The perfect storm gathers: recent announcements by the IRS coupled with the climate of increased law enforcement call into question continuing vitality of announcement 2002-63 regarding tax accrual workpapers.

• Author: Carlucci, Thomas F.

Introduction

Although the Internal Revenue Service has long since shifted from the friendly and service-oriented approach to a tough guy persona, (1) taxpayers have still taken some solace that they could generally enjoy protection of their tax accrual workpapers. (2) Internal Revenue Announcement 2002-63 stated generally that such papers would not be sought if taxpayers complied with the listed transaction disclosure rules, and if "unusual circumstances" were found not to exist. In the current government environment, however, the "unusual" of yesterday may be changing. For instance, in October 2005, Deborah Butler, IRS Associate Chief Counsel (Procedure and administration), noted in a public forum that the IRS had undertaken "a limited expansion of the policy set out in Announcement 2002-63." (1A) Although no further detail was provided at the session where she spoke, such pronouncements highlight the fluid situation with regard to tax accrual workpapers. Just days after she spoke, moreover, the IRS announced that it would implement an Issue Management System (IMS) of the Large and Mid-Size Business Division (LMSB) by 2006. The IMS will "require agents and managers to track all significant workpapers" and will allow information sharing about issues under development. (3) In a real sense, tax practitioners should remember the whisper heard by Kevin Costner's character in the film, Field of Dreams: "If you build it, he will come." This IRS move toward the indexing of workpapers creates a structural incentive to weaken the protected status of the workpapers even further. Prior to Announcement 2002-63, the IRS requested tax accrual workpapers a total of five times in 30 years. In 2005 alone, the IRS "submitted about 50 requests for tax accrual workpapers." (4) The resulting thousand-fold increase, even if limited to listed transactions, is most telling.

It is not an overstatement to say that tax accrual workpapers constitute a tool by which the government, and even private litigants, may be able to invade the innermost thoughts of tax analysts should they continue to regard tax accrual workpapers as confidential. Any time that a corporation faces a restatement of earnings and an ensuing Securities and Exchange Commission Investigation (or a private shareholder derivative action), the tax accrual workpapers will be produced to the government (or private litigants). Given the IRS's increased interest in the workpapers, it is difficult to imagine the IRS scrupulously restraining itself from requesting or otherwise obtaining the workpapers when the workpapers have been disseminated already to plaintiffs' attorneys and the SEC.

In old sailor's jargon, a perfect storm is gathering, and tax accrual workpapers are in the eye of the storm. Consider the trends. Over the last three years, the current administration has increased the IRS's yearly budget to ensure compliance with the revenue laws. (5) At the same time, the IRS is transferring large portions of its workforce from service components to enforcement activities. Possibly fueling both of these changes is the slew of corporate scandals. A storm picks up energy as it passes over warm waters. In a sense, there has been a "global warming" of the enforcement environment throughout the many "seas" of government.

For instance, in certain regards the Sarbanes-Oxley Act has turned auditors and accountants into public watchdogs. At the same time, the Department of Justice has created a Corporate Fraud Task Force to deal with the fall-out of Enron. Numerous companies have paid large civil settlements, and even criminal fines, for myriad violations. Adding to the rising cost of settling a major investigation is the increased pressure from the government to waive the attorney-client and work-product privileges.

Importantly, although the tax accrual workpapers usually reveal no criminal exposure, there is nothing in the law that prevents the DOJ or the SEC from turning over tax accrual workpapers to the IRS. With the increased pressure on the IRS to find revenue, staunch abusive tax shelters, and punish bad corporate actors, it may only be a matter of time before the IRS begins to acquire workpapers from other government agencies. Likewise, private litigants have an interest in accessing the tax accrual workpapers. If a shareholder derivative action can be predicated upon accounting and tax irregularities following a restatement of income, then it seems indisputable that the plaintiffs bar will seek access to the tax accrual workpapers. If the privilege has been waived (and the documents have been produced), then the case law indicates that a resourceful and tenacious plaintiffs attorney will ultimately prevail in the attempt.

