Adrift in a sea of uncertainty: tax accrual workpapers are work-product ... but showing them to your auditor may waive the protection.

• Author: Pawlow, Jean A.

For more than 20 years, the Internal Revenue Service and corporate taxpayers have been embroiled in a battle over the disclosure of tax accrual workpapers. The prize sought by the IRS is a roadmap to the "soft spots" on the tax returns. Taxpayers have been fighting back with some success. In a recent case involving Textron, for example, both the trial court and the U.S. Court of Appeals for the First Circuit sustained the taxpayer's claim of work product protection. The First Circuit's recent opinion in Textron, however, asks as many questions as it answers. Most pointedly, the Textron decision begs the question: How do taxpayers best protect themselves against an IRS push for transparency?

First Out of the Gate: United States v. Textron, Inc.

Like most large corporations, Textron, Inc.'s returns were regularly audited by the IRS, and in seven of the eight previous audit cycles, Textron had administratively contested the IRS examiner's proposed adjustments, with three of those disputes ending up in court. During its examination of Textron's 1998-2001 tax years, the IRS discovered that Textron had executed nine sale-leaseback transactions. The IRS contended that the transactions were substantially similar to the "sale in, lease out" or "SILO" transactions that it had "listed" as abusive tax-shelter transactions, (1) and in accordance with its audit policy, (2) the IRS requested all of Textron's "tax accrual workpapers." (3) One of the documents covered by the IRS's request was a list of items that, in the opinion of Textron's counsel, involved issues that might be challenged because the law was unclear, counsel percentage estimates of success in litigation, dollar amounts reserved per issue if Textron did not prevail, and backup workpapers including notes and memoranda written by in-house counsel. (4) As part of its internal audit process, Textron permitted its independent auditor, Ernst & Young LLP, to examine its workpapers with the express understanding that they were to be kept confidential. When Textron refused to produce these documents, the IRS issued an administrative summons and the government brought suit to enforce the IRS summons.

1. The District Court Upholds Work-Product Protection On August 29, 2007, the U.S. District Court for the District of Rhode Island ruled that the IRS could not force Textron to turn over its tax accrual workpapers on the ground they were protected under the attorney work product doctrine (5) and disclosure to Textron's outside auditors did not waive such protection. (6) The work product privilege, the court explained, applies to material prepared and gathered "in anticipation of litigation," but it is a qualified privilege that can be overcome by a showing of "substantial need."

   The court acknowledged that two tests have been used to determine if a document was prepared "in anticipation of litigation." A minority of courts apply the "primary purpose" test, which protects documents "as long as the primary motivating purpose behind the creation of a document was to aid in possible future litigation." (7) The majority of courts have adopted the more inclusive "because of" test, which asks whether the document was prepared or obtained "because of" the prospect of litigation. (8)

   Noting that the U.S. Court of Appeals for the First Circuit had adopted the "because of" test, (9) and that the work product doctrine does not apply if the materials were prepared in the ordinary course of business, the district court stated that it was clear that the workpapers "would not have been created at all 'but for' the fact that Textron anticipated the possibility of litigating with the IRS." The court explained that, although the workpapers were useful in providing its auditor with justifications for reserve positions Textron took on its returns, the company's creating the reserve at all was evidence that it anticipated litigation with the IRS. The court explained that Textron's subjective belief was objectively reasonable based upon Textron's litigious history with the IRS.

   Moreover, disclosure to Ernst & Young did not waive protection since the purpose of the work product doctrine is "to prevent a potential adversary from gaining an unfair advantage over a party obtaining documents prepared by the party or its counsel in anticipation of litigation which might reveal the party's strategy or the party's own assessment of the strengths and weaknesses of its case." Only disclosures inconsistent with "keeping the information from an adversary constituted a waiver of the work product privilege."

   Textron did not waive its work product privilege by sharing its tax accrual workpapers with Ernst & Young because the disclosure did "not substantially increase the opportunity for potential adversaries to obtain the information." Under the AICPA Code of Professional Conduct, Ernst & Young had a professional obligation not to disclose client information without Textron's consent, and Ernst & Young expressly agreed not to provide the information to any other party. In distinguishing prior case law, the Textron court underscored the point that "E&Y was a truly independent auditor that had no obligation to the IRS to determine whether Textron's tax return was correct and no authority to challenge the return."

   The IRS appealed the district court's decision to the U.S. Court of Appeals for the First Circuit.

   Following on Textron's Coat-Tails

   Before the First Circuit could rule in Textron's case, a district court in Regions Financial Corp. v. United States, 2008 U.S. Dist. LEXIS 41940 (N.D. Al. May 8, 2008), was asked to decide a substantially similar issue. The court in Regions granted work product protection to tax accrual workpapers following much of Textron's legal reasoning.

   During its examination of Regions's 2002 and 2003 tax years, the IRS discovered that Regions had executed two sale lease-back transactions. The IRS served a summons on Regions's independent auditor seeking information about the transactions. Regions's auditor produced approximately 260,000 pages of documents, but at Regions's request, withheld 20 documents that were prepared by Regions's outside counsel and tax advisers, asserting work product protection. The court conducted an in camera review of the withheld documents.

   The issue presented to the court was which test ("because of" or "primary purpose") the Eleventh Circuit would apply in determining whether the putatively protected documents were created "in anticipation of litigation." The district court held that if the Eleventh Circuit was forced to decide, it would choose the broader "because of" test. Nonetheless, the court ruled that applying either test would lead to the same result--the documents were protected work product because they were created in anticipation of litigation.

   The court explained that the critical question was "the purpose for which the documents were created."

   The IRS argued that it should succeed even if the court employed the more expansive "because of" test since the tax accrual workpapers were prepared for business reasons; that is to say, they "would have been prepared, even in the absence of the prospect of litigation, to comply with Regions's public reporting requirement." The court disagreed and found that "[w]ere it not for anticipated litigation, Regions would not have to worry about contingent liabilities and would have no need to elicit opinions regarding the likely results of litigation." The court reasoned that even under the "primary motivating purpose" test the documents would be protected. The court found that the fact that Regions "undertook the time and expense of consulting outside firms to assess its potential liabilities shows that it believed litigation to be likely."

   Primary to the court's decision was its holding that there was no need to show that the withheld documents were prepared solely for litigation and for no other reason. The court held that documents subject to work product protection can have uses other than solely analyzing the litigation issues. Furthermore...