Opinion
6819-20
01-03-2024
OTAY PROJECT LP, ORIOLE MANAGEMENT LLC, TAX MATTERS PARTNER, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
ORDER
Christian N. Weiler Judge
This case is calendared for a two week special trial session of the Court commencing on July 15, 2024, in Washington, D.C. On October 4, 2023, the Commissioner of Internal Revenue (respondent) filed a Motion to Compel Production of Documents. On November 6, 2023, petitioners filed their response to respondent's Motion to Compel, which also included declarations from Mark S. Rhyme and Adriana L. Wirtz. On November 28, 2023, respondent filed a reply to petitioner's response.
Having considered the parties' arguments, the Court is now prepared to rule on respondent's Motion to Compel Production of Documents.
Background
The following facts are drawn from the parties' pleadings and motion papers. The facts stated are not findings of fact by this Court and are stated herein solely for the purpose of ruling on respondent's Motion to Compel Production of Documents.
Oriole Management, LLC (petitioner) is the "tax matters partner" of Otay Project, LP (the "Partnership"). The Partnership is a limited partnership formed under the laws of the State of California. At relevant times, petitioner was a general partner of the Partnership, and Otay Project. LLC (OPLLC) and Otay Ranch Development, LLC (ORD) were limited partners of the Partnership. OPLLC's partners were Oriole and ORD, and ORD was owned by 34 separate limited liability companies which were ultimately owned by Al Baldwin and Jim Baldwin-brothers and business partners-and their family members. In 1999, the Partnership acquired Otay Ranch, a real estate project consisting of 22,000 acres of land in San Diego County, California, and developed Otay Ranch from 2000 through 2005. The property was held in the Partnership.
While developing Otay Ranch, the Partnership sold tracts of land to third parties and other entities owned by Al and Jim Baldwin. The sales involved a contract for land sale by the Partnership and an unsecured promissory note to complete the construction of improvements on the land. The sales ultimately generated over $1,000,000,000 in gross revenue, and the total face value of the promissory notes received by the Partnership was about $921,000,000.
At least some of the contracts prevented buyers from rescinding the contracts even if the Partnership failed to complete its obligations. Instead, remedy under the contracts was limited to damages.
Based on these obligations to complete construction on the land, the Partnership accounted for the majority of the land sales under the completed contract method (CCM) of accounting under section 1.460-4(d), Income Tax Regs. Under the CCM, the Partnership recognized income on a sale only after the construction obligations in the contract were completed. The Partnership accounted for the construction obligations as partnership liabilities under section 752 in the total amount of $175,000,000, and these liabilities were allocated to petitioner, the Partnership's general partner.
Respondent has not challenged the Partnership's use of the CCM in the 2012 taxable year or in 2005, 2006, 2007, or any other taxable year.
Around 2002, Al and Jim Baldwin decided to divide Otay Ranch pursuant to a handwritten memorandum of understanding. In 2005, the Partnership formed two additional lower-tier partnership entities, AB Finco, LLC and JB Finco, LLC (collectively the "Fincos"). Shortly after the formation of the Fincos, the Partnership contributed the promissory notes it held from land sales to the Fincos. According to petitioner, the legal rights to collect on the promissory notes were transferred to the Fincos; however, the obligations to perform the construction improvements to the land remained with the Partnership.
In 2007, Al and Jim Baldwin started forming additional partnerships, whereby Al and Jim Baldwin, along with their respective spouses, transferred (or donated) interests in several upper-tier partnerships (namely some 34 LLCs, collectively holding interests in the Partnership) to newly formed family partnerships which were indirectly owned by their children and grandchildren. Together with the Fincos transactions, these transactions resulted in a basis step-up of some $867 million under section 743(b) to the Partnership property, solely with respect to OPLLC.
More specifically, the Partnership's 2007 tax return reported a positive $866,981,686 step-up for partner OPLLC and a negative adjustment of $283,395 for partner ORD.
