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Tax Returns Of Corporation Subject To Presumption Of Confidentiality When Requested In Civil Lawsuit

By on November 5, 2021 in Evidence with 0 Comments

Plaintiff Charles Parkinson filed a lawsuit against defendants Diamond Chemical Company, Inc. and Harold Diamond, claiming that he was wrongfully terminated based upon his age.  The defendants claimed that the plaintiff was fired for “legitimate, non-discriminatory reasons” and contended that the plaintiff was fired because his “performance had been subpar for some period of time and was continuing to deteriorate.”  In addition to filing an Answer, the defendants filed a Counterclaim, alleging that the plaintiff wrongfully caused harm to the company by allowing his plant to manufacture defective products and being inattentive to his duties.  The issue in the published decision of Parkinson v. Diamond Chemical Company, Inc., 2021 N.J. Super. LEXIS 135 (App. Div. October 27, 2021) was whether the company was required to produce its financial records and income tax returns to the plaintiff.

The plaintiff had requested the financial records and income tax records of the defendants in discovery. The plaintiff contended that the tax filings and financial statements would likely contain “highly relevant information that could both support his affirmative claims and contest defendants’ counterclaims.”  In the defendants’ counterclaim, the defendants claimed that the plaintiff permitted the plant to manufacture defective products, despite knowing that a quality control machine to test those products was not working.  The defendants claimed that it caused a Diamond Chemical customer to lose an estimated $400,000 or more in sales.  The defendants had further allegations in their counterclaim concerning the plaintiff’s inattention to duties and lying to them that his phone was not working.  Additionally, the defendants claimed that the plaintiff breached his contractual obligations by providing services to a Diamond Chemical competitor within several months of his termination and improperly provided confidential information from his former coworkers to the competitor.

The plaintiff denied these allegations and disputed that his actions and inactions caused the company any financial harm.

The defendants objected to producing any of the tax records and financial records, claiming that they “have zero relevance to any of the substantive claims or defenses in this lawsuit.”  Further, the defendants claimed that the tax records, in particular, were “clothed with a presumption of confidentiality, and that plaintiff has failed to show relevance and a compelling need for them under the heightened Ullmann standard.”  Similarly, the defendants contended that the non-tax financial statements were commercially sensitive internal records that deserved protection from disclosure as well.

At the trial court level, after hearing the parties’ arguments, the trial court ruled that given the defendants had a counterclaim which contended that the actions of the plaintiff had a negative impact on the business, the court found that there was a compelling need for the tax returns.  However, the court limited the order to compelling the tax returns of Diamond Chemical and not the tax returns of Mr. Diamond individually.  The court also ordered the production and on-site inspection of the company’s financial records for four years.  The court rejected the defendants’ request for a protective order.

Instead of complying with the order compelling this disclosure, the defendants filed an interlocutory appeal of this order to the Appellate Division.  They argued that the trial court erred by shifting the burden to the company to justify a non-disclosure and that the court’s findings were inadequate to satisfy the Ullmann standard.  Further, the defendants argued that the discoverability of the financial records should not have been permitted without the full disclosure of the records to the court first, who would review them in camera.

The Appellate Division accepted this interlocutory appeal and considered the defendants’ arguments.  It noted that under the Internal Revenue Code, federal tax returns “shall be confidential.”  The Court pointed to a district court decision which ruled that “federal income tax returns are confidential communications between the taxpayer and the government.”  The Code does permit the disclosure of tax returns to persons having a “material interest.”  The Appellate Division noted that the Code “does not explicitly state that courts presiding over civil litigation may order the release of otherwise confidential tax returns and return information.”  However, the Appellate Division also noted that case law has interpreted the Code to authorize such disclosure when mandated by appropriate court orders.  The Court stated that New Jersey laws similarly treated state tax filings as presumptively confidential with a list of exceptions to confidentiality.

The Court delineated the disclosure standards as set forth in the case of Ullmann v. Hartford Fire Ins. Co., 87 N.J. Super. 409 (App. Div. 1965).  In that case, the Appellate Division adopted a “good cause” standard which recognized a presumptive confidentiality of tax filings and required a demonstration of relevance and a compelling need for disclosure of those records.  Under Ullmann, the sufficiency of the need depended upon the circumstances and each case would have to be decided upon its own facts.

Under Ullmann, three items must be demonstrated by a requestor of an opponent’s tax records in civil litigation to be able to obtain those records: 

  1. The records are likely to contain information relevant to the claims or defenses in the case.
  2. The requestor has a “compelling need” for the records to obtain information that cannot be obtained readily from other sources.
  3. Disclosure of the records will serve a “substantial purpose.”

