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Protecting against the disclosure of trade secrets to independent experts and third-party fact witnesses during an Internal Revenue Service audit.

Protecting Against the Disclosure of Trade Secrets to Independent Experts and Third-Party Fact Witnesses During an Internal Revenue Service Audit

I. Introduction

During a coordinated examination of a large corporation, the Internal Revenue Service typically deploys a team of revenue agents, international examiners, engineers, or economists, who possess broad statutory authority to collect facts regarding the taxpayer's property and business. (1) This authority generally is exercised informally through the agents' issuance of Information Document Requests (IDRs). (2). If the taxpayer fails to provide the requested information on an informal basis, however, the IRS can issue an administrative summons to examine "any books, papers, records or other data" or to take testimony of any person which may be relevant or material to the audit inquiry. (3).

It is not uncommon during the audit of highly factual issues for the agents to request information that the taxpayer considers to be confidential trade secrets. For example, an IRS engineer might request access to detailed product cost data, product blueprints, and similar technical data to examine the taxpayer's intercompany pricing or allocation of consideration among intangibles in an asset acquisition. In response, the taxpayer might provide the IRS with copies of the relevant documents or with an opportunity to interview one of its engineers.

The Internal Revenue Code of 1986, as amended, provides certain safeguards to the taxpayer with respect to confidential information disclosed to the IRS during an examination. Specifically, section 6103 (4) provides that "return information" shall be confidential and disclosed by the IRS only in accordance with the statute. A taxpayer is entitled to civil damages for an unauthorized disclosure of return information. (5) Certain willful, unauthorized disclosures are crimes under the Code. (6)

The statutory safeguards applicable to trade secrets are meaningless, however, to the extent that the IRS discloses such information to third parties during the audit under section 6103(k). (7) Such information is likely to be disclosed under two circumstances:

* First, the disclosure may be to an independent expert, whom the IRS has retained to render an opinion. An independent expert is not an employee of the IRS, but generally is an academician or consultant (a professional expert), who provides specialized expertise with respect to the particular case under audit.

* Second, the disclosure may be to a third-party fact witness (e.g., a competitor, supplier, or customer of the taxpayer) to obtain facts. (8) The facts solicited from the third party need not arise from any actual transactions between the third party and the taxpayer. For example, the disclosure might be made to obtain the third party's own analysis of the value of the trade secrets to the taxpayer's business, to the third party's business, or within the industry generally.

The Internal Revenue Manual (the IRM) unfortunately does not require the agent to obtain any authorization prior to disclosing return information, including trade secrets, to a third party pursuant to section 6103(k). (9) Therefore, an agent unilaterally can disclose trade secrets, no matter how sensitive or valuable, to a third party pursuant to section 6103(k) without notice to the taxpayer or any other safeguard procedures.

The IRS's ability to disclose trade secrets to a third party during the audit places the taxpayer in a difficult position. On the one hand, the statutory safeguards clearly do not apply to a third party to whom return information is properly disclosed by the IRS. On the other hand, the taxpayer's ability to protect its trade secrets in the audit context is severely circumscribed due to the IRS's substantial authority under section 7602.

This article first highlights the risks that a taxpayer encounters in disclosing valuable trade secrets to the IRS during an audit. It then reviews the several options available to the taxpayer for protecting its trade secrets during the audit. Because of the shortcomings apparent in the several options, the article concludes that the taxpayer's most effective strategy may consist of controlling the IRS's access to trade secrets during the audit and, if necessary, seeking a conditional - enforcement order from a district court during an administrative summons enforcement proceeding. Recent case law suggests that a district court has the inherent authority to impose conditions on the enforcement of a summons, which the taxpayer may be able to invoke to protect its trade secrets.

II. Trade Secrets and Third Parties:

A Hole in Section 6103

A. Trade Secrets Within the Litigation Context

Before analyzing section 6103, it is appropriate to set forth a working definition of the term "trade secrets":

A trade secret may consist of any formula, pattern

device or compilation of information which is used in

one's business, and which gives him an opportunity

to obtain an advantage over competitors who do not

know or use it. It may be a formula for a chemical

compound, a process of manufacturing, treating or

preserving materials, a pattern for a machine or

other device, or a list of customers. (10)

The concept clearly does not encompass every document or piece of information describing, or generated by, a business entity. Rather, trade secrets are limited to confidential technical, financial, or commercial data, the publication of which would cause the business entity to suffer a real competitive disadvantage. (11) There is no bright line test for determining whether particular information is a trade secret, and the determination depends upon the specific circumstances at the particular point of time when its disclosure is at issue.

Specific procedural rules deal expressly with the protection of trade secrets within the litigation context. Under Tax Court Rule 103(a)(7), the Tax Court can issue a protective order "that a trade secret or other information not be disclosed or be disclosed only in a designated way." This rule was derived from Rule 26(c)(7) of the Federal Rules of Civil Procedure,(12) which authorizes a district court to issue a protective order "that a trade secret or other confidential research, development, or commercial information not be disclosed or be disclosed only in a designated way." (13)

The courts have developed a flexible standard for determining whether particular information constitutes a trade secret for purposes of issuing a protective order. The district court in Zenith Radio Corp. v. Matsushita Electronic Industrial Co. framed this standard, as follows:

Analysis of protective orders under [Federal] Rule

[of civil Procedure] 26(c)(7) requires three lines of

inquiry. First, is the matter sought to be protected "a

trade secret or other confidential research development

or commercial information" which should be

protected? Second, would disclosure of such information

cause a cognizable harm sufficient to warrant

protective order? Third, has the party seeking

protection shown "good cause" for invoking the court's

protection? (14)

In the Zenith Radio Corp. case, the district court recognized that a "wide variety of business information" can satisfy the first requirement, provided its value to the business entity is attributable to its general confidentiality. (15) The second requirement, the establishment of a cognizable harm, is satisfied if the disclosure of the information would place the business entity at a competitive disadvantage. (16) The third requirement, the showing of good cause, is satisfied if the party seeking the court's protection establishes with specificity that disclosure will result in a clearly defined and serious competitive injury. (17)

