When engaged in discovery in business litigation, California’s robust tax return privilege will generally bar any curious opponent from seeking your tax information.
Common instances in which tax returns may be requested include disputes between competitors, involving employees, or insurance companies.
A business may be suing your business and seeking to recover lost profits, or seeking to otherwise discover your business’s financial situation. The first question for a savvy business owner is often: “Are tax returns discoverable?” The short answer is: probably not. Nor should the advice to “just release them to be courteous and cooperative” be heeded.
Releasing tax returns in litigation is rarely a helpful strategy unless absolutely necessary. Beyond balance sheets, tax returns can provide an opponent with a very clear path to unwinding and understanding the most complex workings of your business.
Outside of a few exceptions, tax returns are almost always privileged and not discoverable in civil litigation in California.
There are a couple of places in which California’s strong tax return privilege will not so cleanly apply, and those are:
- In a federal court applying federal law (rather than state law). Even in federal courts, there may be some basis for claiming a privilege from having to produce tax returns, but districts vary in their adherence to the privilege. In an administrative proceeding involving the Internal Revenue Service.
- Beyond those venues, and in California, you can assume that your or your business’s tax returns will not be discoverable if sought by a litigation opponent. For that reason, a business should not feel compelled by a request from an opponent to disclose your returns.
Lawyers and competitors may ask for returns to be disclosed, either in negotiations or as a matter of course in a preemptive litigation posture. In some instances, a neutral judge or arbitrator may request that a party release state or federal tax returns through discovery.
The fact is California’s tax return privilege most likely bars you from having to give up your or your company’s tax returns.
Why Does California Have Such a Strong Tax Return Privilege?
As a matter of public policy, governments tend to favor tax collection. You may be savvy to that very subtle detail if you have ever made any money. Because of that overarching principle, governments also tend to favor facilitating the smooth collection of taxes and to avoid creating any barriers to people or companies being honest and complete in their tax filings.
In order to facilitate this efficient tax enforcement, the government wants to avoid a taxpayer having any fear that his or her tax statements will be used against the taxpayer—as in, during a business lawsuit.
Clear enough? You bet. If you’ve dealt with California’s taxation entities, you likely know that they can be laser-focused on tax collection. The fact that the law is set up in such a way as to provide confidentiality in tax returns is not a surprising coincidence. This is all the better for a business under threat of a lawsuit and being harangued for tax returns.
A good response, if pressed, is to point your over-eager opponent to California’s tax return privilege.
The seminal cases on the subject point to the fact that a taxpayer may withhold disclosure of any copies of both federal and state tax returns, and is under no obligation in the ordinary course of litigation to provide that information to an opponent.
That comes from Webb v. Standard Oil Co., a 1957 California Court of Appeals case. Later courts explained that this privilege is so protective because it promotes and facilitates tax enforcement and collection by encouraging taxpayers to make full, truthful statements on their tax forms, and that those truthful statements should not come back to haunt the taxpayer in litigation. That was laid out in Sav-On Drugs, Inc. v. Superior Court, a 1975 California Court of Appeals case.
So in a motion to compel tax returns or a subpoena for income tax returns, know that there is some protection.
So the Privilege is Strong, but Is It Absolute? No. Know These Exceptions.
Absolute confidentiality is uncommon in the law. California’s tax return privilege, while a dependable source of protection from discovery, is not absolute. Knowing the exceptions to a privilege can be just as important as knowing that privilege exists.
When dealing with opposing attorneys subpoenaing tax returns and considering invoking the tax return privilege, hinging your company’s case on the privilege can come back to bite if an exception applies.
So what are the exceptions to the tax return privilege? In short:
- There has been an intentional waiver of the tax return privilege;
- A public policy that is greater than that supporting tax return confidentiality applies; or
- The lawsuit is one where the “gravamen” or primary focus of the relevant claims are inconsistent with the tax return privilege.
These are worth unpacking.
