On August 29, 2007, the U.S. District Court for the District of Rhode Island issued the much-awaited decision in United States v. Textron, concerning the enforcement of an Internal Revenue Service (IRS) summons seeking the production of Textron’s tax accrual workpapers. The court held that the tax accrual workpapers were protected by the work product protection and thus denied enforcement of the summons.
IRS History of Restraint in Requesting Tax Accrual Workpapers
Tax accrual workpapers provide support for a taxpayer’s financial statement tax reserves. They are sensitive documents because they identify the taxpayer’s judgment about the issues for which the results under the tax laws are unclear (so-called soft spots on the return). The tax accrual workpapers generally reflect the evaluation of the taxpayer’s counsel or accountants as to the likelihood of success if the issues were litigated. In other words, in any dispute with the IRS, the tax accrual workpapers provide the taxpayer’s evaluation of its hazards of litigation. Due to their sensitive nature, access to these workpapers has been an area of long-standing controversy between the IRS and taxpayers.
In United States v. Arthur Young Inc., the U.S. Supreme Court upheld the right of the IRS, under its broad summons authority, to obtain tax accrual workpapers prepared by the taxpayer’s independent auditors, and rejected the taxpayer’s position that the workpapers were not relevant to an IRS audit. In 1981, after the district court in Arthur Young held in favor of the IRS, the IRS adopted a policy of restraint under which it would not seek tax accrual workpapers absent unusual circumstances, such as if the examiner has not been able to obtain the necessary facts from the taxpayer. The IRS adopted this policy in response to serious concerns that unlimited access by the IRS to tax accrual workpapers would have an adverse effect on the preparation of accurate financial statements. Under unusual circumstances, the examiner must obtain written approval from the Chief of Examination, and the request is limited to only the portion of the workpapers believed to be material and relevant to the examination.
In 2002, the IRS announced that it was modifying its historic policy of restraint with respect to asking for a company’s tax accrual workpapers. Under the modified policy, the IRS examiner must request the taxpayer’s tax accrual workpapers for any listed transaction claimed on a return. Moreover, if a taxpayer claims two or more listed transactions on a return, the examiner must request the tax accrual workpapers for all items reported on the return.
Textron is the first test of the IRS’s new, more aggressive posture for requests of tax accrual workpapers.
Background of IRS Investigation
Textron is a large case taxpayer whose tax returns are audited routinely by the IRS. In seven of the eight previous audit cycles, "unagreed" issues were sent to IRS Appeals, and three issues ended up in litigation. During the tax years under the audit, Textron engaged in nine "sale-in, lease-out" (SILO) transactions involving telecommunications equipment and rail equipment. The IRS classified such transactions as "listed transactions." Nearing the end of the audit, the IRS issued a summons requesting "all of the Tax Accrual Workpapers."
The taxpayer refused to produce its tax accrual workpapers, asserting that the summons was issued for an improper purpose; the tax accrual workpapers are protected by the attorney-client privilege, tax practitioner privilege and work product protection; and the disclosure of the tax accrual workpapers to the company’s independent auditor did not waive privilege.
Textron’s tax accrual workpapers consist of a spreadsheet containing lists of items on Textron's tax returns, which, in the opinion of Textron’s counsel, involved issues on which the tax laws are unclear, and therefore maybe challenged by the IRS. The workpapers also contain estimates by Textron’s counsel expressing, in percentage terms, their judgments regarding Textron’s chances of prevailing in any litigation over these issues, and also the dollar amounts reserved to reflect the possibility that Textron might not prevail in such litigation. Additionally, the back-up workpapers include notes and memoranda written by Textron’s in-house tax attorneys, reflecting their opinions as to which items should be included on this spreadsheet and the hazard percentage that should be applied to each item.
Court Holds the Summons Was Issued for a Legitimate Purpose
Textron maintained that the summons was issued for an improper purpose—i.e., the IRS sought the documents to use them as leverage in settlement negotiations. The IRS has broad statutory authority to issue a summons for the production of any book, paper, record or other data that will assist in ascertaining the correctness of any return. However, a summons can neither be issued to gather evidence solely in a criminal prosecution, nor to harass a taxpayer—for example, by putting pressure on the taxpayer to settle a collateral dispute.
