United States v. Arthur Young & Co.

• Decision Date: 26 August 1980
• Docket Number: No. M-18-304 (KTD).,M-18-304 (KTD).
• Parties: UNITED STATES of America, Petitioner, v. ARTHUR YOUNG & COMPANY, Respondent, and Amerada Hess Corporation, Intervenor.
• Court: U.S. District Court — Southern District of New York

496 F. Supp. 1152

UNITED STATES of America, Petitioner, v. ARTHUR YOUNG & COMPANY, Respondent, and Amerada Hess Corporation, Intervenor.

No. M-18-304 (KTD).

United States District Court, S. D. New York.

August 26, 1980.

John S. Martin, Jr., U. S. Atty., New York City, for petitioner; Katherine J. Trager, New York City, of counsel.

Carl Liggio, New York City, for Arthur Young & Co.

Obermaier, Morvillo, Abramowitz & Fitzpatrick, Milbank, Tweed, Hadley & McCloy, New York City, for intervenor; Robert G. Morvillo, Roger B. Oresman, New York City, of counsel.

OPINION

KEVIN THOMAS DUFFY, District Judge:

This matter comes before the court on an order to show cause why respondent, Arthur Young & Company hereinafter referred to as "Young", should not be compelled to obey an Internal Revenue Service hereinafter referred to as "IRS" summons directing it to testify and to produce for examination certain documents pertaining to the tax liabilities of intervenor Amerada Hess Corporation hereinafter referred to as "Amerada" for tax years 1972, 1973 and 1974. The summons was issued pursuant to Section 7602 of the Internal Revenue Code, 26 U.S.C. § 7602,¹ and requested the documents set out in the margin.² The underlying investigation was commenced in August of 1977, after Amerada made certain disclosures to the IRS concerning the deduction of some $7,830 in questionable payments during the years in question.

On January 12, 1978, two IRS summonses "the New Jersey summonses" were served on Amerada at its New Jersey offices. Amerada notified the IRS that it would not comply with these summonses, whereupon the IRS filed an enforcement petition on April 26, 1978, in the United States District Court for the District of New Jersey.

After an evidentiary hearing, the late Judge Barlow entered an order on January 22, 1979, granting the petition to enforce. United States v. Amerada Hess Corp., No. 78-753 (D.N.J.1978) ("Hess I"). The Third Circuit affirmed, 619 F.2d 980 (1980). Although the documents sought, and now turned over, pursuant to the New Jersey summonses are not the same as those sought in the present action, some of the issues litigated and resolved there are germane to these proceedings, as will be discussed below.

The summons in question here was served on Young by Special Agent Kenneth Kalemba of the IRS on April 17, 1978. Notice of this summons was sent to the taxpayer Amerada by certified mail on April 18, 1978. On April 21, 1978, the taxpayer, utilizing the provisions of 26 U.S.C. § 7609(a), directed Young, its outside auditor, not to comply with the summons.

The instant enforcement petition was filed by the IRS in this court on October 15, 1979 under 26 U.S.C. §§ 7402(b) and 7604(a). Respondent Young opposes the summons in its own right, as a matter of its own policy judgments, and not only because it has been directed by its client Amerada not to comply. Young advances five arguments against compliance. Amerada has also intervened and advances arguments of its own against compliance.

Young's Arguments

Young puts forth what it characterizes as basic policy arguments as to why it should not be ordered to comply with the IRS summons. The first of these arguments is that the summons requests virtually every piece of paper in Young's files concerning Amerada, totalling approximately a quarter of a million pages, and that such an overbroad, generic request violates the second of the four requirements of United States v. Powell, 379 U.S. 48, 57-58, 85 S.Ct. 248, 254-255, 13 L.Ed.2d 112 (1964). Under Powell, the four essential criteria for the judicial enforcement of an IRS summons are:

that the investigation will be conducted pursuant to a legitimate purpose, that the inquiry may be relevant to the purpose, that the information sought is not already within the Commissioner's possession, and that the administrative steps required by the Code have been followed . . ..

379 U.S. at 57-58, 85 S.Ct. at 255.

According to Young, a request such as the one at hand is so broad that it negates the court's oversight function and effectively makes the IRS summons self-enforcing, contrary to the intent of Congress as set out in 26 U.S.C. § 7604.

The IRS responds that it has, through the affidavits of its agents, made an initial showing that the four Powell requirements have been satisfied,³ and that the burden is therefore on respondent to show that enforcement would be an abuse of the court's process. The IRS argues that this burden has not been met. It also argues that generic and extensive document requests have repeatedly been upheld by the courts.

