Tax accrual workpapers: IRS efforts to obtain them, corporate strategies to protect them.

• Author: Callahan, Thomas J.

Introduction

There is an ancient Chinese proverb to the effect that even the longest journey is one that begins with a single step. What the proverb does not reveal is that the longest journeys can become longer if the traveler does not have a roadmap.

Corporate tax executives know all too well that Internal Revenue Service examinations often resemble excruciatingly long journeys, as IRS revenue agents probe, prod, and examine corporate financial and accounting records for potential issues. Understandably, IRS agents would like nothing more than to obtain a roadmap of the transactions and issues (plus the underlying analysis) that really matter.

Unfortunately for corporate tax executives, the IRS has identified just such a roadmap in the corporation's tax accrual workpapers, which may show the corporation's annual transactions, analyze so-called soft spots on the tax return, and maybe even reveal the corporation's tax contingency reserve for specific issues. (The tax accrual workpapers and underlying legal analysis will sometimes be referred to in this article as the "Roadmap").

A little more than a year ago, the IRS issued Announcement 2002-63, (1) which signaled a more aggressive approach by the government to requesting and summoning tax accrual workpapers. A corporation's response to Announcement 2002-63, which is part of the IRS's effort to identify and crack down on abusive tax shelters, requires--(1) a thorough understanding of the contours of the attorney-client privilege, the federally authorized tax practitioner privilege, and the work product doctrine;

(2) an awareness of the implications of disclosing tax accrual workpapers to the corporation's independent auditors; and

(3) the development of internal policies to best protect the analysis underlying the corporation's tax contingency reserve.

A lack of preparedness in this area will result in the IRS securing the Roadmap, and following it directly to a multitude of undesirable destinations. In the long run, there can be little doubt that this is one journey that corporate tax executives and their companies would rather not take.

The Arthur Young Case

The IRS's authority to summon tax accrual workpapers was strengthened by the Supreme Court of the United States' 1984 decision in United States v. Arthur Young & Co. (2) In Arthur Young, the Supreme Court unanimously held that a public corporation's tax accrual workpapers, which were prepared by an independent auditing firm during the course of its review of the corporation's financial statements, were not protected from the reach of an IRS summons by the claim of either an accountant-client privilege or an accountant work product privilege. In concluding that no accountant-client privilege or accountant work-product immunity existed to shield the auditor-created tax accrual workpapers, the Supreme Court emphasized the independent auditor's role as "public watchdog." (3) According to the Court, the independent auditor's "public watchdog" role, which required "total independence from the client" and "complete fidelity to the public trust," distinguished it from the attorney's role as a client's confidential adviser and advocate. (4)

Announcement 2002-63

To its credit, the IRS did not attemt to use the Arthur Young decision as a mandate to indiscriminately seek tax accrual workpapers. Rather, the IRS chose to adhere to its pre-Arthur Young policy of requesting tax accrual workpapers only in "unusual circumstances." (5) On June 17, 2002, however, in connection with its increased efforts to crack down on abusive tax shelter transactions, the IRS updated its procedures for seeking tax accrual workpapers. (6)

Under the new procedures, for tax returns filed on or after July 1, 2002, if a taxpayer discloses a "Listed Transaction," (7) the IRS will routinely request tax accrual workpapers--but only for that Listed Transaction. More important, the IRS will routinely request all tax accrual workpapers when any of the following circumstances exists:

* The taxpayer does not disclose the Listed Transaction on the return.

* The taxpayer claims tax benefits on the return from two or more investments in Listed Transactions, regardless of disclosure.

* There are reported financial irregularities (e.g., restatement of earnings) in connection with the examination of a return claiming tax benefits from a disclosed Listed Transaction.

For returns filed before July 1, 2002, the IRS will--in appropriate circumstances (8)--request tax accrual workpapers pertaining only to a Listed Transaction in situations where the taxpayer failed to comply with an obligation to disclose the Listed Transaction. (9)

THOMAS J. CALLAHAN, JEFFRY J. ERNEY, and GREGORY J. GAWLIK are all members of the Tax Controversy Practice Group of the law firm of Thompson Hine LLP in Cleveland, Ohio. Mr. Callahan is Chair of Thompson Hine's Tax Practice Group. Mr. Erney formerly served as IRS Utility Industry Specialization Coordinator. Copyright 2003 by Thompson Hine LLP and Tax Executives Institute, Inc.