In 2012, the Partnership was terminated under section 708 for Federal income tax purposes. At this time, the Partnership had not yet completed its construction obligations. The termination triggered all remaining income deferred under the CCM to be recognized under the "constructive completion rules" of section 1.460-4(k), Income Tax Regs., and the Partnership recognized all of its deferred income of $717,916,957. The vast majority of this income was allocated to OPLLC, which held a 99.9 percent interest in the Partnership. However, OPLLC's previously stepped-up basis under section 743(b) offset this deferred income.
On or about July 8, 2014, respondent notified the Partnership that its 2012 tax return was selected for examination. After issuing several Information Document Requests and holding conferences over a span of four years, respondent issued the FPAA on March 18, 2020. In the FPAA, respondent disallowed the reported stepped-up basis and adjusted the Partnership's 2012 ordinary income by $713,759,615.
On July 10, 2020, petitioner timely filed a Petition for Readjustment of Partnership Items with the Court. On June 16, 2021, Respondent's Amended and Restated Answer was filed asserting additional legal theories in further support of the FPAA, including the common law lack of economic substance doctrine, the codified lack of economic substance doctrine under section 7701(o) , and the substance over form doctrine (collectively the "Answer Theories"). In addition, respondent set forth facts supporting the Answer Theories as well as additional penalties.
Respondent's Amended and Restated Answer filed on June 16, 2021 which, according to respondent, was filed solely to combine his Answer, First Amendment to Answer and Second Amendment to Answer into a single pleading. See Motion for Leave to File First Amended Answer filed on June 10, 2021. Respondent lodged his First Amended and Restated Answer on June 10, 2021, which was later filed with the Court on June 16, 2021.
All section references are to the Internal Revenue Code in effect at all relevant times, and all Rule references are to the Tax Court Rules of Practice and Procedure. We round all monetary amounts to the nearest dollar.
Petitioner filed a Motion for Summary Judgment on November 20, 2020, pursuant to Rule 121. On January 21, 2021, respondent filed his response to petitioner's motion for summary judgment. On February 20, 2021, petitioner filed a motion for leave to file a reply to respondent's response, lodging its reply as an attachment. Similarly, on April 16, 2021, respondent filed a motion for leave to file a sur-reply to petitioner's motion for summary judgment, also lodging his sur-reply as an attachment. The Court granted both petitioner's and respondent's motions for leave on June 28, 2021, and petitioner's reply and respondent's sur-reply were filed into the record.
By order served on November 1, 2021, the Court denied petitioner's Motion for Summary Judgment.
Discussion
I. Summary of Respondent's Argument
Respondent, in his motion to compel, contends petitioner has improperly withheld production of documents on the grounds of attorney-client privilege and/or the federally authorized tax practitioner privilege set forth in section 7525 of the Code. Respondent's motion also asks, pursuant to Rule 104(c), that should petitioner fail to completely comply with this Court's order issued with respect to this motion, this Court would prohibit petitioner from introducing into evidence the requested documents, and testimony that otherwise relate to the assignments of error and/or allegations of fact in the Petition that pertain to the subject matter of the withheld documents requested by respondent, including but not limited to testimony and documents related to petitioner's claimed reasonable cause and good faith defense to the penalties being asserted herein.
In the motion to compel, respondent indicates petitioner has furnished a privilege log for over 10,000 documents. In the log, petitioner asserts the attorney-client privilege, work product and section 7525 privilege (Privileges). Respondent, however, asserts that petitioner has waived these claimed Privileges by placing its state of mind at issue by asserting non-tax motives for the transactions here at issue. More specifically, respondent contends petitioner waived the claimed Privileges when it furnished two copies of an internal memorandum (one in draft format and one in final format) from Mr. Rhyme (Rhyme Memos) and the subsequent declaration by Mr. Rhyme filed with petitioner's motion for summary judgment. Respondent next cites us to paragraphs in the Petition in which petitioner has raised the reasonable cause defense, as further evidence petitioner has waived its privileges over the documents being sought.
