It is boilerplate law that parties are under an obligation to preserve potentially relevant evidence when they identify a “reasonable anticipation of litigation.” Application of that simple rule in the real world is more complicated, however, because the path to litigation is often incremental. Particularly in commercial contexts, there are often many steps and many months that intervene between the time that parties first recognize a potential dispute and the dispute matures to a point where litigation is anticipated. As a result, courts are frequently presented with preservation and spoliations questions focused on the facts-specific question of when litigation is reasonably anticipated (and a duty to preserve is, therefore, triggered).
Determining when litigation is “reasonably anticipated” is particularly difficult in the context of tax controversies.
A well-advised taxpayer considering a potential transaction or reporting methodology should be considering the possibility that the IRS will look askance at the taxpayer’s actions from nearly the first moment that the transaction or reporting position is proposed. Later, the possibility of a dispute with the IRS may be reevaluated many times–when the taxpayer files its return, when its financial auditors and tax counsel opine upon the potential issue, when an audit begins, when the IRS first proposes an adjustment, when the taxpayer files an administrative appeal of the proposed adjustment, and when the taxpayer files suit. At what point in this progression does a potential dispute rise to the level of a “reasonable anticipation of litigation,” thereby triggering a duty to preserve?
There is very little guidance answering this question in the context of tax controversies. One case addressing the issue, Consolidated Edison Co. v. United States, 90 Fed. Cl. 228, 259-63 (2009) (appeal pending on merits only), rejected a government charge of spoliation based upon the taxpayer’s destruction of documents after an audit had begun but before an adjustment had been proposed. More recently, the IRS Chief Counsel issued directions to agency lawyers that they must issue litigation hold letters to ensure preservation of evidence generally in conjunction with the institution of a law suit or assignment of the case to trial counsel—a relatively late step in the development of a dispute into litigation.
More useful guidance has been developed in the context of taxpayer assertion of claims for work product protection of tax accrual workpapers in response to IRS summonses. Those cases apply a seemingly identical “reasonable anticipation of litigation” standard in evaluating the claim for work product protection. For example, in SIANI v. State University of N.Y., a discrimination case, Magistrate Judge Wall in the E.D.N.Y. analyzed whether the “reasonable anticipation of litigation” trigger for work product protection also triggered a legal hold duty, and concluded, “the common sense conclusion that if the litigation was reasonably foreseeable for one purpose in January 2008, it was reasonably foreseeable for all purposes.”
Taxpayers typically claim that the workpapers were prepared in reasonable anticipation of litigation because an IRS challenge to the transactions was inevitable, while IRS takes the view that the workpapers are not protected by work product privilege because they were prepared too early in the development of the dispute to have been prepared in reasonable anticipation of litigation. The courts are divided on the issue. Compare, for example, the D.C. Circuit’s conclusion in Deloitte LLP that workpapers can be protected work product prepared in anticipation of litigation, with the First Circuit’s ruling in Textron that workpapers are not protected work product. The government continues to litigate the issue in other circuits.
The bottom line is that there is no clear rule on when litigation is reasonably anticipated and the duty to preserve is triggered in tax controversies. But several things are clear. First, the duty to preserve relevant evidence applies equally to both IRS and taxpayers involved in tax controversies; both taxpayers and IRS (along with their counsel) must address their own compliance with the duty to preserve in all developing controversies. Second, counsel for both IRS and taxpayers can find easily find themselves advocating inconsistent positions from case-to-case and from issue-to-issue; establishment of an early date for when litigation is reasonably anticipated will benefit the IRS in some instances and taxpayers in other instances. Third, a litigant’s treatment of work product privilege and the duty to preserve need to be considered together because of what courts may treat as a common legal standard; no party wants to successfully assert a work product claim only to later find that the victory is pyrrhic because it triggered a duty to preserve that it cannot satisfy. Most important, so long as debate persists upon the legal standard, well advised clients will consult counsel before taking a position on when litigation is reasonably anticipated in tax controversies and when they have a duty to preserve.