A Loose Standard For IRS Summons Enforcement
The article by tax partner Kat Saunders Gregor and a former Ropes & Gray attorney was originally published in Law360 on August 16, 2016.
Taxpayers defending against IRS enforcement actions face an interesting quandary: the IRS is increasingly asking for document discovery during examinations in a manner that would not be permitted under the Federal Rules of Civil Procedure and Tax Court rules. This asymmetry has encouraged the IRS, particularly in large, high-profile suits, to actively push factual development of future litigation into the examination stage. While, on the one hand, this may encourage earlier resolution of issues, on the other, burdens are placed on taxpayers that, as a policy matter, have been rejected by federal courts.
A recent example is playing itself out in the courts now. On July 6, 2016, in a widely reported action, the government filed a summons enforcement suit against Facebook in a U.S. district court in California. Its amended petition filed July 25 alleged that Facebook had failed to produce any response to seven IRS summonses requesting documents, including electronically stored information, regarding Facebook’s transfer of various intangible assets to its Irish subsidiary, which, if valid, would allow Facebook to benefit from Ireland’s low corporate tax rate.
While Facebook has not yet responded to the petition, the government’s petition suggests that one of Facebook’s defenses could be centered in part on the differences between a party’s obligations under civil discovery and when served with an IRS summons. In particular, according to the government, Facebook refused to respond to the summonses absent an agreement under Federal Rule of Evidence 502(d). Added to the Federal Rules of Evidence in 2008, Rule 502(d) allows federal judges to enter orders providing that attorney-client and work product privilege “is not waived by disclosure connected with the litigation pending before the court,” allowing parties to produce documents more readily with less concern that a single missed privileged document would waive attorney-client privilege.
The purpose of 502(d) was to respond to the “widespread” concern that in the era of electronic discovery “litigation costs necessary to protect against waiver of attorney-client privilege or work product have become prohibitive due to the concern that any disclosure (however innocent or minimal) will operate as a subject matter waiver of all protected communications or information.” These orders have become commonplace in federal civil litigation where parties often readily agree to such orders in light of the benefits for both sides. However, if parties cannot agree, a federal court can also fashion an appropriate 502(d) order and impose it on all litigants, including in tax cases.1
No known case has applied 502(d) to summons cases, but by its plain language, which applies to “disclosure connected with the litigation pending before the court,” it should apply in the context of a petition to quash or enforce an IRS summons. Indeed, its use has been recommended to protect privilege in other administrative investigations.2 Also, prior to 502(d), one court ordered in a summons enforcement case that a law firm could produce documents in response to an IRS summons “without prejudice to ... asserting a claim of privilege as to any specific materials” provided.3 However, absent court involvement, no such protection is offered for taxpayers responding to IRS summonses.
In addition to Rule 502(d), other recent developments in the Federal Rules also recognize the way electronic discovery is changing civil litigations. For instance, the 2015 amendments to Rule 26 of the Federal Rules of Civil Procedure made as their focus “[r]estoring proportionality as an express component of the scope of discovery” to help mitigate the “[t]he information explosion of recent decades [which] has greatly increased both the potential cost of wide-ranging discovery and the potential for discovery to be used as an instrument for delay or oppression.” The current rule requires a balancing of “importance of the issues at stake in the action, the amount in controversy, the parties’ relative access to 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.” Fed.R.Civ.P. 26(b)(1).
Similarly, Tax Court Rule 70(c) requires the court to consider whether discovery “is unreasonably cumulative or duplicative,” “obtainable from some other source,” or “unduly burdensome or expensive, taking into account the needs of the case, the amount in controversy, limitations on the parties’ resources, and the importance of the issues at stake in the litigation” as well as whether electronically stored information is “not reasonably accessible because of undue burden or cost.”
In contrast, the law on IRS summonses has not adapted to fit the demands of large-scale electronic discovery. Instead, to enforce an IRS summons, the government must only meet an extremely liberal four-factor test set more than 50 years ago, requiring that the government show that (1) “the investigation will be conducted pursuant to a legitimate purpose,” (2) “the inquiry may be relevant to the purpose,” (3) “the information sought is not already within the Commissioner's possession,” and (4) “the administrative steps required by the Code have been followed — in particular, that the ‘Secretary or his delegate,’ after investigation, has determined the further examination to be necessary and has notified the taxpayer in writing to that effect.”4
These factors are intended to require the IRS to meet only a “minimal” burden. Accordingly, the rule provides only a minor check on the IRS’ summons power. Indeed, the court in the Facebook case has already entered a show-case order noting that the government made “a prima facie showing that the examination is being conducted for legitimate purposes, that the inquiries may be relevant to those purposes, that the information sought is not already within the Commissioner’s possession, and that the administrative steps required by the Internal Revenue Code have been followed,” shifting the burden to Facebook “to oppose enforcement of the summonses.”
The first factor requires merely for the government to show that the investigation is aimed at the civil determination of tax liability and not for another purpose, such as gathering evidence in a criminal prosecution.5 In this context, even the fact that the statute of limitations had run regarding the time period being investigated does not necessarily mean that the government’s summons is improper.6
The second factor, requiring that the inquiry be relevant, has also been interpreted very broadly. Courts have specifically noted that IRS’ summons power specifically authorizes the IRS “to fish,” and so it is permissible for it to conduct fishing expeditions. IRS must merely meet the baseline standard that its summons request “might throw light upon the correctness of the taxpayer's return.”8
Since producing documents in response to a summons is not discovery, even in the summons enforcement context, taxpayers may not avail themselves of the new provisions of the Federal Rules regarding proportionality when a dispute about the adequacy of their responses to a summons arises with the government. While some may argue this is justified since summonses assist the government in fulfilling its investigatory function, even cases applying the Powell factors have recognized that “the Government may not exercise its investigative and inquisitorial power without limit — the examination is ‘unreasonable’ and impermissible if it is overbroad, ‘out of proportion to the end sought.’”9 However, this apparent proportionality standard has so far been applied in fairly limited circumstances.10 As one court noted, “the question of burdensomeness and interference with the business cannot be considered separate from the sine qua non of these enforcement proceedings — relevancy.”11
Accordingly, courts have only prevented the IRS from enforcing summonses that request from third parties a wide range of information not relevant to the investigation of a particular taxpayer or taxpayers or a small category of documents, such as bills issued to the taxpayer and budgets,13 employee performance evaluations,14 and correspondence not relevant to IRS’ inquiry.15 Similarly, courts have exercised their power to modify summonses largely only to enforce the basic Powell criteria, for example, declining to order production of documents not in possession of the IRS.16
These cases fail to confront an increasingly common conundrum for parties faced with responding to an IRS summons: the information sought by an IRS summons is or at least could be relevant, but the cost of such disclosure is out of proportion to the amount of the IRS’ tax claims or the IRS’ likely ability to assert such claims successfully. Since the Facebook suit may implicate up to $5 billion in tax claims, the Facebook case is unlikely to be the one in which these proportionality questions are addressed.17
Moreover, given the extremely loose standard for enforcement and the risk of changing the cooperative tone of an audit, practitioners have historically been far more likely to counsel that their clients reach compromise with the IRS rather than provoke a potential legal battle over summons responses. However, where an increasing number of audits request electronically stored information, this may soon change. This is particularly true where arguments limiting the scope of administrative subpoenas issued by other agencies, some relying on the same early cases cited in the IRS summons enforcement context, have already been successful.18 In the meantime, we can wait and watch which arguments Facebook raises against enforcement of the IRS summons — the show-cause hearing is scheduled for Nov. 17, 2016.