On March 27, 2017, the United States District Court for the Eastern District of Kentucky in United States v. Micro Cap KY Insurance Company held that documents sought by the Internal Revenue Service in a summons enforcement proceeding were protected under the attorney-client privilege. Specifically, the District Court rejected the Government’s argument that the taxpayers waived any privilege by asserting a reasonable cause/reliance on counsel’s defense against penalties.
Taxpayers were co-owners of Owensboro Dermatology Associates, PSC and Dermatology Property Management, LLC (collectively, “the Dermatology businesses”). In 2008, the taxpayers established Beveled Edge Insurance Company “as a captive insurance company providing direct property and casualty insurance policies to [the Dermatology businesses] to cover risks of the business supplemental to those covered by their commercial policies.” They jointly operated Beveled Edge for three years, then decided to dissolve it and establish their own captive insurance companies to insure their respective portions of the Dermatology businesses’ risks.
The taxpayers sought advice from attorneys at Moore Ingram Johnson & Steele, LLP (“MIJS”), who assisted them in forming Micro Cap KY Insurance Company, Inc. and Cavallo Nero Insurance, Inc. (collectively, “Respondents”). Respondents were organized as C corporations and elected tax treatment as Section 831(b) captive insurance companies. MIJS Captive Management, LLC, a subsidiary of MIJS, currently manages Respondents under the terms of two captive management agreements.
In 2014, the Internal Revenue Service opened an audit of Beveled Edge, as well as the Dermatology businesses. The IRS later initiated an investigation into Respondents’ income tax liabilities for the taxable years ending on December 31, 2012, December 31, 2013, and December 31, 2014. As part of this inquiry, the IRS issued a summons to Respondents, directing them to produce several categories of documents for examination. Respondents produced all documents identified in the summons, except for a series of email communications exchanged with MIJS attorneys. Respondents insisted that they should not be required to disclose these emails because they were subject to the attorney-client privilege. Petitioner, the United States, acting on behalf of the IRS, then initiated a summons enforcement action in an effort to secure full compliance with the summons.
The District Court referred the matter to a magistrate judge for a hearing, at which counsel for Respondents tendered privilege logs to the court and the United States. Thereafter the magistrate ultimately found it necessary to conduct an in camera review of the documents at issue. After reviewing the documents, the court concluded that further summons enforcement was inappropriate, and found that Respondents had properly invoked the attorney-client privilege, as each document “predominately involve[d] legal advice within the retention of  counsel.” The magistrate also rejected the United States’ argument that each Respondent had waived its attorney-client privilege by allowing the information at issue to be shared with the principal of the other Respondent, reasoning that the Respondents “jointly retained the law firm for the purposes of captive formation, management and compliance” and had a “clear commonality of interests.” The United States filed an objection to the district court.
Pursuant to Federal Rule of Civil Procedure 72, upon objection by a party, the district court judge was required to review the contested portions of the magistrate’s report de novo and “accept, reject, or modify the recommended disposition; receive further evidence; or return the matter to the magistrate judge with instructions.” Fed. R. Civ. P. 72(c). The Government argued that the Respondents waived their attorney-client privilege by filing a petition against the Commissioner of Internal Revenue in the United States Tax Court. Specifically, the Government claimed that Respondents, who are styled as Petitioners in that proceeding, placed their attorney-client communications at issue in that case by asserting in their Petition that they “relied solely on the advice of counsel for all positions taken on the income tax returns for the 2012, 2013 and 2014 tax years.” The United States acknowledged that it did not present this argument to the magistrate judge, but claimed that “exceptional circumstances exist because of the timing of the current proceedings and those of the Tax Court case.” The District Court held that because the United States did not raise this issue before the magistrate judge, the argument was waived. However, the Court considered the argument on the merits and concluded that it would fail.
On the merits of the Government’s argument, the Court said “that use of the ‘reasonable cause’ defense may result in a waiver of the attorney-client privilege in a variety of proceedings, including those before the Tax Court.” However, the Court recognized that “the assertion of the ‘reasonable cause’ defense in a pleading does not lead to the automatic disclosure of privileged documents.” For example, in Ad Investment 2000, the Tax Court concluded that the taxpayers had waived their attorney-client privilege by putting protected communications at issue, and ordered the taxpayers to produce the privileged documents. However, the Tax Court “simultaneously indicated that the petitioners could still protect their documents from disclosure by abandoning their ‘reasonable cause’ defense” (stating that, if the petitioners “persist, they sacrifice the privilege to withhold the contents of the opinions”).
By raising the reasonable cause defense in their Petition, the Court noted that Respondents gave the Commissioner grounds to request that the Tax Court compel production of documents subject to the attorney-client privilege. But the Court was told that the Commissioner had not made such a request. Thus, the Court concluded that the Government was requesting the Court to order the disclosure of privileged material based on what may happen in another forum—the Tax Court. Given the early stage of the Tax Court litigation, the Court refused to rely on the Government’s prediction or how discovery might proceed in Tax Court. The Court said that “if Respondents persist in asserting the ‘reasonable cause’ defense, then disclosure of privileged documents may later result in that forum. However, this is a strategic decision that must be made by Respondents.” The Court refused to order the disclosure of documents that are otherwise privileged.