The denial of IRS access to its adversary's playbook.

• Author: Madison, Allen D.

1. INTRODUCTION II. TAX ACCRUAL WORKPAPERS III. WORK PRODUCT PROTECTION IV. ANALYSIS A. PROTECTION OF "TAX ACCRUAL WORKPAPERS" FROM THE IRS 1. The "Use" Test 2. The "Purpose" Test 3. The "Because of" Test 4. The Unaltered Language of Rule 26(b)(3) 5. Fairness B. REFUTING THE COUNTERARGUMENTS TO PROTECTION 1. Supreme Court Precedent 2. Differences in Tax Cases 3. Remoteness 4. Ordinary Course of Business 5. Function V. CONCLUSION I. INTRODUCTION

   The Supreme Court had the opportunity to resolve a three-way split in the federal circuit courts of appeals regarding the work product protection but refused to do so. (1) That refusal has caused contusion in the lower courts as to whether certain documents are subject to protection from disclosure to adversaries as work product. At its next opportunity, the Supreme Court should sort out the confused state of the law.

   The confusion in the case law leaves the appropriate protections for tax accrual workpapers especially uncertain. (2) A set of tax accrual workpapers is a special group of accounting documents that the IRS often seeks during an examination of a corporate taxpayer's income tax return. These workpapers exist to document transactions on which the IRS might dispute the tax result. The IRS pursues the workpapers while the taxpayers want to withhold them from the IRS. The reasoning for withholding is because workpapers often contain assessments of the taxpayer's litigating position should the IRS challenge the transaction in court.

   Work product protection derives from the Federal Rules of Civil Procedure and Supreme Court case law. Rule 26(b)(3) and Hickman v. Taylor (3) protect from disclosure "documents and tangible things that are prepared in anticipation of litigation or for trial by or for another party or its representative...." (4) The rule and the case law provide even greater protection for "the mental impressions, conclusions, opinions, or legal theories of a party's attorney or other representative concerning the litigation." (5)

   The split in the circuits concerns three interpretive tests. Courts rely on these tests to determine whether certain tax accrual workpapers deserve work product protection. First, some circuits protect documents from disclosure to the IRS where the taxpayer's primary motivating puroose for preparing the document was potential litigation--the "purpose" test. (6) Under the purpose test, United States v. El Paso Co. permitted the IRS access to the to taxpayer's tax accrual workpapers. (7) Second, other circuits permit taxpayers to withhold documents created because of the prospect of litigation--the "because of' test. (8) Under the because of test, United States v. Deloitte L.L.P. protected the taxpayer's tax accrual workpapers from the IRS. Third, the First Circuit protects taxpayer documents from disclosure to the IRS only if they were prepared for use in litigation--the "use" test. (9) Under the use test, United States v. Textron Inc. held that the IRS was entitled to the taxpayer's tax accrual workpapers.

   This article argues that none of these interpretive tests is satisfactory because the courts use them to essentially change the language of Rule 26(b)(3) or limit the rule's application. (10) Instead, courts should simply apply the unaltered language of Rule 26(b)(3). Applying the unaltered language of the rule protects taxpayer's litigation assessments--essentially their playbooks--from the IRS despite their appearance in the taxpayer's tax accrual workpapers.

   Part II of this article describes tax accrual workpapers and why the IRS aggressively pursues them. (11) Part III sets forth the parameters of work product protection and how it limits the IRS's authority to obtain tax accrual workpapers. (12) Part IV discusses in more detail the current split among the circuits, the correct application of work product protection to tax accrual workpapers, and addresses the arguments against protecting documents from the IRS raised by the IRS and writers. (13) Part V concludes that the Supreme Court should afford taxpayer's protection of the work product in tax accrual workpapers because providing the IRS access to its adversary's playbook violates Rule 26(b)(3), Hickman, and common fairness. (14)

2. TAX ACCRUAL WORKPAPERS

   The public financial statements of a corporation subject to regulation by the Securities Exchange Commission ("SEC") must undergo audit by a certified public accounting firm ("CPA firm") using Generally Accepted Accounting Principles ("GAAP"). (15) The CPA firm verifies that the company's financial statements accurately reflect the corporation's financial condition. (16) Corporations enter into many transactions--large and small. A corporate taxpayer will often enter into transactions where the potential tax consequences are uncertain. (17) The uncertainty makes sense because the corporate taxpayer and the IRS have opposing goals. The taxpayer wants to incur as little tax as possible without breaking the law, and the tax collectors want to collect as much tax as possible without breaking the law. (18) The law, however, is not always clear.

