Third time's not a charm: en banc first circuit permits IRS to obtain roadmap to "soft spots" on Textron's returns.

• Author: Pawlow, Jean A.

For the last several years, Textron, Inc. has been seeking to keep its tax accrual workpapers away from the prying eyes of the IRS. That struggle took a turn for the worse on August 13, 2009, when a divided U.S. Court of Appeals for the First Circuit sitting en banc ruled that Textron's tax accrual workpapers were not protected by the work product privilege. A vigorous dissent effectively dissects the majority's opinion and suggests that it is time for the Supreme Court to intervene. Whether or not Textron's battle may have ended, the war over the disclosure of taxpayers' tax accrual workpapers will surely endure.

Background of the Textron Dispute

During an audit of Textron's 1998-2001 tax cycle, the IRS discovered that Textron had engaged in a series of sale-leaseback transactions that the IRS alleged were substantially similar to the so-called SILO transactions that the IRS had "listed" as abusive tax shelters. In accordance with its audit policy, the IRS requested all of Textron's tax accrual workpapers. (1) Among the documents that were responsive to the request were a series of spreadsheets that contained Textron's in-house counsel's lists of return items thought to involve unclear law, "hazards of litigation percentages," and tax reserve amounts quantifying the hazards of litigation, as well as backup workpapers, including in-house counsel notes and memoranda documenting the rationale behind the numbers in the spreadsheets. As part of its internal audit process, Textron permitted its auditor, Ernst & Young LLP (E&Y), to examine its workpapers with the express understanding that they were to be kept confidential. Textron asserted that the workpapers were protected from disclosure under the "work product doctrine." Textron's resistance to producing the workpapers was met by an IRS administrative summons, which the IRS enforced by bringing suit.

Trial Court: Workpapers Are Protected from Disclosure

On August 29, 2007, the U.S. District Court for the District of Rhode Island ruled that the IRS could not forcibly obtain Textron's workpapers because they were protected under the work product doctrine and because disclosure by Textron to its independent auditor did not waive that protection. (2) The district court acknowledged that courts wrestling with this issue have employed two tests to determine if a document was prepared "in anticipation of litigation." A minority of courts employ the restrictive "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." (3) On the other hand, a majority of courts apply the more inclusive "because of" test, which asks whether the document was prepared or obtained "because of" the prospect of litigation. (4)

Following the First Circuit's decision in Maine v. Department of the Interior, (5) which adopted the "because of" test, the district court held that that the workpapers "would not have been created at all 'but for' the fact that Textron anticipated the possibility of litigating with the IRS." Furthermore, the court held that disclosure to E&Y did not waive work product protection since the disclosure did "not substantially increase the opportunity for potential adversaries to obtain the information." In fact, E&Y had a professional duty to keep the workpapers confidential.

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

First Circuit Panel Affirms Trial Court

On January 21, 2009, a three-judge panel of the First Circuit affirmed the district court's decision that Textron's workpapers were protected by the work product doctrine. (6) The court rejected the IRS's argument that "the mere presence of a business or regulatory purpose defeats work-product protection." (7) The court explained that "'dual-purpose' documents created because of the prospect of litigation are protected even though they were also prepared for a business purpose." The court found that "the business purpose derives from and is inextricably related to anticipating litigation. That the anticipation of such disputes (and corresponding potential litigation) also triggered certain business and accounting obligations does not bar the protection of the work-product doctrine."

Moreover, the work product protection applied despite the fact that Textron did not have specific litigation in mind when the documents were created. Indeed, the court found that Textron had a subjective belief that litigation was a real possibility and that belief was objectively reasonable.

The IRS argued that Textron had waived protection when the workpapers were shared with E&Y. The court acknowledged that disclosure of protected material "in a way inconsistent with keeping it from an adversary waives work product protection." Indeed, "disclosure to a conduit to a potential adversary can also waive work-product protection," which "occurs upon disclosure to a third party that 'substantially increased the opportunities for potential adversaries to obtain the information.'" Despite the IRS's argument, the court found that E&Y was not a potential adversary to Textron: "While it is possible to imagine circumstances where E&Y's professional obligations could cause E&Y and Textron to come into conflict on some legal question, the IRS can point to 'no conceivable scenario in which E&Y would file a lawsuit again [Textron] because of something...