II. Summary of Petitioner's Argument
Petitioner opposes the relief being sought by respondent. First, petitioner contends in its response that respondent has previously litigated and lost this issue in Federal District Court. Next, petitioner contends that it has not waived its Privileges by asserting financial and estate planning purposes for the transactions at issue or in producing the Rhyme Memos and Affidavit. Petitioner also contends it is premature to determine whether it has waived the Privileges, since it has not decided whether or not to assert a reasonable cause defense. Finally, petitioner contends if Privileges have been waived, the waiver is limited in scope and does not cover all documents identified on its privilege log.
III. Analysis
Respondent does not dispute the petitioner's assertion of these Privileges; rather, respondent contends these Privileges have been waived. It is true Federal Courts have held that "[t]he attorney-client privilege may be waived by a client who asserts reliance on the advice of counsel as an affirmative defense." Glenmede Trust Co. v. Thompson, 56 F.3d 476, 486 (3rd Cir 1995). However, the operative word is "may" and, therefore, much care and analysis must be made to determine to what extent, if any, these Privileges have been waived.
In Ad Investment 2000 Fund LLC v. Commissioner, 142 T.C. 248 (2014), the Commissioner moved to compel the production of attorney opinion letters being relied upon by a taxpayer in its reasonable cause defense of penalties. We granted respondent's motion to compel, finding that the taxpayer had in fact forfeited its attorney client privileges over these documents since the communication was relevant to the content and the formation of the taxpayer's legal knowledge, understandings, and belief. However, our conclusion was largely predicated upon the reasonable cause defense, which put into contention the taxpayer's state of mind and our order was limited to compelling the production of these opinion letters. Id. at 258-59.
In Hartz Mountain Industries v. Commissioner, 93 T.C. 521 (1989), a principal dispute was over the tax character of payments made by the taxpayer in settlement and resolution of a civil antitrust lawsuit. In Hartz Mountain, the taxpayer filed a motion for partial summary judgment which included the tax treatment of civil antitrust settlement payments. In support of its motion for partial summary judgment, the taxpayer included two affidavits from Arthur Andersen, petitioner's in-house counsel. In one of the affidavits, Mr. Andersen discussed and set forth petitioner's internal position in the antitrust litigation.
In discovery, the Commissioner requested documents, notes and minutes of board meetings pertaining to the negotiations, and the settlement agreement entered into by the taxpayer related to the antitrust litigation. The taxpayer in Hartz Mountain objected to the discovery request by asserting attorney-client privilege over some of the documents; the Commissioner then moved to compel the production of documents. In its motion to compel, the Commissioner argued that the taxpayer had waived the attorney-client privilege by (1) contending in its petition that its intent in the antitrust settlement was to pay damages for past lost income; and (2) submitting the affidavits of Arthur Andersen, petitioner's in-house counsel, in support of its summary judgment motion.
In Hartz Mountain, we agreed with the second position of respondent and reserved ruling on the first; we concluded that the taxpayer had in fact waived the attorney-client privilege as to the tax treatment of civil antitrust settlement payments through submitting the Anderson affidavits. Id. at 525-26. We also held that the work product doctrine did not apply to the discovery being sought by the Commissioner related to the tax treatment of civil antitrust settlement payments. Id. at 528.
We find our foregoing decisions in Ad Investment 2000 Fund and Hartz Mountain, supra, to be guiding here. While it is true that the U.S. District Court quashed IRS administrative summons issued to Forestar, LLC seeking tax opinions provided by Ernst and Young, LLP to the Partnership and all documents related to the Rhyme Memo, the question now is whether the Privileges have been waived in this subsequent proceeding.
Respondent contends petitioner has now waived their applicable Privileges over the documents at issue, by submitting the Rhyme Memos and Affidavit in support of their previously filed motion for partial summary judgment. Petitioner, however, seeks to distinguish itself from Hartz Mountain, and first contends there has been no waiver, and second if there was a waiver, it was limited in scope.
