A New Jersey law firm won’t have to turn over documents to the government for use in a tax case over $77 million in capital losses claimed by a client.

U.S. District Judge Kevin McNulty in Newark on Monday upheld a magistrate judge’s decision that the 63 documents the Internal Revenue Service sought in Kearney Partners Fund v. U.S., 11-cv-4075, were shielded by the attorney-client privilege, work-product privilege or both, and that the client, Raghunathan "Pat" Sarma, had not waived those privileges.

On Jan. 3, 2011, the IRS subpoenaed the records from Sarma’s lawyers, Rabner, Allcorn, Baumgart & Ben-Asher of Upper Montclair, in a tax case in the Middle District of Florida.

Three entities in which Sarma owns a partnership interest are challenging an IRS decision to disallow $77 million in combined losses in litigation consolidated as Kearney Partners Fund v. U.S., 10-cv-153.

The companies’ initial disclosures identified Sarma’s attorney, Dennis Sabourin of Rabner Allcorn, as someone on whom they might rely to support their position. They also identified representatives of Arnold & Porter, which provided two opinion letters about tax treatment of the transactions.

Among other documents, they requested those relating to Sabourin’s due diligence regarding the transactions, his services and advice to Sarma, and billing records.

Rabner Allcorn produced thousands of documents, according to Sabourin, and a privilege log of the 63 that were withheld.

On July 13, 2012, U.S. Magistrate Judge Michael Shipp ruled, based on an in camera review of the documents, that the attorney-client privilege applied because Sabourin was providing legal advice to Sarma about transactions in the tax case and the possibility of litigation arising from them.

He rejected the IRS’s view that Sarma had waived the privilege by placing the advice of counsel at issue on the ground that Rabner Allcorn and the Sarma entities had certified they would not rely on Rabner Allcorn’s advice in the Florida litigation.

Further, even if Sabourin were called as a witness in Florida, he could not waive the privilege because it was not his to waive and the United States had failed to argue that application of the privilege would deprive it of information vital to the tax case, Shipp pointed out.

In addition, Shipp found the work-product doctrine applied, disagreeing with the IRS that the communications were not prepared in anticipation of litigation with the IRS but reflected Sabourin’s evaluation of the investment.

Shipp held the documents were "intended to inform Mr. Sarma about the complexity of the proposed investment that could lead to legal exposure because of its aggressive nature."

He also found no basis for the IRS’s attempt to rely on the crime-fraud exception to the attorney-client privilege.

The government alleged that the withheld communications furthered a fraud against the United States: "The sheltering of over $77.6 million in capital gain from taxation through an abusive tax shelter called FOCus."

Shipp said the IRS failed to make a prima facie showing that Sarma intended to commit a crime or fraud by investing with the companies in the tax litigation.

The government appealed to McNulty only on the waiver of attorney-client privilege issue.

In his terse opinion, McNulty said he did not have to decide the attorney-client privilege question given the government’s failure to appeal on work-product privilege.

"[E]ven if I were to accept the arguments in the Government’s brief regarding waiver of the attorney client privilege, it would not result in the relief requested," McNulty wrote. "Simply put, the Government has failed to even disagree with Judge Shipp’s work product ruling, let alone show that it was clearly erroneous or contrary to law."

Sabourin welcomes McNulty’s decision, saying a contrary one "would essentially have failed to take into account the role that attorneys take in advising business clients."

He adds, "I don’t know any attorney who advises business clients who gives advice that doesn’t have business overtones. It’s always intermingled."

Department of Justice spokeswoman Deana Iverson declines comment because of the pending litigation in Florida.

This is the second time the IRS has struck out in trying to get a document about Sarma from a New Jersey lawyer.

On Jan. 9, 2012, Shipp denied the government’s motion to compel Wilentz, Goldman & Spitzer of Woodbridge to produce a letter written to Sarma from the firm’s Steven Marshall.

Shipp held the letter, which he described as "an opinion on gains and losses of possible investments that could give rise to litigation," was protected by the attorney-client and work-product privileges.

The IRS, which wanted the letter for the litigation in Florida, had argued, as it did with the Rabner Allcorn documents, that it was prepared solely for business-related reasons.

Shipp ruled that even if the letter was not prepared in anticipation of imminent litigation, "the motivating purpose … was to aid in possible future litigation."

The IRS did not appeal that decision to the district judge.