The Waiver Exception
The first item, waiver, deals with a fairly common practice in legal disputes involving tax return discovery. One party will seek to have another agree to, or sign a waiver of rights to contest claims, or claim privacy, or something of the like.
There are not many waivers that explicitly ask a party to waive their right to protest another party seeking their tax returns. Still, a waiver in this context is not unheard of. If a party puts their income at issue or their lost profits at issue, a court can deem that a waiver sufficient to set aside the strong privilege against having to release tax returns.
This can happen between a business and its competitor, or in a matter as personal as a divorce involving the separation of finances.
Before agreeing to “furnish any instrument or information necessary to show your finances,” or anything along those lines, consider that such an agreement may be a waiver, and therefore an off-ramp from this protection. If there is any gray area, consider consulting an attorney to determine whether you remain protected.
The Public Policy Exception
The second piece, where a public policy outweighs the protection, is a stranger beast than a simple waiver agreement. For this exception to apply, the proponent—the one trying to get the tax return—must show that some public policy is greater than a taxpayer’s interest in privacy in their taxes.
This is a high bar to prove and only applies in very specific situations.
One instance in which this arose, and an illustration of the narrowness of this exception, is a case in which a party to a divorce proceeding claimed inability to pay child support yet still held up the privilege to protect his tax returns. The court did not buy that and found that the applicable laws referred to tax information to determine ability to pay child support obligations.
In that instance, the court did not consider the tax return privilege applicable.
In business disputes, this exception has cropped up where one party has been wholly unwilling to share any financial information—corporate books and records, refusal to share records of transactions at issue in the dispute, uncooperative discovery tactics, etc.
There, the court was willing to limit the tax return privilege after a very significant showing of lack of cooperation and unwillingness to be forthright.
This is public policy exception is, by definition, the exception rather than the rule, but its application in various narrow instances can serve as a clear cautionary tale that the tax return privilege is strong, but it is not a free pass to avoid all process.
If a lawyer or judge infers that the public policy exception is applicable just because your tax returns would provide a clear picture of your finances, they are likely wrong.
Even in the instance where no clear legislative purpose applied but the Court of Appeals overturned the privilege, there was significant failure to comply with other less intrusive means of revealing the truth of the company’s finances. It is worth pushing back on this exception if it is touted in your case, as it is probably inapplicable.
The Gravamen Exception
Sometimes, a plaintiff actually bringing a lawsuit can put his or her own tax returns at issue. In that instance, the privilege from having to produce tax returns through the normal course of discovery may be considered “inconsistent with the gravamen of the lawsuit.”
This wanders into the land of legalese quickly, so this exception warrants only brief treatment for a full understanding of where the tax return privilege is not as strong.
Of many cases finding specifically that the tax return privilege was inconsistent with the claims in those cases are one involving claims of lost income (in the instance of an employment dispute), or suits in which a plaintiff claims having suffered economic hardship.
As is fairly evident, the rule of thumb to be drawn from this “gravamen” exception is: If you bring a claim putting your finances at issue, that is not the place to try to hide the clearest picture of your finances.
This is far less likely to arise in a business dispute, but one should never say never.
Conclusion: The Tax Return Privilege is Strong, and the Exceptions are Narrow
The question “Do I have to produce my tax returns in a business lawsuit?” is a common one.
The answer: Tax returns are protected in a lawsuit, and having to produce them in a suit for lost profits or other similar business dispute is rare and should be avoided if possible.
Remember, short of some limited exception laid out in detail above, a business or the individual taxpayer does not have to produce its tax returns in litigation or threatened litigation. Your taxes are your business, and the law favors confidence in the confidentiality save for very narrow exceptions.
Pushing back against attempts to obtain your personal or business taxation information is worth the effort. Wanton disclosure is both unnecessary and potentially debilitating in a business lawsuit.
Know the applicability of this privilege and protect your business’s financial information.