The cases cited by the IRS support its position and Young's attempts to distinguish them are unconvincing. In United States v. Acker, 325 F.Supp. 857 (S.D.N.Y. 1971), Judge Frankel approved a similarly broad IRS summons and construed 26 U.S.C. § 7602 as authorizing IRS inspection of documents which "`might' throw light upon subjects under legitimate inquiry." 325 F.Supp. at 862. As Judge Frankel reasoned in Acker, the IRS agents cannot and need not establish "probable cause" to justify their document demands. What they must do, and have done in the case at hand, is to show that the documents are sought in pursuit of a legitimate purpose and may be relevant to that purpose. See United States v. Powell, supra, 379 U.S. at 57, 85 S.Ct. at 254.

The end result of respondent's argument about generic document demands would be that a reviewing court must test each individual piece of paper for relevance and this cannot be.⁴

The materials demanded must be "sufficiently relevant to the investigation," United States v. Harrington, 388 F.2d 520, 523 (2d Cir. 1968), a standard to be applied to categories of documents, not to every single document within any category. So, for example, to look no further than the case just cited, it may be confidently supposed that not all the books and records there required to be produced (by a third party, not the taxpayer himself) would prove "relevant or material" to the subject being explored. But it was enough even where the burden was upon the third party there involved that there was "in the particular circumstances an indication of a realistic expectation rather than an idle hope that something might be discovered."

United States v. Acker, 325 F.Supp. at 862.⁵

Young attempts to distinguish the other cases relied on by the IRS on the grounds that the broad document requests approved in those cases were limited to records of actual transactions between the taxpayer and the third party. In most of the cases, however, the third party was a bank and the requests were only for records of transactions between the taxpayer and the bank. United States v. Coopers & Lybrand, 413 F.Supp. 942 (D.Colo.1975), aff'd, 550 F.2d 615 (10th Cir. 1977), is the one case that did involve an independent auditor, and made a distinction between transactional and other kinds of records. That case, however, is of no support to Young's attack on the breadth of the summons, for it denied enforcement of the summons only as to the audit program and tax pool analysis file. These issues will be discussed below.

Young's first argument must fail in that the present summons cannot be resisted simply on the grounds that it is overbroad.

Young next argues that its tax accrual files should, as a matter of law and policy, be protected from disclosure to the IRS. Tax accrual files, or the tax pool analysis papers, are the auditor's evaluation of the adequacy of the taxpayer—client's provision for taxes on the client's financial statements. They contain projections, opinions and hypotheses of possible tax consequences based on factual data derived from the client's records. Young argues that disclosure of such files to the IRS would seriously undermine the ability of the client to deal candidly with its auditor. It also argues that since they consist primarily of opinion, such files are not relevant to determining the client's tax liability. Finally, Young seeks to assert an indirect auditor-client privilege by arguing that the client enjoys an expectation of privacy for communications to its auditor.

Although case law on this precise question is spare and in apparent conflict, enough of a pattern has emerged to support the view that the tax accrual workpapers should be turned over.

In United States v. Coopers & Lybrand, 413 F.Supp. 942 (D.Colo.1975), the District Court held the IRS had failed to establish the relevance of the audit program (discussed below) and of the tax accrual files of Johns-Manville's outside auditor. Accordingly, the court refused to order and enforcement of the summons. The Tenth Circuit affirmed, 550 F.2d 615 (10th Cir. 1977), relying on the undisputed facts that the files in question were not used in connection with the preparation and filing of the taxpayer's returns and that the auditor had no responsibility for any of the client's tax matters. That is not quite the situation which obtains in the case at bar.

The opposite result was reached in United States v. Arthur Andersen & Co., 474 F.Supp. 322 (D.Mass.) dismissed without opinion, 612 F.2d 569 (1st Cir. 1979) (Table), where the court was not persuaded by Andersen's accountant-client privilege argument or by its relevance argument. Rejecting the reasoning of Coopers & Lybrand, supra, the District Court in Andersen relied on the language of § 7602 to conclude that the audit program and the tax accrual papers were "both relevant and reachable," in that the statute's "expansive language invites, and has generally been accorded, a liberal construction." 474 F.Supp. at 329. The court specifically rejected the argument that the papers should be shielded from disclosure because they were not used in preparing the tax returns under investigation.

The respondent and intervenor in Arthur Andersen, supra, failed to obtain a stay of the enforcement order from the District Court, the First Circuit, or the...