In addition to these burdens placed upon the requestor, the Ullmann Court prescribed that the trial court judge generally should not order the release of tax filings without first performing an in camera review and considering whether a partial disclosure of redacted records would suffice.

In this case, the plaintiff presented the novel argument that the heightened standard of Ullmann only applied to individual tax returns and did not apply to the tax returns of corporations and other businesses.  The Appellate Division rejected that argument. 

First, it found that the language of the confidentiality provisions within the Internal Revenue Code and New Jersey’s tax statutes make no distinction between the tax returns of businesses from those of individual taxpayers.  Second, the Court noted that the plaintiff had not cited a single reported case from any jurisdiction that treated business tax returns as any less confidential than those of individual taxpayers.  Third, the Appellate Division found no public policies that “should dilute the strong presumption of confidentiality for business tax returns.”  It noted that tax returns could conceivably reveal information about the enterprise that is commercially sensitive.  Their disclosure beyond tax officials to competitors or other persons outside the company could at times be harmful.

Thus, in conclusion, the Appellate Division held that the Ullmann standard of heightened good cause “does indeed apply to business tax returns as well as individual tax returns.”  After reaching that decision, and reviewing the trial court’s rulings, the Appellate Division found that the trial court judge did not adequately analyze the requirements of Ullmann as they pertained to this case.  The rulings were too conclusory and did not mention whether the information within the tax filings could be readily obtained from other sources.  Further, the trial court’s opinion did not discuss whether a substantial purpose would be achieved by disclosure.

Finally, and the Appellate Division found “most importantly,” that the trial court did not rule that it should examine the tax records in camera to assess whether the records contained relevant information and, if so, whether a partial disclosure of those records would be sufficient. Hence, the Appellate Division remanded for this important step to be completed.

However, as to the turnover of the company’s financial statements, unlike tax records, the production of these records are governed by the ordinary standards for discovery and protective orders.  They are subject to a balancing test for the trial court to weigh the accommodation of a plaintiff’s need for discovery and the defendant’s right to maintain the confidentiality of information about its financial condition.  Based upon the Appellate Division’s review of the trial court record, it found that an in camera review of the financial statements would be beneficial and fairer to both parties.  Thus, it ordered an in camera review of those non-tax records be undertaken as well.

In summary, the Appellate Division vacated the trial court’s order compelling the full disclosure of the defendant Diamond Chemical’s tax filings and financial statements for the years in question and remanded the matter back to the trial court in anticipation for an in camera review of these filings and records with the trial court’s more detailed findings upon review.  The Appellate Division further suggested that the court convene a case management conference with counsel within thirty days to plan the remand.

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About the Author

About the Author:

Ms. Ramos is an Executive Committee Member and Co-Chair of the Litigation Department at Capehart Scatchard, P.A. located in Mount Laurel, New Jersey. She is an experienced litigator with over 30 years experience handling diverse matters. Practice areas include tort defense, business litigation, estate litigation, tort claims and civil rights defense, construction litigation, insurance coverage, employment litigation, shareholder disputes, and general litigation.

For the years 2020 and 2021, Ms. Ramos was selected for inclusion in The Best Lawyers in America© in the practice area of Litigation - Insurance. The attorneys on this list are selected based upon the consensus opinion of leading lawyers about the professional abilities of their colleagues within the same geographical area and legal practice area. A complete description of The Best Lawyers in America© methodology can be viewed via their website at: https://www.bestlawyers.com/methodology.

In 2021, Capehart Scatchard and Ms. Ramos received the “Best Law Firm” ranking in the area of Litigation – Insurance (Metro, Tier 3) published by U.S. News & World Report and Best Lawyers®. Law firms included on the list are recognized for professional excellence with consistently impressive ratings from clients and peers. To be eligible for a ranking, a firm must have at least one attorney who has been included in the current edition of Best Lawyers in America, which recognizes the top five percent of practicing lawyers in the United States. Betsy Ramos (Litigation – Insurance) was recognized for this prestigious award in the 2021 edition. For a description of the “Best Law Firm” selection methodology please visit: https://bestlawfirms.usnews.com/methodology.aspx.

“Best Law Firms” is published by Best Lawyers in partnership with U.S. News & World Report. For a description of the selection methodology please visit: https://bestlawfirms.usnews.com/methodology.aspx.

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