The status of relevant and necessary information as a trade secret is not an absolute defense to its disclosure during discovery or at trial. (18) Instead, if a court concludes that particular information constitutes a trade secret, the court will tailor a protective order that protects the proprietary data without obstructing its use within the litigation. (19) The Tax Court has characterized these two-fold objectives, as follows:

In all these cases access to the protected documents

was granted, but the extent to which the parties

could use them was limited by the courts. Hence,

from these cases it is clear the paramount concern is

to accord the parties access to all relevant and necessary

information so that they can adequately

prepare their cases without permitting improper or

unfair use of the materials produced. (20)

Where the court deems a protective order appropriate, it will creatively draft its provisions to address narrowly the perceived risk to the trade secrets in the specific case. (21)

As the foregoing demonstrates, a body of case law has developed to accomplish, in a given case, the dual objectives of (i) allowing a litigant full access to relevant and necessary trade secrets for the purpose of presenting its case at trial, and (ii) protecting a party from the competitive injury that could result from the disclosure of trade secrets. The standard focuses on whether particular information is a trade secret and tailors the protective order to befit the circumstances. This flexible approach has proven to be a workable means of protecting trade secrets within the litigation context.

B. Statutory Confidentiality Under Section 6103

The IRS's examination of a taxpayer is not subject to the courts' procedural rules relating to protective orders within the litigation context, even though the IRS effectively conducts discovery during an audit through IDRs and administrative summonses. Nevertheless, the Code contains several provisions that are intended to provide safeguards to the taxpayer regarding information collected by the IRS during the examination. The linchpin is section 6103, which provides:

Returns and return information shall be confidential,

and except as authorized by this title -

(1) no officer or employee of the United States,

(2) no officer or employee of any State, any local

child support enforcement agency, or any local agency

administering a program listed in subsection (1)(7)(D)

who has or had access to returns or return information

under this section, and

(3) no other person (or officer or employee thereof)

who has or had access to returns or return information

under subsection (e)(1)(D)(iii), paragraph (2) or

(4)(B) of subsection (m) or subsection (n),

shall disclose any return or return information obtained

by him in any manner in connection with his

service as such an officer or an employee or otherwise

or under the provisions of this section. For purposes

of this section, the term "officer or employee" includes

a former officer or employee.

Section 6103 identifies 13 exceptions to the general confidentiality rule, allowing the disclosure of return information in certain circumstances.(22) One exception allows the IRS to disclose return information to an independent expert or third-party fact witness to obtain information in connection with an examination.(23)

For purposes of section 6103, return information is defined broadly, as follows:

[A] taxpayer's identity, nature, source, or amount of

his income, payments, receipts, deductions, exemptions,

credits, assets, liabilities, net worth, tax liability,

tax withheld, deficiencies, overassessments, or

tax payments, whether the taxpayer's return was, is

being, or will be examined or subject to other investigation

or processing, any other data, received by,

recorded by, prepared by, furnished to, or collected by

the Secretary with respect to a return or with respect

to the determination of the existence, or possible

existence of liability (or the amount thereof) of any

person under this title, or any tax, penalty, interest,

fine, forfeiture, or other imposition, or offense. . . (24)

Although section 6103 makes no express reference to trade secrets, they clearly fall within the statutory definition of return information.

The statute provides a civil damage remedy to a taxpayer if return information is disclosed in violation of section 6103. The taxpayer can bring a civil damage action against the United States "if any officer or employee of the United States knowingly, or by reason of negligence, discloses any return or return information with respect to a taxpayer in violation of any provision of section 6103." (25) The taxpayer can also bring a civil damage action against an individual who is not an officer or employee of the United States, if such person "knowingly, or by reason of negligence, discloses any return or return information with respect to a taxpayer in violation of any provision of section 6103." (26) In either proceeding, no civil liability arises if the disclosure results from a good faith, but erroneous, interpretation of section 6103. (27) Upon finding liability, the taxpayer is entitled to the greater of its actual damages or $1,000 for each act of unauthorized disclosure. If the taxpayer can prove that the disclosure was willful or the result of gross negligence, it also is entitled to punitive damages. (28)

The statute also prescribes criminal liability for willful violations of section 6103. It is a felony under section 7213(a)(1) for an officer or employee of the United States or any person described in section 6103(n) willfully to disclose return information in violation of section 6103. (29) It also is a felony "for any person to whom any return or return information (as defined in section 6103(b)) is disclosed in a manner unauthorized by this title thereafter willfully to print or publish in any manner not provided by law any such return or return information." In addition, it is a felony for certain state and local employees or shareholders, to whom return information has been disclosed under section 6103, thereafter to disclose such information in violation of section 6103. (30) Finally, it is a felony for any person willfully to solicit for value return information. (31)

Independent of section 6103, it is a misdemeanor under section 7213(b) for an officer or employee of the United States to divulge or make known in any manner not authorized by law "the operations, style of work, or apparatus of any manufacturer or producer visited by him in the discharge of his official duties. . . ." Violation of section 7213(b) is punishable by a maximum fine of $1,000 and maximum imprisonment of one year, as well as termination of employment. (32)

The foregoing statutory provisions are deficient in two critical respects. First, section 6103(k)(6) grants the IRS authority to disclose return information, including trade secrets, to a third party for investigative purposes. Second, section 6103 and the enforcement provisions are not applicable to an independent expert or a third-party fact witness to whom the trade secret information has been disclosed pursuant to section 6103(k). This omission is because section 6103 applies only to (i) officers or employees of the certain local enforcement agencies, and (iii) persons who have had access to return or return information under certain specific subsections of section 6103, other than subsection (k). Consequently, a taxpayer that has disclosed trade secrets to an agent during the audit lacks any statutory protection vis - a - vis a third - party recipient of the trade secrets under section 6103(k).

