meaningless, however, to the extent that the IRS discloses such information to third parties during the audit under section 6103(k). (7) Such information is likely to be disclosed under two circumstances:

   * First, the disclosure may be to an independent expert, whom the IRS has retained to render an opinion. An independent expert is not an employee of the IRS, but generally is an academician or consultant (a professional expert), who provides specialized expertise with respect to the particular case under audit.

   * Second, the disclosure may be to a third-party fact witness (e.g., a competitor, supplier, or customer of the taxpayer) to obtain facts. (8) The facts solicited from the third party need not arise from any actual transactions between the third party and the taxpayer. For example, the disclosure might be made to obtain the third party's own analysis of the value of the trade secrets to the taxpayer's business, to the third party's business, or within the industry generally.

   The Internal Revenue Manual (the IRM) unfortunately does not require the agent to obtain any authorization prior to disclosing return information, including trade secrets, to a third party pursuant to section 6103(k). (9) Therefore, an agent unilaterally can disclose trade secrets, no matter how sensitive or valuable, to a third party pursuant to section 6103(k) without notice to the taxpayer or any other safeguard procedures.

   The IRS's ability to disclose trade secrets to a third party during the audit places the taxpayer in a difficult position. On the one hand, the statutory safeguards clearly do not apply to a third party to whom return information is properly disclosed by the IRS. On the other hand, the taxpayer's ability to protect its trade secrets in the audit context is severely circumscribed due to the IRS's substantial authority under section 7602.

   This article first highlights the risks that a taxpayer encounters in disclosing valuable trade secrets to the IRS during an audit. It then reviews the several options available to the taxpayer for protecting its trade secrets during the audit. Because of the shortcomings apparent in the several options, the article concludes that the taxpayer's most effective strategy may consist of controlling the IRS's access to trade secrets during the audit and, if necessary, seeking a conditional - enforcement order from a district court during an administrative summons enforcement proceeding. Recent case law suggests that a district court has the inherent authority to impose conditions on the enforcement of a summons, which the taxpayer may be able to invoke to protect its trade secrets.

2. Trade Secrets and Third Parties:

   A Hole in Section 6103

   1. Trade Secrets Within the Litigation Context

      Before analyzing section 6103, it is appropriate to set forth a working definition of the term "trade secrets":

      A trade secret may consist of any formula, pattern

      device or compilation of information which is used in

      one's business, and which gives him an opportunity

      to obtain an advantage over competitors who do not

      know or use it. It may be a formula for a chemical

      compound, a process of manufacturing, treating or

      preserving materials, a pattern for a machine or

      other device, or a list of customers. (10)

      The concept clearly does not encompass every document or piece of information describing, or generated by, a business entity. Rather, trade secrets are limited to confidential technical, financial, or commercial data, the publication of which would cause the business entity to suffer a real competitive disadvantage. (11) There is no bright line test for determining whether particular information is a trade secret, and the determination depends upon the specific circumstances at the particular point of time when its disclosure is at issue.

      Specific procedural rules deal expressly with the protection of trade secrets within the litigation context. Under Tax Court Rule 103(a)(7), the Tax Court can issue a protective order "that a trade secret or other information not be disclosed or be disclosed only in a designated way." This rule was derived from Rule 26(c)(7) of the Federal Rules of Civil Procedure,(12) which authorizes a district court to issue a protective order "that a trade secret or other confidential research, development, or commercial information not be disclosed or be disclosed only in a designated way." (13)

      The courts have developed a flexible standard for determining whether particular information constitutes a trade secret for purposes of issuing a protective order. The district court in Zenith Radio Corp. v. Matsushita Electronic Industrial Co. framed this standard, as follows:

      Analysis of protective orders under [Federal] Rule

      [of civil Procedure] 26(c)(7) requires three lines of

      inquiry. First, is the matter sought to be protected "a

      trade secret or other confidential research development

      or commercial information" which should be

      protected? Second, would disclosure of such information

      cause a cognizable harm sufficient to warrant

      protective order? Third, has the party seeking

      protection shown "good cause" for invoking the court's

      protection? (14)

      In the Zenith Radio Corp. case, the district court recognized that a "wide variety of business information" can satisfy the first requirement, provided its value to the business entity is attributable to its general confidentiality. (15) The second requirement, the establishment of a cognizable harm, is satisfied if the disclosure of the information would place the business entity at a competitive disadvantage. (16) The third requirement, the showing of good cause, is satisfied if the party seeking the court's protection establishes with specificity that disclosure will result in a clearly defined and serious competitive injury. (17)

      The status of relevant and necessary information as a trade secret is not an absolute defense to its disclosure during discovery or at trial. (18) Instead, if a court concludes that particular information constitutes a trade secret, the court will tailor a protective order that protects the proprietary data without obstructing its use within the litigation. (19) The Tax Court has characterized these two-fold objectives, as follows:

      In all these cases access to the protected documents

      was granted, but the extent to which the parties

      could use them was limited by the courts. Hence,

      from these cases it is clear the paramount concern is

      to accord the parties access to all relevant and necessary

      information so that they can adequately

      prepare their cases without permitting improper or

      unfair use of the materials produced. (20)

      Where the court deems a protective order appropriate, it will creatively draft its provisions to address narrowly the perceived risk to the trade secrets in the specific case. (21)

      As the foregoing demonstrates, a body of case law has developed to accomplish, in a given case, the dual objectives of (i) allowing a litigant full access to relevant and necessary trade secrets for the purpose of presenting its case at trial, and (ii) protecting a party from the competitive injury that could result from the disclosure of trade secrets. The standard focuses on whether particular information is a trade secret and tailors the protective order to befit the circumstances. This flexible approach has proven to be a workable means of protecting trade secrets within the litigation context.

   2. Statutory Confidentiality Under Section 6103

      The IRS's examination of a taxpayer is not subject to the courts' procedural rules relating to protective orders within the litigation context, even though the IRS effectively conducts discovery during an audit through IDRs and administrative summonses. Nevertheless, the Code contains several provisions that are intended to provide safeguards to the taxpayer regarding information collected by the IRS during the examination. The linchpin is section 6103, which provides:

      Returns and return information shall be confidential,

      and except...