Second Court to Hold Tax Accrual Workpapers Protected from IRS Summons
May 12, 2008
Court rejects IRS’s claim that a taxpayer must show that it was motivated by preparation for litigation and nothing else in order to claim that a document is protected by work product.On May 8, 2008, the U.S. District Court for the Northern District of Alabama held that Regions Financial Corporation (Regions) did not have to turn over its tax accrual workpapers to the Internal Revenue Service (IRS) because they were protected by the work product doctrine. See Regions Financial Corp. v. United States, Case. No. 2:06-CV-00895-RDP (N.D. Al. May 8, 2008). Click here for more information.
During its examination of Regions’ 2002 and 2003 tax years, the IRS discovered that Regions had engaged in two “listed” tax shelter transactions. The IRS served a summons on Ernst & Young, LLP (E&Y), Regions’ auditors, seeking information about the tax shelter transactions. Regions directed E&Y to withhold 20 documents based on the work product doctrine. The withheld documents fell into two categories, core documents and derivative documents. The core documents expressed opinions, evaluated legal theories and analyzed the tax shelter transactions. These core documents were created by Region’s outside lawyers and E&Y tax advisors because Regions’ general counsel thought that litigation might ensue from the tax position Region’s had taken with respect to the tax shelter transactions. The derivative documents were documents that discussed, explained or quoted from the core documents. The court in Regions was asked to decide whether the work product doctrine protected the withheld documents from disclosure to the IRS and whether Regions had waived that protection by giving those documents to its independent auditor.
Federal Rule of Civil Procedure 26(b)(3) codifies the work product doctrine. Under that rule, to be entitled to protection from disclosure, a party must show that the document was “prepared in anticipation of litigation.” Courts have historically struggled with articulating a clear test for applying this standard. The Fifth Circuit in United States v. El Paso Co., 682 F.2d 530, 542 (5th Cir. 1982) established the more restrictive “primary motivating purpose” test. Under this formulation, to assert work product protection, litigation need not be imminent “as long as the primary motivating purpose behind the creation of the document was to aid in possible future litigation.” However, the majority of the circuit courts have adopted the broader “because of” text articulated by the Second Circuit in United States v. Adlman, 134 F.3d 1194, 1202 (2d Cir. 1998), which only requires a showing that “in light of the nature of the document and the factual situation in the particular case, the document can fairly be said to have been prepared or obtained because of prospect of litigation.”
In Regions, the parties asked the court to decide which test the Eleventh Circuit applies, although both the taxpayer and the IRS each maintained that they should prevail under both the “primary motivating purpose” and “because of” tests. The court held that the Eleventh Circuit has not yet adopted a test for determining when a document is prepared in anticipation of litigation, but if the Eleventh Circuit was forced to decide the issue, the court concludes that the Eleventh Circuit would choose the broader “because of” test. Nonetheless, the court held that applying either test, the result was the same—the documents were created in anticipation of litigation and were protected work product. The court explained that the critical inquiry under both tests “is the purpose for which the documents were created.”
The IRS urged that it should prevail under the “because of test” since “E&Y’s withheld tax accrual workpapers . . . would have been prepared, even in the absence of the prospect of litigation, to comply with Regions’ 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.” Likewise, the court did not view the “primary motivating purpose” test as requiring a different result. As indicia of Regions’ primary motivation, the court stated 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.”
Importantly, the court disagreed with the IRS that a party must show it was solely motivated by the preparation of litigation and nothing else in order to claim that the document was prepared in anticipation of litigation. The court recognized that the protected documents can have uses other than analyzing the litigation issue. Lastly, the court held that Regions had not waived work product protection by disclosing the documents to E&Y. The court found that E&Y was not an adversary and “[t]here is simply no conceivable scenario in which E&Y would file a lawsuit against Regions because of something E&Y learned from Regions’ disclosures.” As such, E&Y was neither an adversary nor a conduit to an adversary.
Regions follows on the coattails of the Textron decision and cites approvingly thereto. See United States v. Textron, 507 F.Supp.2d 138 (D.R.I. 2007). Under factual circumstances similar to Regions, the Textron court found that the taxpayer’s tax accrual workpapers were protected under the work product doctrine that had not been waived by disclosure to its auditors. The government has appealed the decision in Textron, which is presently before the U.S. Court of Appeals for the First Circuit Court.
Regions is important because it provides work product protection for a tax opinion that is prepared to evaluate the litigation risk of a particular transaction, even if it is understood at the time of preparation that such opinion will likely be disclosed to the independent auditor. In Regions, the court rejects the IRS’s claim that a taxpayer must show that it was motivated by preparation for litigation and nothing else in order to claim that a document is protected by work product.
Additionally, Regions joins the courts in United States v. Roxworthy, 357 F.3d 590, 595 (6th Cir. 2006) and Textron in their concern that it is an unfair advantage for the IRS to obtain the taxpayer’s legal analysis of its strengths and weaknesses.