Because an independent expert or third - party fact witness is not an officer or employee of the United States, the taxpayer cannot bring a civil damage action against the United States for disclosures by these individuals. In addition, because an independent expert or third - party fact witness is not subject to section 6103, his disclosure of return information cannot be a "violation of any provision of section 6103" within the meaning of section 7431(a)(2) such that the taxpayer could bring a civil damage action against the individual.

The relevant criminal provisions also are not applicable to an independent expert or third - party fact witness. Because these individuals had access to return information pursuant to section 6103(k), they are not within any of the categories of individuals subject to criminal prosecution under section 7213(a). (33) Similarly, section 7213(b) is applicable only to officers or employees of the United States.

The Internal Revenue Manual expressly recognizes that the civil and criminal disclosure penalties are not applicable to an independent expert or third - party fact witness who has received return information under section 6103(k)(6). (34) In lieu of the statutory provisions, the IRM suggests that return information be protected by including specific clauses restricting the independent expert's disclosure of such return information in a contract retaining an independent expert. (35) The IRM recommends that such contracts provide that failure to abide by the contract's disclosure limitations will be deemed to be "a material breach of the contract subjecting the contractor to damages and/or adversely affecting the contractor's eligibility to receive future contracts with the Service." (36)

The IRM's suggested use of contractual provisions to protect trade secrets does not adequately protect the taxpayer if the independent expert discloses or utilizes such trade secrets for purposes other than the IRS's examination and any subsequent litigation. His misuse of trade secrets would not provide the basis for a civil damage action against either the United States or the individual under section 7431. Furthermore, the taxpayer does not have a clear contractual basis for maintaining a civil damage action against the independent expert. (37) The taxpayer's civil remedies are even more speculative where the IRS discloses trade secrets to a third-party fact witness on a noncontractual basis. Finally, even if the taxpayer could maintain a civil damage action, there may be insurmountable evidentiary obstacles to the taxpayer's prevailing (e.g., it may be virtually impossible to prove that the third party improperly utilized the taxpayer's trade secrets in its own trade or business).

III. Options for Protecting Against the Disclosure

of Trade Secrets to Third Parties

Absent a statutory amendment to impose civil and criminal liability upon an independent expert or third - party fact witness who violates the confidentiality provisions, a taxpayer faces a substantial business risk whenever it discloses trade secrets to the IRS. A taxpayer has only three realistic options to deal with this risk. First, it can pursue civil remedies under section 7431(a)(1) against the United States on the ground that disclosure to the particular independent expert or third - party fact witness is not permissible under section 6103(k). Second, it can attempt to control informally the IRS's access to, and use of, trade secrets during an audit. Finally, it can attempt to invoke a district court's protection in a summons enforcement proceeding.

None of the foregoing options offers the taxpayer absolute certainty. Of the several options, section 7431 relief probably is the least effective. The taxpayer's most effective course of action probably lies in a strategy of both (i) limiting the IRS's access to such information during the audit process and, if necessary, (ii) imposing conditions upon the IRS's use of such information in a summons enforcement proceeding.

In order to utilize any of the several options effectively, the Company's tax personnel should meet prior to the audit's commencement with the operations personnel, who are responsible for the proprietary information of the business entity (e.g., patent counsel), to determine the specific types of documents and information that are regarded as trade secrets by the Company. The tax personnel should consult regularly with the operations personnel during the audit to review any IDR that might reach such trade secrets.

Involvement of the operations personnel in the development of the Company's position with respect to trade secrets is important for several reasons. First, the Company already may have specific policies regarding proprietary data (e.g., stamping documents with confidentiality legends and general disclosure procedures). The tax personnel should follow Company policy during the audit. Second, the operations personnel can provide the specific facts necessary to prove that particular information constitutes a trade secret. Third, the operations personnel may be able to provide (based on prior commercial experience) practical guidance regarding the terms of a confidentiality agreement or order to protect the trade secrets. Finally, if the IRS discloses the identity of an independent expert or third - party fact witness during the audit, the operations personnel can provide valuable input regarding the Company's sensitivity, if any, to the disclosure of trade secrets to this particular person. (38)

A. Civil Remedies Under Section 7431

Two potential civil remedies might be considered by the taxpayer as means of protecting its trade secrets. First, there may be grounds for a civil damage action under section 7431. Although disclosure by the third party is not actionable under section 7431(a)(2), the taxpayer may have a civil damage action against the United States under section 7431(a)(1) if the agent's disclosure to the third party was unauthorized under section 6103. Second, in a specific case the taxpayer may be able to enjoin the agent's disclosing of trade secrets to an independent expert or third - party fact witness.

Section 6103(k)(6) provides the operative exception to the general confidentiality rule under section 6103(a) with respect to the agent's disclosure of return information to an independent expert or third - party fact witness. Section 6103(k)(6) provides:

An internal revenue officer or employee may, in connection

with his official duties relating to any audit,

collection activity, or civil or criminal tax investigation

or any other offense under the internal revenue

laws, disclose return information to the extent

that such disclosure is necessary in obtaining information,

which is not otherwise reasonably available,

with respect to the correct determination of

tax, liability for tax, or the amount to be collected or

with respect to the enforcement of any other provision

under this title. Such disclosures shall be made

only in such situations under such conditions as the

Secretary may prescribe by regulation.

Treas. Reg. # 301.6103(k)(6) - 1(b) describes seven situations in which disclosure of return information is authorized. Several are potentially relevant:

(1) To establish or verify the correctness or completeness

of any return (as defined in section

6103(b)(1) of the Code) or return information;

(3) To establish or verify the liability (or possible liability)

of any person, or the liability (or possible liability)

at law or in equity of any transferee or fiduciary

of any person, for any tax, penalty, interest,

fine, forfeiture, or other imposition or offense under

the internal revenue laws or the amount thereof to

be collected; [and]

(5) To obtain the services of persons having special

knowledge or technical skills (such as, but not limited

to, knowledge of particular facts and circumstances

relevant to a correct determination of a

liability described in subparagraph (3) of this paragraph

or skills relating to handwriting analysis,

photographic development, sound recording enhancement,

or voice identification) or having recognized

expertise in matters involving the valuation

of property where relevant to proper performance

of a duty or responsibility described in this paragraph . . .

