On August 15, 2012, the United States District Court for the Northern District of Ohio ruled for the taxpayer in three out of four Internal Revenue Service (“IRS”) summons enforcement actions. These significant rulings represent rare taxpayer victories in summons enforcement proceedings against corporate taxpayers under IRS audit. Corporate taxpayers should pay close attention to the Northern District’s ruling, because the Court reached several holdings that will affect taxpayers’ obligations in responding to IRS requests for information.

On March 13, 2012, the United States filed four petitions in the District Court for the Northern District of Ohio seeking to enforce IRS summonses issued to several executives of Eaton Corporation and Includible Subsidiaries (“Eaton”). Typically, the IRS can summon all relevant documents, with relevance being a minimum standard requiring only that the summoned documents be helpful to the IRS’s investigation. This is a very low burden, and courts almost always find it to be met.

The IRS was examining Eaton’s 2005 and 2006 tax liabilities, and during the course of the audit Eaton provided a substantial amount of documents in an attempt to resolve the exam. Although Eaton felt that it had complied with the IRS’s requests, the agency disagreed and filed petitions in District Court seeking additional information. After extensive briefing the Court issued a memorandum opinion and order on August 15, 2012, refusing to enforce three of the four summonses.

As part of its investigation, the IRS sought performance evaluations of a former employee of Eaton’s tax department responsible for managing Eaton’s compliance with Advanced Pricing Agreements (“APAs”) entered into between Eaton and the IRS. Eaton refused to turn over the performance evaluations because they were not relevant to the IRS investigation and intruded on the former employee’s privacy. The IRS filed a complaint seeking to compel Eaton to produce the evaluations. Eaton argued that the personal nature of the performance evaluations required the government to meet a higher standard of relevancy than would normally apply. Specifically, Eaton argued that the IRS had to show that the employee’s job performance somehow affected the company’s tax liability. The IRS argued that it only had to meet the low standard of relevancy applicable to summonses generally, and that the performance evaluations might shed light on Eaton’s tax liabilities.

The Court agreed with Eaton that the IRS had not shown the relevance of the performance evaluations, and refused to enforce the summons. The Court held that Eaton had “persuasively demonstrated” the “purely speculative” nature of the IRS’s position. This ruling, which is the first to deal with this issue in a summons enforcement action, is particularly important since we have observed multiple instances of the IRS seeking employment evaluations. Implicit in the Court’s ruling is an acceptance of Eaton’s argument that IRS requests for personnel evaluations give rise to privacy concerns. Corporations should be sure to consider the relevancy of the evaluations to the IRS’s investigation and the privacy concerns of current and former employees involved when deciding whether to turn over performance evaluations during audit.

In addition to performance evaluations, Eaton refused to produce several categories of documents related to its APAs on the grounds of privilege. The IRS filed two separate complaints seeking to compel production of the withheld documents. The Court noted that Eaton had turned over several thousand pages of documents, but withheld some on the grounds of privilege after providing the IRS with a privilege log. Eaton argued in part that the documents sought were protected by the attorney-client privilege, the IRC section 7525 “tax practitioner privilege,” and the attorney work-product doctrine. In addition to attorney-client privileged materials, Eaton contended that certain documents were protected by section 7525 because that section applies to both in-house and external tax advisors, while the work product doctrine applied to several documents because they were prepared in anticipation of an “adversarial administrative proceeding” against the IRS. Although Eaton was under continuous audit, its relationship with the IRS had become contentious and adversarial, and Eaton argued that documents prepared in anticipation of its audit were properly characterized as attorney work-product. The IRS countered that the tax practitioner privilege was limited to external advisors, and that the work product doctrine did not protect documents prepared during the course of an audit or in anticipation of an administrative dispute with the IRS. The IRS further argued in the alternative that Eaton’s privilege log was inadequate and lacked necessary information, and that Eaton had waived any claimed privileges by contesting an IRS Notice of Deficiency in the United States Tax Court.

The Court agreed with Eaton and refused to enforce the summonses. The Court held that the IRS had not provided adequate grounds to contest Eaton’s privilege claims, and refused to undertake an in camera review of the documents at issue absent more than the IRS request for one. The Court found that Eaton’s privilege log contained sufficient information to put the IRS on notice of the basis for the claimed privilege. In addition, the Court agreed with Eaton that certain documents prepared by in-house tax advisors were protected by the section 7525 taxpractitioner privilege because that section was not limited only to external advisors. Further, the Court agreed that documents prepared by Eaton in anticipation of its audit were entitled to work product protection, rejecting an IRS argument that Eaton had not generated the documents at issue “in anticipation of litigation” with the agency. The Court agreed with language in Court of Appeals for the Sixth Circuit precedent that the documents sought were entitled to work product protection because Eaton had demonstrated that the particular IRS audits at issue were adversarial and contentious. See United States v. Roxworthy, 457 F.3d 590 (6th Cir. 2006). As a result, the Court recognized that the documents at issue were “aptly characterized as prepared ‘in anticipation of litigation’” and thus were properly considered attorney workproduct that need not be turned over to the IRS. Lastly, the Court held that Eaton had not implicitly waived its claims of privilege by filing a petition in the Tax Court.

The Court’s rulings on the tax-practitioner and attorney work-product questions raised by Eaton’s case highlight the privileges that may apply to taxpayer records. Corporate taxpayers should carefully consider the role of in-house tax practitioners and the nature of the taxpayer’s relationship with the IRS when determining what privileges may apply to documents sought during an audit. Although many large companies are under continuous audit, and although most tax disputes are settled without litigation, the Court’s opinion shows that the work product doctrine may apply during an IRS audit.

Although the Court ruled for Eaton in 3 of the 4 cases, it did enforce one IRS summons seeking notes of interviews held with employees as part of the APA application process. The Court accepted that the documents might be privileged but enforced the summons because Eaton had not provided a privilege log. Eaton had taken the position that a privilege log was not required since the request on its face reflected the privileged nature of the documents. However, the taxpayer submitted an affidavit sworn by an Eaton in-house tax practitioner that she was familiar with the documents sought by the IRS and that the notes were privileged because they were prepared after meetings held specifically to assist Eaton in procuring tax advice. The ruling is at odds with case law holding that privilege logs are unnecessary when they would not provide any useful information. Taxpayers claiming privilege should undertake a careful analysis to determine whether a privilege log is necessary. Although in some cases it might seem as if the specificity of the request renders the need for a privilege log moot, Eaton’s case highlights the discretion trial judges have in deciding questions of privilege.