For corporate tax executives, Announcement 2002-63 should be a catalyst for developing new strategies to protect the corporation's most sensitive tax contingency material. Remember, the IRS is seeking the Roadmap, and the IRS is using the existence of Listed Transactions as the first step in obtaining it. The risks associated with losing control over the corporation's Roadmap are fully detailed in the Disclosure Matrix at the conclusion of this article. The bottom line is that the corporation potentially risks disclosure of the descriptions and analyses behind all of its transactions if the IRS identifies undisclosed or multiple Listed Transactions. Of course, this would make Revenue Agents' job much easier, enabling them to use the Roadmap to raise issues beyond just the Listed Transactions.

Faced with this type of exposure, tax executives have three courses of action. First, corporation management can take appropriate steps to ensure that the corporation does not engage in Listed Transactions (including transactions that are substantially similar to Listed Transactions). Second, if the corporation has engaged in only one Listed Transaction, then the company can seriously consider disclosing that transaction to the IRS; such a disclosure will limit the request for tax accrual workpapers to only that Listed Transaction, and also permit the corporation to rely on advice of its tax advisers to avoid accuracy-related penalties. (10) Finally, tax executives can develop policies and procedures to enable the corporation to be in the best position possible to assert the attorney-client privilege, the federally authorized tax practitioner privilege, or the work product doctrine with respect to its most sensitive tax contingency material, including legal analyses and memoranda.

For all circumstances falling outside the scope of Announcement 2002-63, the IRS asserts that it will exercise restraint in requesting tax accrual workpapers--meaning that it will request them only in "unusual circumstances." Tax executives, however, should keep in mind that there is nothing to prevent the IRS from broadening this policy over time, seeking all tax accrual workpapers in every case. This possibility magnifies the importance of developing internal policies to ensure that the critical analysis behind the tax contingency reserve is protected to the fullest extent possible.

IRS Procedures for Obtaining Tax Accrual Workpapers

Once a Revenue Agent determines that a corporation has engaged in one or more Listed Transactions--through disclosure by the corporation, the issuance of the Mandatory Tax Shelter Information Document Request (IDR) developed by the IRS's LMSB Division in January 2002, or contact with LMSB's Office of Tax Shelter Analysis (OTSA)--the Revenue Agent will be expected to work with the IRS local counsel's office to develop appropriate language to be contained in the request for tax accrual workpapers. Additionally, the Revenue Agent must obtain approval from senior IRS management (specifically, the appropriate LMSB Director of Field Operations) to request the tax accrual workpapers.

Tax executives should expect the corporation to receive advance notice from the Revenue Agent of the request for tax accrual workpapers. Likewise, tax executives should expect that the request will be addressed to both the corporation's independent auditor and the corporation itself. The scope of the request ultimately will be determined by the number of Listed Transactions discovered and the procedures set forth in Announcement 2002-63.

Any initial disputes concerning the corporation's and independent auditor's responses to the request for tax accrual workpapers, including any claims of privilege and the timing of the response, likely will be addressed by the Revenue Agent, working with the local counsel's office. Continued noncompliance by the corporation or independent auditor will prompt the Revenue Agent to seek approval for the issuance of a summons. Should a summons be issued, a corporation must carefully weigh its options in deciding how to respond, especially when considering the manner in which to assert privilege over sensitive materials. Corporate strategies in responding to an IRS summons are beyond the scope of this article, but it should be understood that noncompliance with the summons could lead to the IRS's initiation of a summons enforcement action in a U.S. District Court. (11)

The Attorney-Client Privilege

Myriad treatises and cases alike have set forth extensive definitions of the attorney-client privilege. (12) For purposes of understanding how the privilege applies to tax accrual workpapers, it is most important to keep in mind the following elements:

* Communications must be made by the client to an attorney for the purpose of seeking "legal advice."

* The client must intend for the communications to be "confidential," and the communications must, in...