The regulation authorizes disclosures of return information to third parties to obtain necessary information in the foregoing situations "only if such necessary information cannot, under the facts and circumstances of a particular case, otherwise reasonably be obtained in accurate and sufficiently probative form, or in a timely manner, and without impairing the performance of such duties and responsibilities,. . . without making such disclosure." (39)

The agent's authority to disclose return information to an independent expert is expressly limited by the statute and regulations, which require that (i) the disclosure is necessary to obtain information, and (ii) the information is not otherwise reasonably available. (40) If either prerequisite is absent, the taxpayer can bring a civil damage action against the United States under section 7431(a)([1.sup. 41]). The taxpayer's maintaining a civil damage action generally is not a feasible means, however, of protecting its trade secrets for two reasons.

First, except in an unusual case, the taxpayer is unlikely to prevail in a civil damage action. The few cases decided under section 7431 involving disclosures during an examination suggest that a court will find the United States liable only if no nexus exists between the disclosure and the IRS's obtaining information during the audit. (42) If there is such a nexus, a court will find the disclosure "necessary" under section 6103(k)(6). A court will not inquire into whether the information sought from the third party is necessary to the examination. (43) As long as a reasonable basis exists for seeking information from a third party (i.e., the information is not otherwise reasonably available), the courts appear averse to limiting the IRS's scope of action. (44)

Assuming that the trade secrets were disclosed to the third party for the purpose of obtaining an opinion or facts, the taxpayer's prevailing under section 7431 would require proof that the information was otherwise reasonably available. In this regard, the taxpayer probably cannot compel the IRS to rely exclusively on the taxpayer for the information. The taxpayer's case might be appealing, however, if multiple, equally-qualified third parties were available to provide the information to the IRS and the IRS's use of the particular third party posed a clear risk to the taxpayer's business. This situation might exist if the third party and the taxpayer contemporaneously were engaged in sensitive commercial litigation.

The taxpayer's likelihood of prevailing under section 7431 is further minimized by the good-faith exception under section 7431(b). Hence, even if neither prerequisite to disclosure under section 6103(k)(6) has been satisfied, a court will not hold the United States liable if the agent acted in good faith, although erroneously, under section 613(k). (46)

The second reason rendering a civil damage action under section 7431 a poor means of protecting trade secrets is that it is a remedial action that arises after the disclosure of the trade secrets to the independent expert. Therefore, an action under section 7431 will not shield trade secrets; instead, it only will compensate the taxpayer for damages sustained as a result of the disclosure of trade secrets. Indeed, the taxpayer's victory in holding the United States liable may be pyrrhic, because the taxpayer's damages will be limited to $1,000 for each act of unauthorized disclosure unless the taxpayer can prove actual damages. The taxpayer may find it impossible as a practical matter to prove causation between the disclosure of the trade secrets and the business injury or to quantify the business injury.

Because the taxpayer lacks an adequate legal remedy, the taxpayer may be able to obtain a temporary or permanent order enjoining the IRS from disclosing trade secrets to an independent expert or third-party fact witness. The taxpayer's chances of obtaining an injuction are minimal, however, unless the taxpayer presents sufficient facts to qualify for a narrow judicial exception to the Anti-Injunction Act. (47) Subject to certain specific statutory exceptions not relevant here, section 7421(a) prohibits any suit to restrain the assessment or collection of tax. The courts have interpreted this provision broadly to prohibit injunctions against any activities by the IRS that might culminate in the assessment or collection of taxes. (48) A judicially created exception to section 7421, however, allows the taxpayer to maintain an injunctive action, provided that it establishes (i) irreparable injury and the inadequacy of legal remedy, and (ii) that government has no chance of prevailing under the "most liberal view of the law and the facts." (49)

The taxpayer's grounds for an injunction would be that the IRS's disclosure of trade secrets to a third party would violate section 6103(k)(6) and that the legal remedy under section 7431(a)(1) is inadequate because of the irreparable harm that such disclosure would cause the taxpayer. The Fifth Circuit's decision in Kemlon Products and Development Co. v. United States (50) illustrates the taxpayer's heavy burden in qualifying for the judicial exception to section 7421.

In Kemlon Products, the taxpayer engaged in the research, development, manufacture, and sale of various patented products for the oil and gas industry. The agent advised the taxpayer that he intended to interview the taxpayer's customers to elicit information to determine the value and useful life of certain patents held by the taxpayer. The taxpayer's counsel offered to secure the relevant information on behalf of the agent or to arrange the agent's interviews, provided the agent gave the taxpayer his written questions in advance. The agent refused this request, but invited the taxpayer's representative to attend the interviews.

The taxpayer sought to enjoin the agent's disclosure of return information to the taxpayer's customers on the ground that the disclosure would violate section 6103(k)(6) and cause the taxpayer irreparable harm. As proof of irreparable harm, the taxpayer offered affidavits that its industry was highly competitive, that its customers were interested in doing business only with financially stable companies, and that disclosure of the return information would result in a loss of business reputation and new projects. Because the taxpayer had shown irreparable harm and the lack of adequate legal remedy, the district court ordered the IRS to disclose the written questions for the purpose of allowing the taxpayer to introduce evidence on the issue of the IRS's likelihood of prevailing on the merits. When the IRS refused to produce the relevant written questions, the district court granted injunctive relief as a sanction.

The Fifth Circuit reversed on the ground that the judicial exception to section 7421 had not been satisfied. The court of appeals held that the taxpayer had not specifically shown how its customers' knowledge of the audit would cause irreparable harm to the taxpayer's business. In rejecting the assertions of irreparable harm, the appeals court noted that the taxpayer had neither asserted nor proven in the proceedings before the district court "that irreparable harm would result because of the disclosure of confidential or secret information concerning the patent or other device." (51)

In dictum, the Fifth Circuit stated that an injunction was not appropriate because the taxpayer had failed to prove that under no circumstances could the IRS prevail on the appropriateness of the disclosure under section 6103(k)(6). The court found evidence in the record that the disclosures were necessary to the agent's obtaining facts from the customers relevant to his determination of the patents' value and useful life. The court also found the agent's testimony (i.e., that direct communications with the customers was necessary to ensure candid responses) supported the claim that the information was "not otherwise reasonably available" under section 6103(k)(6). Because there was a possibility of the IRS's prevailing on the merits, the appeals court denied an injunction under section 7421.