   A taxpayer corporation often sits at a vantage point; it can see a potential dispute on the horizon with the IRS over the tax consequences of a particular transaction or set of transactions. (19) Where a potential dispute approaches, the taxpayer's tax liabilities for such a transaction become uncertain. Prudence suggests two things. First, from a legal standpoint, it may be prudent for a taxpayer to understand the legal underpinnings of a complex transaction (or set of complex transactions) so it can assess whether the taxpayer would be willing to take the case to court. (20) Perhaps the taxpayer will have an attorney prepare a legal memorandum explaining the law behind the transaction or transactions as well as the strengths and weaknesses of a potential case. (21) Such memoranda are commonplace for corporations facing potential litigation in any area of the law. Second, prudence may also require setting aside funds to cover the uncertain tax liabilities in the event the IRS prevails in a dispute over the tax consequences of the transaction. (22) In accounting terms, the taxpayer would put the set aside funds in a reserve or similar account. (23) CPA firms review tax reserve accounts to determine whether the reserves are sufficient such that the financial statements continue to reflect the corporation's financial condition. (24)

   Under GAAP, CPA firms review the corporate taxpayer's tax reserves. (25) The documents generated or collected in the CPA firm's review constitute the "tax accrual workpapers." These tax accrual workpapers of a large corporate taxpayer are extremely valuable to the IRS. The value to the IRS is in litigation. The tax accrual workpapers document the taxpayer's uncertain positions--i.e., the analysis and conclusions of the taxpayer and its representatives regarding whether to litigate against the IRS, how to conduct such litigation, and the likelihood of success of litigating against the IRS on a particular tax position.

   The CPA firm relies on the tax accrual workpapers in forming its opinion as to whether the financial statements in which the tax reserve amounts ultimately appear fairly reflect the corporation's financial condition. To determine whether the tax reserves accurately reflect the corporation's financial condition, the CPA firm has to assess how uncertain the tax positions are. (29) Perhaps a CPA firm would not need heavy documentation of uncertain return positions where the amount at issue is small or the uncertainty is only slight. (30) Where amounts at issue are larger or there is more uncertainty, the CPA firm is likely to want more documentation. Although many CPA firms have some expertise to assess the uncertainty, one would expect that the CPA firm and the taxpayer might sometimes disagree over whether the taxpayer has provided proper support. As a result, there are times when the CPA firm might ask the taxpayer to provide substantiation to the CPA firm of the level of uncertainty associated with a return position or that the return position was even justified. (31)

   There are a number of different types of documents that can appear in tax accrual workpapers. Documents a taxpayer might have that would be unrelated to future litigation may include e-mail messages, computations of amounts, charts, or graphs. (32) In addition, there may be documents related to preparation for litigation against the IRS such as legal analysis, legal opinions concerning the transactions, or legal assessments of the strength of the taxpayer's case. (33)

   To a party that is responsible for enforcing the tax laws the tax accrual workpapers can be valuable. According to the Supreme Court in United States v. Arthur Young & Co., "tax accrual workpapers pinpoint the 'soft spots' on a corporation's tax return by highlighting those areas in which the corporate taxpayer has taken a position that may, at some later date, require the payment of additional taxes." (34) The workpapers provide "an item-by-item analysis of the corporation's potential exposure to additional liability." (35) Thus, both sides have strong motivations regarding tax accrual workpapers. The IRS, on the one hand, wants the tax accrual workpapers because anyone involved in a lawsuit would want to know the potential adversary's impression of the strengths and weaknesses of the case. On the other hand, taxpayers try to keep the workpapers from the IRS because of the value the IRS would gain from seeing their litigation assessments. No one facing potential litigation would want their impressions of the case in the hands of a would-be adversary, just as no coach would want the opponents to have the team's playbook. (36)

   The corporation might turn over some documents to the CPA firm's possession for inclusion in the firm's tax accrual workpapers. With respect to other documents, the...