Under Federal Rule of Evidence 502(a), the scope of a privilege waiver "extends to an undisclosed communication or information . . . only if: (1) the waiver is intentional; (2) the disclosed and undisclosed communications or information concern the same subject matter; and (3) they ought in fairness to be considered together." The waiver, however, extends "only as to communications about the matter actually disclosed." see Chevron v. Pennzoil, 974 F.2d 1156, 1162 (9th Cir. 1992)(citing Weil v. Investment/Indicators, Research & Management, 647 F.2d 18, 25 (9th Cir. 1981))
On November 20, 2020, petitioner submitted the affidavit of Mark S. Rhyme. Mr. Rhyme is an officer for petitioner and also a licensed CPA. In his affidavit, Mr. Rhyme recites the background of facts surrounding the development of Otay Ranch by Al Baldwin and Jim Baldwin, including the construction performance obligations held by the Partnership. The Rhyme Memos were furnished during the IRS examination of the Partnership, and again in response to discovery requests in this case. Considering the foregoing, we find that petitioner's waiver was intentional.
Next, we find that the disclosed Ryme Memos, also include undisclosed communications concerning the same subject matter; namely the business purpose surrounding the estate planning by Al and Jim Baldwin and their spouses. Which included the formation of new partnerships, and transfers (or donation) of interests in several upper-tier partnerships (some 34 LLCs) to newly formed family partnerships which were indirectly owned by the children and grandchildren of Al and Jim Baldwin. Finally, petitioner is using (and has used) the Rhyme Memos and Rhyme Affidavit in this litigation which weighs in favor of respondent as to fairness for the production. Accordingly, we find the three elements of Federal Rule of Evidence 502(a) have been met here.
According to respondent, in the Rhyme Memo, Mr. Rhyme opines on the federal income tax consequences on the transactions giving rise to the section 743(b) adjustment at issue herein. His opinions include that the transactions at issue had sufficient business and/or estate planning purposes such that they should be respected under Treasury Regulation section 1.701-2 and the economic substance doctrine.
Now finding the waiver of Privileges has occurred, the next question before us is to what extent the waiver was made and over which documents have the Privileges been waived.
Petitioner, in its response, maintains that it has not decided whether (or not) it will proceed at trial with a reasonable cause and good faith defense, and whether this defense will include advice given by Mr. Rhyme. As petitioner points out discovery is ongoing; however, a trial date of July 15, 2024, has also been set at the parties' request. It is true that petitioner need not disclose (in advance) its so-called "trial strategy." However, a waiver of applicable Privileges has already occurred through the production of the Rhyme Memos; consequently, petitioner is obligated to produce requested relevant records under our Rules. Unlike the Coca-Cola Co. v. Commissioner Order (which was cited by petitioner), the requests here do not call for them blanket "production of [all] documents to be used a trial." Rather, the request is specific in nature and seeks the underlying internal communications surrounding the Rhyme Memos. We conclude the documents are more than likely discoverable, since the communications presumably concern the same subject matters discussed in the Rhyme Memos.
See the parties joint status report, filed on June 15, 2023.
See Rule 70(a)(2) addressing the Time for Discovery; and Rule 72 generally.
T.C. Docket No. 31183-15, June 29, 2017 Order.
Considering the foregoing, however, we also find respondent's Document Requests to be broad in nature, and beyond petitioner's waiver of these Privileges. We do not accept respondent's argument for a blanket waiver of all 10,000 records being withheld based on petitioner's Privileges. Accordingly, we will first leave it to the parties to resolve the scope of waiver based on our guidance herein; and if still unresolved, either party may renew the issue through a newly filed motion.
Considering the foregoing, it is
ORDERED that respondent's Motion to Compel Production of Documents, filed on October 4, 2023, is denied, without prejudice.