Based on the Fifth Circuit's reasoning in Kemlon Products, it will be difficult to obtain an injunction to prevent the IRS's disclosing trade secrets to an independent expert or third-party fact witness. First, the taxpayer must establish with specificity that irreparable harm will result from the disclosure. Second, it must establish that under no circumstances can the IRS prevail in arguing that the disclosure is authorized under section 6103(k)(6). Given the discretion allowed the IRS under section 6103(k)(6), it is questionable whether the taxpayer can prevail in an injunctive action except in an egregious case (e.g., peculiar circumstances render a particular independent expert unfit and alternative independent experts are available).

B. Controlling IDR Responses

The IRS's collection of facts during an audit generally is an informal process. In response to an IDR, the taxpayer may provide an oral response, a written response, an opportunity to interview employees, an opportunity to examine original documents, copies of documents, or a tour of its facilities. The audit's informality allows a taxpayer certain "self-help" opportunities to protect its trade secrets.

Once the tax personnel have determined (based on their discussions with operations personnel) that certain information or documents should be regarded as trade secrets, they should treat such data as trade secrets during the audit. Independent of the tax audit, the Company may affix a legend to all trade secrets before such documents are disclosed to third parties, such as the following:

CONFIDENTIAL PROPRIETARY INFORMATION

OF [TAXPAYER'S NAME]: DISCLOSURE OR

USE PROHIBITED WITHOUT SPECIFIC

PERMISSION OF [TAXPAYER'S NAME]

This legend should be affixed to all documents containing trade secrets to which the IRS is given access. Even if the Company does not otherwise stamp documents "confidential," the tax department should have a rubber stamp made that would be used to mark all trade secret documents requested by the agents.

The tax personnel also should consider discussing the Company's concerns regarding the disclosure of trade secrets with the agent either at the commencement of the audit or at the time that the first sensitive IDR is issued. The taxpayer should advise the agent of the information that the Company regards as trade secrets and inquire (i) how the IRS intends to use the trade secrets and (ii) whether any special steps can be taken to ensure the data's confidentiality. The tax personnel and the agent may be able to agree upon means to address the taxpayer's concerns. For example, the agent may be amenable to reviewing documents containing trade secrets on site without making copies for the IRS's files. The parties also may enter into a written confidentiality agreement providing that the IRS will not publicly disclose, in the context of a trial or otherwise, such documents without first notifying the taxpayer so that the taxpayer can take any necessary steps to protect confidentiality.

Because of the informality of the examination process, the taxpayer possesses a certain degree of flexibility in responding to IDRs. If an IDR calls for disclosure of trade secrets, the taxpayer may be able to narrow its scope or provide other responsive information in lieu of the trade secrets.

If the agent nevertheless demands access to the trade secrets and the taxpayer concludes that the risk of disclosure is too great under the circumstances, the taxpayer can refuse to answer the IDR. The IRS will not automatically issue an administrative summons for noncompliance. (52) If the taxpayer otherwise has been cooperative and responsive, the information reasonably constitutes a trade secret, and the responsive information is not essential to the IRS's case, there is a strong likelihood that no summons will be issued.

Finally, the tax personnel should attempt to determine (directly or indirectly) whether the IRS intends to disclose trade secrets to an independent expert or third-party fact witness during the audit. The agent is not required to inform the taxpayer of such disclosure, although the agent may advise the taxpayer, particularly if the independent expert is a high-profile professional expert or the agent intends to have the independent expert present at the taxpayer's facility to review documents, interview employees, or tour the site. In other situations, the agent may not advise the taxpayer of the disclosure, for example, where the agent is soliciting opinions or facts from competitors, suppliers, or customers of the taxpayer.

The foregoing suggestions constitute informal means of reducing the risk that trade secrets will be compromised during an audit; they will not guarantee that the taxpayer's trade secrets will not be disclosed to an independent expert or third-party fact witness. Therefore, if the information is particularly sensitive, the only effective means of self-help is to deny the agent any access to the trade secrets.

C. Conditional-Summons Enforcement

If the IRS refuses to acquiesce to the taxpayer's noncompliance with an IDR seeking trade secrets, the IRS can issue an administrative summons under section 7602. If the taxpayer fails to comply with the summons, the IRS can commence an enforcement action under section 7604. A summons enforcement proceeding is summary in nature, and the IRS establishes a prima facie case by an affidavit or other evidence -

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 by the Code have

been followed .... (53)

Despite the perfunctory nature of the foregoing elements, the district court has the inherent authority to deny enforcement of a summons under certain circumstances (e.g., an improper purpose), because "[i]t is the court's process which is invoked to enforce the administrative summons and a court may not permit its process to be abused." (54)

The status of documents or information as trade secrets probably will not preclude the enforcement of a summons under the foregoing standard. In light of the Supreme Court's recent decision in United States v. Zolin, (55) however, a taxpayer may be successful in urging the district court to impose conditions on the enforcement of the summons analogous to a protective order issued to protect trade secrets during litigation.

In the Zolin case, the IRS issued an administrative summons to the Clerk of the Los Angeles County Superior Court for sealed documents relating to the taxpayers in an unrelated action. The IRS instituted an enforcement proceeding in which the taxpayers intervened. The taxpayers argued that the summons should not be enforced because it was issued for an improper purpose. Specifically, the taxpayers argued that the IRS previously had made unauthorized disclosures of return information under section 6103 to another governmental agency in connection with an ongoing criminal investigation.