Owing to the current enforcement environment, it could be naive to draft tax accrual workpapers under the assumption that their contents will remain confidential or of limited circulation. Simply put, the IRS may well be tempted to expand the "unusual circumstances" exception of Notice 2002-63 through direct requests to taxpayers sooner rather than later. Given the astronomical increase in IRS demand for workpapers last year, this expansion may already be happening. Even barring that event, however, a very tempting backdoor exists for the IRS and private litigants to acquire these documents via their earlier production in a DOJ or SEC investigation. In short, taxpayers should listen for the thunder, and prepare for the storm. While there are some practical ways to prepare for landfall and attempt to shield workpapers, nothing may prevent the ultimate disclosure of those materials. Given what appears to be an inevitability, it may be time to consider changes in how workpapers are prepared. (6)

The Perfect Storm

Before 2002, the IRS had a relatively laissez-faire policy in requesting tax accrual workpapers. For the most part, such information was not solicited. (7) Indeed, up until June 2002, the IRS requested tax accrual workpapers a total of 5 times in 30 years. (8) Announcement 2002-63 changed that environment dramatically. Although it promised to limit the request of tax accrual workpapers to listed transactions with the rarest of exceptions, that limitation seems to be expanding with the changing weather. Subsequent pronouncements and decisions, often benign on their face, have increased the possibility of disclosure. Additionally, increased enforcement by the IRS itself, and its cooperation with other agencies, has added to the tempest. With storm clouds approaching, there can no longer be business as usual.

The IRS issued Announcement 2002-63 as part of its efforts to shut down abusive tax shelter transactions. Generally, the announcement provided that the IRS would seek tax accrual workpapers in two situations. First, a request would be made when a return claimed a tax benefit from a listed transaction. Second, a request would also be made under "unusual circumstances." (9) Although not defined at the time, the IRS indicated that unusual circumstances would exist if three conditions were met: first, if an examiner identified a specific issue for which additional facts were needed; second if the examiner sought all facts relating to the specific issue from the taxpayer and any available third parties; and finally, if the examiner performed a reconciliation of the taxpayer's Schedule M-1 or M-3 pertaining to the specific issue in addition to seeking a supplementary analysis. (10)

Notwithstanding the seemingly taxpayer protective approach in Announcement 2002-63, the first condition begged the question. When would additional facts be needed? Would an investigation by another administrative agency trigger the need for additional facts?

Rather than answering those questions directly, the IRS has chosen to rely on two supposed safeguards. First, in response to concerns that the request of tax accrual workpapers would become routine, Donald L. Korb, IRS Chief Counsel, explained that procedural safeguards existed to prevent a flash flood of requests. Specifically, in order to obtain an applicable summons, the agent has to secure the approval of a chain of upper IRS officials. (11) Second, the IRS highlighted that Announcement 2002-63 contains an incentive to taxpayers not to engage in listed transactions: If taxpayers avoid listed transactions, the IRS will not request their tax accrual workpapers. (12) To reverse course now and increase requests for workpapers, the thinking goes, could backfire on the IRS. In short, those who decided to avoid risky tax shelters because they wanted to keep their workpapers confidential might conclude that there is no longer a real confidentiality incentive and, all other things being equal, simply decide to engage in listed transactions.

Notwithstanding the safeguards, there remains cause for concern. Continuing focus on corporate fraud and financial accounting irregularities may have seeded the clouds of suspicion and caused the IRS to rethink its previous policy. To be sure, the climate changed just one year after Announcement 2002-63 was issued, when the IRS posted frequently asked questions regarding tax accrual workpapers. Although it affirmed that the "unusual circumstances" language meant the IRS would seek workpapers in rare instances only, the FAQs confirmed that the standard still required careful factual and legal analysis on a case-by-case basis. The FAQs also contained examples indicating where "unusual circumstances" could exist. The second situation illustrated that where the IRS developed a reasonable suspicion--through third-party information--that a taxpayer was destroying factual information relating to an audited transaction, it would then be appropriate to seek the tax accrual workpapers relating to that transaction. (13) This has left the door ajar. At this point, all that appears to be keeping the door swinging open is IRS self-restraint and the initial promise made in IRS Announcement...