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Tax Court allows use of predictive coding to meet IRS’s discovery request

Dynamo Holdings Limited Partnership, et al, (2014) 143 TC No. 9143 TC No. 9

In consolidated cases, the Tax Court has concluded that, in responding to IRS’s request to review electronically stored information on backup tapes that contained both tax-related and privileged information, the taxpayers could use predictive coding—a technique prevalent in the technology industry but not previously formally sanctioned by the Tax Court—to efficiently and economically identify the nonprivileged information that was responsive to IRS’s discovery request.

Background on discovery.Under the Tax Court Rules of Practice and Procedure, a party in Tax Court litigation generally may obtain discovery of documents and electronically stored information to the extent that the information contained therein isn’t privileged and is relevant to the subject matter of the case.(Rule 70(a)(1), Rule 70(b)) Documents and electronically stored information include “writings, drawings, graphs, charts, photographs, sound recordings, images, and other data compilations stored in any medium from which information can be obtained, either directly or translated, if necessary, by the responding party into a reasonably usable form.”(Rule 72(a)(1)) A party is generally required to produce documents or electronically stored information in the form in which they are maintained (Rule 72(b)(3)), but isn’t required to provide discovery of electronically stored information from sources that the party establishes are not reasonably accessible because of undue burden or cost unless the Court concludes that the requesting party has shown good cause for the discovery.(Rule 8 70(c)(2))

Observation: The Tax Court noted that these rules under the Tax Court Rules of Practice and Procedure are all similar to corresponding provisions found in the Federal Rules of Civil Procedure, i.e., Fed. R. Civ. P. 34(a)(1)(A), Fed. R. Civ. P. 34(b)(2)(E), and Fed. R. Civ. P. 26(b)(2)(B).

Background on predictive coding.Predictive coding, as explained by the Tax Court, is an expedited and efficient form of computer-assisted review that allows parties in litigation to avoid the time and costs associated with the traditional, manual review of large volumes of documents.Computers can predict the relevance of documents to a discovery request and then identify which documents are and are not responsive through the coding of a relatively small sample of documents.The parties—typically through their counsel or experts—select a sample of documents from the universe of those documents to be searched by using search criteria such as keywords, dates, custodians, and document types, and the selected documents become the primary data used to cause the predictive coding software to recognize patterns of relevance in the universe of documents under review.

The software distinguishes what is relevant, and each iteration produces a smaller relevant subset and a larger set of irrelevant documents that can be used to verify the integrity of the results.Through the use of predictive coding, a party responding to discovery is left with a smaller set of documents to review for privileged information, resulting in a savings both in time and in expense.The party responding to the discovery request is also able to give the other party a log detailing the records that were withheld and the reasons they were withheld.

Facts.Beekman Vista, Inc. (Beekman) is a corporation wholly owned by a Canadian entity which is controlled by Delia Moog.Dynamo Holdings Limited Partnership (Dynamo) is a limited partnership owned by a corporation and two trusts that were established for Ms. Moog’s daughter and nephew.Dynamo backs up onto tapes its entire exchange server (inclusive of emails, operating system, and configuration information).Dynamo performs this backup work every four weeks and at the end of every month.Dynamo generally retains its backup tapes for one year.

The cases involving IRS and Dynamo and Beekman concerned various transfers from Beekman to Dynamo (a related entity).IRS determined that the transfers were disguised gifts to Dynamo’s owners, while Dynamo and Beekman asserted that the transfers were loans.

IRS requested that Dynamo and Beekman produce electronically stored information contained on two backup storage tapes or, alternatively, the tapes themselves (or copies of them).The taxpayers acknowledged that the tapes contained tax-related information, but asserted that the tapes also contain privileged or confidential information.This information included “personal identification information, health insurance information, HIPAA protected information and other confidential information” that taxpayers maintained they had a duty to protect.Dynamo and Beekman asserted that they would have to review the responsive information on the tapes before giving the information to IRS to ensure that privileged or confidential information wasn’t disclosed.They requested that the Tax Court allow them to use predictive coding to help identify the information that was responsive to IRS’s request.

Tax Court’s decision.The Tax Court, noting that it had not previously addressed the issue of computer-assisted review tools, determined that Dynamo and Beekman could use predictive coding in responding to IRS’s request.The Court found no reason that the taxpayers shouldn’t be allowed to use predictive coding to respond to the discovery where, as here, the taxpayers reasonably requested to use the technique to conserve time and expense, and represented to the Court that they would retain electronic discovery experts to meet with IRS’s counsel or its experts to conduct a search acceptable to IRS.

The Tax Court rejected IRS’s contention that predictive coding shouldn’t be used because it was an “unproven technology.”The Court found that although predictive coding was a relatively new technique, and a technique that had yet to be sanctioned (let alone mentioned) by the Court in a published opinion, the understanding of e-discovery and electronic media had advanced significantly in the last few years so that predictive coding was more acceptable in the technology industry than it may have previously been.In fact, the Court understood that the technology industry now considered predictive coding to be widely accepted for limiting e-discovery to relevant documents and effecting discovery of electronically stored information without an undue burden.

The taxpayers’ expert witness, Mr. James Scarazzo, concluded that the taxpayers’ approach would reduce the universe of information on the tapes using criteria set by the parties to minimize review time and expense and ultimately result in a focused set of information germane to the matter.He estimated that 200,000 to 400,000 documents would be subject to review under this approach at a cost of $80,000 to $85,000, while 3.5 million to 7 million documents would be subject to review under IRS’s approach at a cost of $500,000 to $550,000.

The Tax Court noted that its discovery rules were to “be construed to secure the just, speedy, and inexpensive determination of every case” (Rule 1(d)), and allowed the taxpayers to use predictive coding.If, after reviewing the results, IRS believed that the response to the discovery request to be incomplete, the Court said IRS could file a motion to compel at that time.(Rule 104(b), (d))

References:For discovery in the Tax Court, see FTC 2d/FIN ¶ U-2802 ; United States Tax Reporter ¶ 74,536.0704 .

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