Although the district court in the Zolin case enforced the summons, it expressly conditioned enforcement by ordering the IRS not to disclose documents to any other governmental agency unless criminal tax prosecution were sought or upon order of the district court. The IRS appealed, claiming that the conditional - enforcement order was an abuse of the court's discretion for two reasons. First, the IRS argued that the conditional - enforcement order conflicted with section 6103, which provides the exclusive limitations upon the IRS's disclosure of return information. Second, the IRS argued that the district court's order violated section 7421.

The Ninth Circuit rejected both of the IRS's arguments. As a threshold matter, the court held that the district court had the inherent authority to prevent abuses of its process by imposing conditions on an enforcement order. (56) The appeals court also held that the district court's order did not violate section 7421, because the order merely restrained the IRS from disclosing the return information to another governmental agency and did not enjoin the IRS's use of the return information for tax assessment and collection purposes. (57)

Because of a conflict among the circuits, (58) Zolin was reviewed by the Supreme Court. An evenly divided Court affirmed the Ninth Circuit with respect to the issue of the district court's power to place restrictions upon the IRS's disclosure of return information pursuant to a conditional-enforcement order under section 7604. (59) Unfortunately, the opinion provides no further analysis of the legal issues which divided the Court. Nevertheless, under Zolin a district court now has the authority to impose conditions upon a summons enforcement order.

Where the taxpayer is confronted with an administrative summons seeking trade secrets, the taxpayer should request that the district court use its inherent authority to prevent abuse of process to impose conditions upon the IRS's disclosure of the information as would be appropriate in a protective order under Rule 26(c)(7) of the Federal Rules of Civil Procedure. The use of a conditional-enforcement order to protect trade secrets clearly is an extension of the present case law. Nevertheless, the district court's inherent authority to impose such conditions on a summons enforcement should be recognized.

In the Zolin case, the IRS's argument that section 6103 provides the exclusive limitations on the IRS's disclosure of return information was rejected. The fact of the matter, however, is that the disclosure at issue in that case probably was not an authorized disclosure under section 6103. The IRS's disclosure of trade secrets to an independent expert or third-party fact witness may be an authorized disclosure under section 6103(k)(6). The IRS could argue that a conditional-enforcement order should not be issued unless the IRS's disclosure to the third party violated section 6103. The fact that the disclosure is authorized under section 6103 should not necessarily preclude the court's issuance of a conditional-enforcement order. In Estate of Yaeger v. Commissioner, (60) the Tax Court recently issued a protective order under Tax Court Rule 103 that certain information to be produced by the taxpayer-estate during discovery not be disclosed by the IRS to the decedent's ex-wife. Because the ex-wife had initiated a series of unsuccessful lawsuits against the estate, the estate was concerned that the IRS's disclosure of return information to her would result in additional lawsuits. Section 6103(e), however, authorized the IRS to disclose return information to the ex-wife. Citing the Ninth Circuit's Zolin opinion, the Tax Court held:

Respondent comes before this Court asking us to

compel petitioner to produce the requested documents.

Absent our explicit order, petitioner will not

voluntarily comply with respondent's request. Both

the Ninth Circuit and the Fifth Circuit have held

that the Service's authority to disclose under section

6103 does not override a court's power over its own

procedures and areas of authority. We concur in this

reasoning. Our authority to prescribe rules to govern

the practice before this Court was granted by

Congress. Sec. 7453. Furthermore, section 6103 is

a permissive statute, and the Secretary is authorized,

but not compelled, to disclose returns and return

information under certain situations and to

certain persons or organizations. We conclude that

we have the authority to condition and restrict the

use of our own discovery procedures with respect to

information jointly covered by section 6103 and Rule

103. Thus, notwithstanding the Service's authority

under section 6103, we will issue a protective order

if we determine that it is appropriate in this case. (61)

In the Yaeger case, the Tax Court tailored the protective order to permit the IRS to use the information in the context of the pending tax litigation, but precluded the IRS from disclosing the information to the ex-wife.

There still is an open issue whether a conditional - enforcement order restricting the IRS's disclosure of trade secrets to an independent expert or third-party fact witness violates section 7421. In Zolin, the Ninth Circuit reasoned that the conditional-enforcement order did not violate section 7421 because the IRS merely was enjoined from disclosing the return information to another agency and was not restricted in its use of such return information for purposes of assessment and collection of taxes. (62) Although this argument potentially may distinguish that case, the Fifth Circuit previously had held that a conditional-enforcement order may be appropriate in a situation where it would restrict the IRS's disclosure of return information in connection with an examination. (63) More fundamentally, because the IRS is invoking the district court's jurisdiction to enforce a summons, a strong argument exists that the district court has the inherent authority to impose conditions on such enforcement to ensure that its process is not abused by the IRS. (64)

For evidentiary and strategic purposes, the taxpayer should approach a conditional-enforcement order vis-a-vis its trade secrets like a protective order under Rule 26(c)(7) of the Federal Rules of Civil Procedure. The taxpayer should present specific evidence to establish that (i) the information constitutes trade secrets, and (ii) specific injury would result from disclosure. If the IRS makes a prima facie showing of relevance, the taxpayer probably will not be able to quash the summons on the grounds that the information constitutes trade secrets. (65) Therefore, the taxpayer should present the court with draft terms for an order that precisely addresses the taxpayer's specific concerns with respect to its trade secrets and minimally interferes with the IRS's use of the information during the examination. Although the specific relief requested by the taxpayer will depend on the particular circumstances, several conditions may be particularly appropriate.

First, because the taxpayer does not possess a remedy under section 7431 if the third party misuses trade secrets disclosed to him during the examination, the conditional-enforcement should address the statutory ommission. For example, the court might order (subject to sanctions) the third party not to use or disclose the trade secrets for any purpose other than assisting the IRS in its investigation and any subsequent litigation. In addition, the court might require the IRS to include in any contract with the third party a clause allowing the taxpayer to proceed against the third party under a third-party beneficiary theory if the third party improperly discloses or misuses the trade secrets. Alternatively, the court might require that the third party enter into a confidentiality agreement directly with the taxpayer.