The court summarily rejected Textron’s claim that the summons was issued for an improper purpose, because the IRS disputed the company’s allegation that summons was issued after the examination was substantially completed. Accordingly, the court concluded that the IRS had made a prima facie showing that the Powell requirements had been satisfied, and that Textron had failed to rebut that showing.
Applicability of Privileges
Textron argued that its tax accrual workpapers are protected by the attorney-client privilege, the tax practitioner privilege created under section 7525, and the work product protection.
The tax accrual workpapers are protected by attorney-client privilege.
Textron submitted affidavits indicating that the tax accrual workpapers were prepared by counsel and reflected the counsel’s legal conclusions identifying items on Textron’s returns that may be challenged in an assessment of Textron’s prospect of prevailing in any ensuing litigation. The IRS argued that the workpapers are not protected by attorney-client privilege because Textron’s attorney’s were not providing legal advice, but rather performing an accounting function by reconciling the company’s tax records and financial records.
The court agreed that Textron’s counsel was providing legal advice, not an accounting function. Citing United States v. Chevron Texaco Corp., the court reasoned that "communications containing legal advice provided by an attorney may be privileged even though they are made in connection with the preparation of a return." The court also concluded that the IRS’s reliance on United States v. Arthur Young was misplaced. "[A]lthough Arthur Young deemed tax accrual workpapers pinpointing the ‘soft spots’ on a corporations tax return relevant to examination of the corporations return, it did not hold the attorney-client privilege inapplicable to legal conclusions of counsel contained in the workpapers." Accordingly, the court held that Textron’s tax accrual workpapers were protected by attorney-client privilege.
The tax accrual workpapers are protected by the tax practitioner privilege.
Textron alleged that, to the extent the tax accrual workpapers reflect the advice from certified public accountants in its tax department, the workpapers were protected by the tax practitioner privilege created by section 7525. The IRS responded that the opinions of in-house tax accountants do not qualify for protection under section 7525, and even if they did, they fall within the exception contained in section 7525(b). The court found that the tax accountants were performing "lawyers’ work" by advising Textron regarding its tax liability and estimating the hazards of litigation percentages. Accordingly, such advice qualified for the tax practitioner privilege. Moreover, the court found that the written communications by the tax accountants did not fall within the exception in section 7525(b) for communications made in connection with the promotion of a tax shelter. Here the accountants were not "peddlers of corporation tax shelter" or outside promoters soliciting the taxpayer’s participation in the SILO transactions. Instead, the tax accountants were providing their opinions regarding the foreseeable tax consequences of transactions that already had taken place.
The tax accrual workpapers are protected by the work product protection.
The taxpayer also maintained that the tax accrual workpapers were prepared in anticipation of litigation and therefore were protected work product. The work product protection applies to materials prepared by a party or the party’s representative in anticipation of litigation or preparation for trial. The privilege first was articulated by the U.S. Supreme Court in Hickman v. Taylor and later was codified in Rule 26(b)(3) of the Federal Rules of Civil Procedure.
The court noted that two different tests have been applied to determine whether a document was prepared "in anticipation of litigation." Under the "primary purpose" test, documents are held to be prepared in anticipation of litigation "as long as the primary motivating purpose behind the creation of a document was to aid in possible future litigation" (United States v. El Paso Co.) The majority of the courts, however, apply the more expansive "because of" test, which provides that the relevant inquiry is whether the document was prepared or obtained "because of" the prospect of litigation (United States v. Adlman). The U.S. Court of Appeals for the First Circuit, to which an appeal from Textron would lie, has adopted the "because of" test.
Textron pointed to the hazards of litigation percentages on the workpaper spreadsheets as evidence that the possibility of such litigation was the reason for preparing the workpapers. The IRS argued to the contrary, that the workpapers were prepared in the ordinary course of business; in order to satisfy the requirements of the securities laws with which financial statements filed by publicly traded companies must comply.
