The Tax Court recently issued an opinion in AD Investment v. Commissioner, 142 T.C. No. 13, in which the Court granted the IRS’s motion to compel the production of documents. The controversy arose in the context of two consolidated Tax Court proceedings involving partnership-level actions related to a possible Son-of-BOSS tax shelter from tax year 2000.

During the course of civil discovery, the IRS sought the production of several opinion letters related to the purported tax shelter transactions. The IRS claimed that these opinion letters would reflect a law firm’s opinion as to whether it was more likely than not that the transactions at issue would be upheld for federal tax purposes. The partners refused to turn these letters over to the government, claiming that these letters were protected by the attorney-client privilege. The IRS argued that the privilege was waived when the partners relied on affirmative defenses to the penalties that turned on the partnerships’ beliefs or state of mind.

At issue in these consolidated proceedings were accuracy-related penalties under I.R.C. sec. 6662. There are several distinct affirmative defenses to accuracy-related penalties. In this case, the partners specifically did not raise the affirmative defense of reliance on professional tax advice. Rather, the partners claimed that the penalties did not apply because there was substantial authority for the treatments of the items, and because the partnerships reasonably believed that the tax treatment of those items was more likely than not the proper tax treatment.

The partners sought to avoid production of the opinion letters by choosing not to assert a defense based upon reliance on professional tax advice. Instead, the partners hoped that their “good faith” defense would not be considered a waiver of the attorney-client privilege.

The Tax Court did not agree with the partners, and found that the partnerships had waived their attorney-client privileges by putting forth a good faith or state-of-mind defense, which placed the partnerships’ legal knowledge, understanding, and beliefs into contention. The Court found that if the partners “are to rely on the legal knowledge and understanding of someone acting for the partnerships to establish that the partnerships reasonably and in good faith believed that their claimed tax treatment of the items in question was more likely than not the proper treatment, it is only fair that [the IRS] be allowed to inquire into the bases of that person’s knowledge, understanding, and beliefs including the opinions (if considered).”

The Court also held that the partners had forfeited the attorney-client privilege by raising the separate reasonable cause exception to the accuracy-related penalties for the same reasons the Court described in its analysis of the good faith defense.

The Court concluded its opinion by granting the IRS’s motions to compel production of the opinion letters. The Court noted that if the partners did not disclose the opinion letters, then it would consider precluding the partners from introducing other evidence that the partnerships had acted in good faith and that there was an honest misunderstanding of law.