Second, the conditional-enforcement order should prescribe various procedures to control the dissemination of the trade secrets. The court might require that the third party examine confidential documents at the taxpayer's facility and preclude the third party's retention of copies. The court also might limit the number of copies that the IRS or a third party can make of confidential documents and require that all confidential documents be returned to the taxpayer at the conclusion of the case. The court might order the IRS to maintain a "disclosure log" identifying the specific trade secrets and the third parties to whom such trade secrets were disclosed. The disclosure log would be provided to the taxpayer contemporaneously or at the conclusion of the controversy so that the taxpayer could determine whether the third party subsequently misused the information.

Finally, the conditional-enforcement order should provide guidelines in an appropriate case for the selection of third parties to whom the trade secrets will be disclosed. The court might limit the IRS's authority to disclose trade secrets to court-approved or mutually agreed upon independent experts or third-party fact witnesses. If there is a greater risk to the taxpayer from disclosure to a particular third party, the court might prohibit the IRS from disclosing the trade secrets to this person.

IV. Conclusion

Under current law, a taxpayer faces a real risk of losing trade secret information if the IRS discloses the trade secrets to independent experts and third-party fact witnesses during an examination. Clearly, section 6103 and the related civil and criminal liability provisions should be amended to impose liability either on the United States or the third party for latter's unauthorized disclosure or misuse of trade secrets. Even if the statute is amended, however, the remedial nature of the provisions still leaves the taxpayer in a dilemma in certain situations (e.g., the disclosure of a valuable trade secret to a particular third party could destroy the taxpayer's business).

Given the IRS's substantial authority under section 7602 to collect facts during an examination, few effective means exist to protect against the IRS's disclosure of the taxpayer's trade secrets to third parties during the examination. The taxpayer's best defense lies in its controlling the IRS's access to trade secrets during the audit. Where the access issue becomes confrontational and the IRS issues an administrative summons, the taxpayer may be able to obtain a conditional-enforcement order from the district court. Although the case law still is unsettled, the use of a conditional-enforcement order, like a protective order within the litigation context, to protect trade secrets has considerable merit. The conditional-enforcement order allows the IRS access to trade secrets for the purpose of the pending controversy, while imposing certain conditions on its use to the extent necessary to protect the taxpayer's bonafide property interest in the trade secrets. Because the IRS is invoking the court's jurisdiction to enforce the summons, the court should have the inherent authority to impose such conditions on the enforcement order as required in the interest of justice.

Footnotes - Protecting Trade Secrets During an IRS Audit

(1) I.R.C. [section] 7602(a).

(2) I.R.M. Part 403(23) (June 6, 1976).

(3) I.R.C. [section] 7602(a).

(4) All section references are to the Internal Revenue Code, unless otherwise stated.

(5) I.R.C. [section] 7431.

(6) I.R.C. [section] 7213.

(7) See Part III.A., infra, for the statutory language under section 6103(k).

(8) The IRS also might utilize a nonprofessional expert, who possesses significant technical or industry expertise, to render an opinion on a specific issue. Such a non-professional expert again might include a competitor, supplier, or customer of the taxpayer.

(9) I.R.M. Part (21)10 (May 29, 1984); I.R.M. Part (21)30 (May 29, 1984).

(10) Restatement (First) of Tort [section] 757 (1939); see Colgate-Palmolive Co. v. Carter Products, Inc., 230 F.2d 855, 864 (4th Cir.), cert. denied, 352 U.S. 843 (1956); Continental Data Systems, Inc. v. Exxon Corp., 638 F.2d 432 (E.D. Pa. 1986).

(11) Willie Nelson Music Co. v. Commissioner, 85 T.C. 914,921 (1985)

(12) Tax Ct. R. 103 (Advisory Committee's Note), 60 T.C. 1057,1123 (1973).

(13) See also Cl. Ct. R. 26(c)(7)(identical language).

(14) 529 F. Supp. 866, 889-90 (E,D.Pa. 1981).

(15) Id. at 890.

(16) Id. at 890; Essex Wire Corp. v. Eastern Electric Sales Co., 48 F.R.D. 308, 310 (E.D. Pa. 1969).

(17) Zenith Radio Corp. v. Matsushita Electronic Industrial Co., 529 F. Supp. at 891.

(18) Federal Open Market Comm. v. Merill, 443 U.S. 340, 362(1979). See generally 8 C. Wright & A. Miller, Federal Practice and Procedure [section] 2043 (1970).

(19) Johnson Foils, Inc, v. Huyck Corp., 61 F.R.D. 405, 409-10 (N.D.N.Y.1973).

(20) Willie Nelson Music Co. v. Commisioner, 85 T.C. at 922.

(21) See, e.g., Downs v. United States, 382 F. Supp. 713, 758 (M.D. Tenn. 1974), rev'd on other grounds, 522 F.2d 990 (6th Cir. 1975)(sealing the record); Estate of Yaeger v. Commissioner, 92 T.C. 180 (1989) (prohibit disclosure to specific individual); Davis v. General Motors Corp., 64 F.R.D. 420, 422 (N.D. Ill. 1974) (limit disclosure to parties' attorneys and court-approved experts). (22) I.R.C [sub. section] 6103(c)-(o).

(23) I.R.C. [section] 6103(k); Treas. Reg. [section] 301.6103 (k)(6)-1(b). This exception is discussed in Part III.A., infra.

(24) I.R.C. [section] 6103(b)(2)(A) (emphasis added).

(25) I.R.C. [section] 7431(a)(1).

(26) I.R.C. [section] 7431(a)(2). The taxpayer, however, has no recourse against the United States under these circumstances.

(27) I.R.C. [section] 7431(b).

(28) I.R.C. [section] 7431(c)(1)(B)(ii).

(29) Section 7213(a)(3) prescribes a maximum fine of $5,000 and a maximum imprisonment of five years. Under the alternative sentencing guidelines, the maximum fine for violation of section 7213 is the greater of $250,000 or twice the amount of pecuniary gain realized by the defendant or pecuniary loss suffered by another party as a result of the unauthorized disclosure. 18 U.S.C. [sub.section]3623(a), (c)(1).

