Best practices for creating, maintaining, and protecting state income tax audit files.

• Author: Mata, Pilar

Introduction

This decade has brought significant change to the legal landscape facing large, multistate taxpayers. The Sarbanes-Oxley Act of 2002 created sweeping rules that increased financial oversight and forced taxpayers to reevaluate the provision of non-audit services by public accounting firms. Management must now evaluate income tax positions for financial statement purposes using the heightened more-likely-than-not standard of FASB Interpretation No. 48 (FIN 48). These changes have led taxpayers to create and maintain more detailed documentation to support their income tax return positions.

As the volume of tax-related documentation has increased, taxpayer expectations of maintaining any protection from the disclosure of those documents have eroded to the point that many taxpayers now assume that all documents must be turned over in the context of state tax litigation. The First Circuit's recent decision in United States v. Textron (1) has furthered this perception. Work-product protection, however, remains a fundamental component of the American judicial system and qualifying documents can retain protection--even in the context of state taxation.

Background: The Attorney-Client Privilege and Work-Product Privilege

In recent years, numerous courts have considered the extent to which confidential information may be protected from disclosure to the Internal Revenue Service (IRS). Case law interpreting the scope of the federal attorney-client privilege and work-product privilege provides a starting point for taxpayers seeking to protect information during a state tax audit. (2)

1. Federal Attorney-Client Privilege

   The attorney-client privilege protects confidential communications between a client and the client's attorney made for the purpose of providing the client with legal advice. (3) The purpose of the attorney-client privilege is to encourage open and candid communications between the attorney and his or her client. (4) Only communications pertaining to the legal advice--as opposed to the underlying facts discussed--are protected by the privilege. (5)

   The attorney-client privilege is generally waived if the communication is disclosed to third persons without the need to know such information. (6) Communications within a company generally will not constitute disclosure if the communications are limited to employees with a substantive need for the information. (7) Disclosure to employees who do not have a need to know such information, however, may waive the privilege.

   The attorney-client privilege will not be waived simply because the communication is disclosed, in confidence, to an external non lawyer if the purpose of that communication is to assist the attorney in providing legal advice. If the disclosure is made for another purpose--for example, to aid external auditors in a financial statement audit--the privilege will be waived. (8) This limitation on the attorney-client privilege materially affects how taxpayers should treat state tax audit files.

2. Federal Work-Product Privilege

   While the attorney-client privilege is intended to protect communications between a client and his or her attorney, the work-product privilege is designed to protect the adversarial process. Rule 26(b) of the Federal Rules of Civil Procedure codifies the federal rule, which was articulated by the Supreme Court of the United States in Hickman v. Taylor. (9) Rule 26(b)(3) provides, in relevant part:

   (A) Documents and Tangible Things. Ordinarily, a party may not discover documents and tangible things that are prepared in anticipation of litigation or for trial by or for another party or its representative (including the other party's attorney, consultant, surety, indemnitor, insurer, or agent). But, subject to Rule 26(b)(4), those materials may be discovered if:

   (i) they are otherwise discoverable under Rule 26(b)(1); and

   (ii) the party shows that it has substantial need for the materials to prepare its case and cannot, without undue hardship, obtain their substantial equivalent by other means.

   (B) Protection Against Disclosure. If the court orders discovery of those materials, it must protect against disclosure of the mental impressions, conclusions, opinions, or legal theories of a party's attorney or other representative concerning the litigation.

   Unlike the attorney-client privilege, work-product protection is only waived by disclosure to an adversary or a conduit to a potential adversary. (10)

   What constitutes documentation prepared "in anticipation of litigation" (as used in Rule 26) is perhaps the most important question with respect to the work-product privilege, and the federal circuit courts are split as to the appropriate test for making this determination. At least one circuit has applied a narrow "primary motivating purpose" test. (11) This standard provides that in order to obtain protection, the document must be created primarily to assist in future litigation. Thus, the "primary motivating purpose" test considers the most important reason for generating the document and only protects documents that are primarily created for litigation. (12)

   Most other federal circuits have adopted the "because of" test. (13) The "because of" test generally examines whether the document was created because of potential or anticipated litigation, and provides that the protection will not be waived simply because the document was created for purposes that are in addition to potential or anticipated litigation. (14) Thus, so-called dual purpose documents are entitled to protection under this standard.

   In the recent case of United States v. Textron, the First Circuit purported to apply the "because of" test but interpreted the test in a manner that provides even less protection than the "primary motivating purpose" test. (15) The court held that Textron's tax accrual workpapers did not constitute documents prepared in anticipation of litigation because the documents were not "case preparation materials" and "were not prepared for use in possible litigation." (16) The Textron decision was followed by a hearty dissent, criticizing the majority for articulating a new legal standard and calling upon the Supreme Court "to intervene and set the circuits straight" on the issue. (17) In December 2009, Textron filed a petition for certiorari with the Supreme Court providing an opportunity for the Court to address the split of authority between circuits on the appropriate test for what constitutes "in anticipation of litigation."

3. Multiple States- Multiple Doctrines

   Although federal work-product protection has received much attention, taxpayers should be aware that states have enacted and interpreted several...