The court agreed with Textron that the tax accrual workpapers were prepared in anticipation of litigation. In this regard, the court stated, "it is clear that the opinions of Textron’s counsel and accountants regarding items that might be challenged by the IRS, their estimated hazards of litigation percentages and their calculation of tax reserve amounts would not have been prepared at all ‘but for’ the fact that Textron anticipated the possibility of litigation with the IRS." The court concluded that "there would have been no need to create a reserve in the first place, if Textron had not anticipated a dispute with the IRS that was likely to result in litigation or some adversarial proceeding." Moreover, the court was convinced that Textron’s belief in the likelihood of litigation with the IRS was well founded. The workpapers dealt with issues in which the law was unclear, and Textron had a history of tax controversy, including litigation.
The court found unpersuasive the IRS’s reliance on the El Paso case for the proposition that tax accrual workpapers are prepared in the ordinary course of business, and therefore not protected by work product. The court distinguished El Paso because it applied the "primary purpose" test for determining whether documents are prepared in anticipation of litigation, and not the "because of" test adopted by the First Circuit.
Importantly, the court held that even if the tax accrual workpapers were needed to satisfy Textron’s compliance with generally accepted accounting principals, that would not alter the fact that the workpapers were prepared "because of" anticipated litigation with the IRS. In this regard, the court cited Lawrence E. Jaffe Pension Plan v. Household Int’l, Inc. In Jaffe Pension Plan, the court held that an attorney’s opinion letters containing an assessment of pending litigation were protected by work product, even though the securities laws required that the letters be provided to the corporation’s independent auditor.
Waiver of Privilege
Disclosure to the auditor waived the attorney-client and tax practitioner privileges.
Having found that the tax accrual workpapers were protected by both the attorney-client and tax practitioner privileges, the court considered and concluded that disclosure of the workpapers to the auditors waived these privileges. It is well established that disclosure to any third party waives attorney-client privilege and the tax practitioner privilege. The court noted that Textron’s argument that providing the tax accrual workpapers to its auditors did not waive privilege because the auditors themselves would be protected by the tax practitioner privilege was not persuasive.
The work product protection was not waived by the disclosure to the auditors.
The court noted that the work product privilege serves a purpose different from the attorney-client or tax practitioner privileges, and thus the conduct that waives these privileges also differs. Whereas the attorney-client and tax practitioner privileges are waived by disclosure to any third party, the work product protection is waived only if disclosure is in a manner that is inconsistent with keeping the information from an adversary.
The court then analyzed whether disclosure to an independent auditor would result in waiver of work product. The court noted that most courts considering the question had held that disclosure of information to an independent auditor does not waive the work product privilege because it does not substantially increase the opportunity for potential adversaries to obtain the information. The court agreed that the disclosure of Textron’s tax accrual workpapers to the auditor did not substantially increase the IRS’s opportunity to obtain the information contained in them. The court cited to two facts for support: American Institute of Certified Public Accountants Code of Professional Conduct section 301, which provides that the auditor has a professional obligation not to disclose any confidential client information without the specific consent of the client; and the auditor’s express agreement not to provide any of the information to any other party.
Finally, the court evaluated whether the IRS had overcome the work product protection by a showing of substantial need for the protected documents and an inability to otherwise obtain the information contained therein, or its substantial equivalent, without due hardship. The court concluded that the IRS had failed to carry the burden of demonstrating a substantial need for ordinary work product, let alone the heightened burden applicable to Textron’s tax accrual workpapers, which constitute opinion work product. Although the court recognized that the opinions and conclusions of Textron’s counsel and tax advisors might provide insight into Textron’s negotiating position or litigation strategy, it held that those opinions or conclusions had little bearing on the determination of its tax liability. Moreover, the court stated that "the forced disclosure of those opinions would put Textron at an unfair disadvantage in any dispute that it might arise with the IRS."
The district court’s decision in Textron addressed important issues concerning the scope of the work product doctrine and waiver of work product protection. The court also appears to have been influenced it its decision by a more basic point—the unfairness of requiring one party to a dispute, the taxpayer, to provide its view of the litigating hazards to its adversary without a reciprocal obligation by the IRS to do the same. The IRS undoubtedly will appeal this decision. The IRS Chief Counsel already has predicted that the taxpayer’s victory will be short lived. Thus, Textron is an important taxpayer victory, but not the last word on this issue.