(30) I.R.C. [sub.section] 7213(a)(2), (5).

(31) I.R.C. [section] 7213(a)(4).

(32) Under the alternative sentencing guidelines, the maximum fine is the greater of $100,000 or twice the amount of pecuniary gain realized by the defendant or twice the amount of pecuniary loss suffered by another party as a result of the unauthorized disclosure. 18 U.S.C. [sub.section] 3623(a), (c)(1).

(33) If the disclosure by the IRS to the third party were unauthorized under section 6103, he would be criminally liable under section 7213(a)(3).

(34) I.R.M. Part (21)40(1) (May 29, 1984).

(35) I.R.M. Part (21)40(2), (3) (May 29, 1984).

(36) I.R.M. Part (21)40(4) (May 29, 1984).

(37) Because the taxpayer is not a party to the contract, the taxpayer is not a party to the contract, the taxpayer would have to rely upon a third-party beneficiary" or similar legal theory to sue the independent expert.

(38) For example, the Company may have retained the specific independent expert previously in an unrelated matter;; the operations personnel may be familiar with the general reputation of the individual within the industry; or the individual may be a competitor, supplier, or customer whose access to the information could be particularly damaging to the Company's business.

(39) Treas. Reg. [sub.section] 301.6103(k)(6)-(1)(b). The IRS regards this regulation as the relevant authorization for disclosure of return information to an independent expert or third-party fact witness. I.R.M. Part (21)30(1) (May 29,1984).

(40) Barrett, Jr. v. United States, 795 F. 2d 446 (5th Cir. 1986).

(41) Malis v. United States, 87-1 U.S. Tax Cas. 9212 (C.D. Cal. 1986).

(42) Id. at 87,352 (United States liable under section 7431 where agent disclosed return information which was not intended to elicit information from third parties).

(43) Barrett, Jr. v. United States, 795 F. 2d at 451.

(44) See, e.g., Kemlon Products and Development Co. v. United States, 638 F.2d 1315 (5th Cir.), modified, 646 F.2d 223 (5th Cir.), cert. denied, 454 U.S. 863 (1981).

(45) Id. at 1323.

(46) In Calhoun v. Wells, 80-2 U.S. Tax Cas. 9643 (D.S.C. 1980), the court found no liability under section 7431 where an agent disclosed to the taxpayer's clients the fact that the taxpayer was under criminal investigation, even though this particular disclosure was not necessary to obtaining information from the third parties, because the agent acted in good faith.

(47) I.R.C. & 7421; Enochs v. Williams Packing & Navigation Co., 370 U.S. 1 (1962).

(48) Kemlon Products and Development Co. v. United States, 638 F.2d at 1320;; United States v. Dema, 544, F.2d 1373, 1376 (7th Cir. 1976), cert. denied, 429 U.S. 1093 (1977);; Bob Jones University v. Simon, 416 U.S. 725, 738-39 (1974).

(49) Enochs v. Williams Packing & Navigation Co., 370 U.S. at 7. In South Carolina v. Regan, 465 U.S. 367 (1984), the Supreme Court recognized a further exception to section 7421 if the taxpayer had absolutely no legal alternative (e.g., a refund suit) to challenge the validity of the tax.

(50) 638 F.2d a6t 1315.

(51) Kemlon Products and Development Co. v. United States, 638 F.2d at 1322. The taxpayer apparently argued for the first time on appeal that the information contained trade secrets. The Fifth Circuit refused to hear this argument on procedural grounds.

(52) Obviously, to the extent that the information is relevant to the agent's determination, the agent may propose an adjustment, among other things, on the ground that the taxpayer failed to substantiate its position by refusing to disclose the responsive trade secrets. See also I.R.C. & 6038A. Furthermore, the agent may take other enforcement steps, short of issuing an administrative summons, such as issuing a formal document request for foreign-based documentation under section 982.

(53) United States v. Powell, 379 U.S. 48, 57-58 (1964).

(54) Id. at 58.

(55) 109 S. Ct. 2619 (1989), aff'g in part and vac'g and rem'g in part, 809 F.2d 1411 (9th Cir. 1987).

(56) United States v. Zolin, 809 F.2d at 1417; United States v. Author Service, Inc., 804 F.2d 1520, 1525 (9th Cir. 1986). See also United States v. Arditi, 78-1 U.S. Tax Cas. 9435 at 84,150 (S.D.N.Y. 1978); United States v. Texas Heart Institute, 755 F.2d 469, 481-82 (5th Cir. 1985).

(57) United States v. Zolin, 809 F.2d at 1417; United States v. Author Service, Inc., 804 F.2d at 1526.

(58) The Ninth Circuit's decision created a conflict with the Fifth Circuits decision in United States v. Barrett, 837 F.2d 1341 (5th Cir. 1988), cert, denied, 106 L. Ed. 609 (1989). In Barrett, the Fifth Circuit acknowledged that the district court had discretion to enter a conditional-enforcement order in an administrative summons proceeding, but concluded that the taxpayers exclusive remedy for the IRS's violation of section 6103 was a civil damage action under section 7431. Id. at 1350.

(59) 109 S.Ct. 2619 (1989). Justice Blackmun took no part in the consideration or decision of the case.

(60) 92 T.C. 180 (1989).

(61) Id. at 188-89.

(63) United States v. Texas Heart Institute, 755 F.2d at 482 (disclosure of return information to the taxpayer''s patients to determine taxpayer's revenues).

(64) United States v. Zolin, 809 F.2d at 1416-17; United States v. Powell, 379 U.S. at 58;; Estate of Yaeger v. Commissioner, 92 T.C. at 188-89; United States v. Rockwell International, Inc., 90-1 U.S. Tax Cas. 50, 151 (3d Cir. 1990).

(65) C. Wright & A. Miller, Federal Practice and Procedure & 2043 (1970) (relevant and necessary trade secrets discoverable under Rule 26(c)(7)).
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