Can Tax Accrual Work Papers Be Privileged?
Some documents included in a firmís tax accrual work papers can be shielded from IRS scrutiny if they contain "legal" analyses of the hazards of "soft spots" in the firm's returns.
October 25, 2007
by John Karayan, JD/PhD
Generally Accepted Accounting Principles (GAAP) requires that income tax expense must be matched with corresponding revenue, even if the actual tax might not be due for years. Generally Accepted Auditing Standards (GAAS) requires that auditors opine on the fairness of management’s efforts to estimate the accruals of such deferred taxes, and routinely maintain tax accrual work papers on their own, or evaluate a firm’s internal work papers which support the tax accrual. These work papers are an IRS auditor’s dream, because they provide a road map pinpointing the "soft spots" in a firm’s tax return. They often include information which would give an IRS auditor a great deal of leverage when negotiating the appropriateness of positions taken by the taxpayer. These positions could include memoranda or opinions letters about such sensitive issues as the extent to which a position is supported by “substantial authority” as well as its “more-likely-than-not” status.
For nearly a quarter century, it has been the IRS’ opinion that United States v. Arthur Young & Co., 465 U.S. 805 (1984) recognize the IRS’ right to obtain tax accrual work papers during an audit. Internal Revenue Manual Sec. 22.214.171.124.2. In practice the Service has followed a policy of restraint: In non-criminal cases, tax accrual work papers are not to be requested except in unusual circumstances. Announcement 2002-63, 2002-2 C.B. 72 (allowing routine requests for such work papers regarding tax shelter activities).
Recent court cases have suggested, however, that tax accrual work papers can be privileged. A good example is U. S. v. Roxworthy, rev’g & rem’g an unpublished decision of the DC WD Kentucky, 457 F. 3d 590 (6th Cir. 2006). At issue there were two memoranda prepared by external non-law firm consultants. The memos included analyses of possible IRS counter-arguments to taxpayer’s position, as well as evaluating “more-likely-than-not” consequences of the taxpayer's return position and the extent to which it was supported by “substantial authority.” The Court held that these were protected by the attorney work product privilege. They also would have been protected by both the attorney-client and the new IRC Sec. 7525 tax practitioner-client privilege, except these were waived because the taxpayer disclosed the documents to an independent auditor for SEC purposes. Most recently, in U. S. v. Textron, Inc. (DC Rhode Island 2007), 2007-2 USTC ¶50,605 — handed down in August — it was held that tax accrual work papers were not protected from the IRS by the attorney-client privilege, but were protected by both the new IRC Sec. 7525 tax practitioner-client privilege, and by the attorney work product privilege.
The IRS has returned fire to judicial decisions limiting IRS access to tax accrual work papers. Within 24 hours of Textron, IRS Chief Counsel Donald Korb held a press conference to emphasize the IRS’ strong opposition to the holding. “IRS Will Not Change Tax Accrual Workpapers Policy Despite Textron”, CCH Daily Tax News, J.8 (8/31/2007). Practitioners polled after these events generally have agreed with the Court. Id. On October 1, Action on Decision 2007-00 was issued to state the IRS’ non-acquiescence to Roxworthy. (This suggests the IRS’ ferverence on the issue. Although acquiescence or non-acquiescence is routinely announced for regular Tax Court decisions, the IRS does so for only a handful of other Federal cases each year.) Thus, the IRS plans to recognize the precedential value of Roxbury only within the appellate jurisdiction of the Sixth Circuit.
Notwithstanding the IRS’ opposition, these cases can be useful to corporate tax professionals by suggesting how to increase the odds of protecting their tax accrual work papers from discovery during a regular IRS audit. Keep in mind that tax accrual work papers vary a lot. Primarily, they exist to document the taxpayer’s estimates of a company's tax liabilities under GAAP. To do so, they usually include descriptions of atypical tax planning strategies, as well as fairly detailed evaluations of key tax-advantaged transactions, particularly if they are controversial. These descriptions often include analyses of the extent to which there is substantial authority, as well as document reliance on external advisors in making these determinations. As indicated in Roxworthy, tax accrual work papers may very well include opinion letters or memoranda obtained from the in-house counsel, outside counsel, or non-lawyer consulting firms, such as the tax department of the firm’s financial statement audit firm.
Of the three possible privileges, the hardest to maintain is the attorney-client privilege. As its very name suggests, it only protects confidential communications between an attorney and client relating to legal advice sought from the attorney. Thus, work papers prepared by the corporation's independent auditor are not covered. Arthur Young, 465 U.S. at 819. Note that the reason why the memoranda in Textron were covered was that they were prepared for its counsel whose function was to provide legal advice. The privilege is narrowly construed, particular in the tax area. Arthur Young, 465 U.S. at 816. Furthermore, the privilege does not apply to non-“legal” work, even if performed by a lawyer. Thus merely preparing a tax return is not covered by this privilege, U. S. v. Frederick, 182 F.3d 496 (7th Cir. 1999), although it is now covered by the new Sec. 7525 tax practitioner-client privilege. However, tax planning — particularly evaluating the application of primary authorities — is “lawyer’s work.” Thus, although mere preparation of tax accrual work papers is not covered, “a lawyer's analysis of the soft spots in a tax return and his judgment on the outcome of the litigation on it,” is privileged (United States v. El Paso Co. 682 F.2d 530 (5th Cir. 1982)).
Unfortunately, the attorney-client privilege is easy to waive. The privilege is waived for documents disclosed to outside accountants unless they are retained to facilitate legal advice by attorneys (Cavallaro v. United States, 284 F.3d 236 (1st Cir. 2002)). Thus, to the extent tax accrual work papers are reviewed by outside accountants in the ordinary course of a financial statement audit, the work papers lose any attorney-client privilege. The lesson to be learned is to try to minimize disclose of documents to financial statement auditors, which often is simply not practical.
The new IRC Sec 7525 tax practitioner-client privilege extends an attorney-client privilege to federally authorized tax practitioners when performing “lawyers work” in rendering tax advice, except where tax shelters are involved. Thus, although non-lawyers merely preparation of returns is not privileged, the confidential communications of those who participate in evaluating uncertain tax precedents — such as in estimating the “hazards of litigation” — are privileged. This is why the memoranda prepared by Textron’s external accountants would have been privileged had they, too, not been disclosed to Textron’s outside auditors. Again, try to minimize disclose of documents to financial statement auditors to the extent practical.
The corporate tax practitioner’s best shield is the work-product privilege. This is intended to protect against “disclosure of the mental impressions, conclusions, opinions or legal theories of an attorney or other representative of a party concerning the litigation.” Federal Rule of Civil Procedure 26(b)(3) The privilege is not absolute: A judge can allow disclosure if the IRS can show a “substantial need … and … undue hardship to obtain the substantial equivalent of the materials by other means”. Id. Most importantly, the privilege does not apply to documents produced during the ordinary course of business, but only those gathered by an attorney in anticipation of litigation. Some Courts require that the primary motivating purpose of privileged documents must be to aid in possible future litigation (U. S. v. El Paso Company, 682 F.2d 530 (5th Cir. 1982)). This makes it very difficult to cover tax accrual work papers, because they, by definition, have another primary purpose: Sufficiently documenting a firm’s tax accrual for financial statement disclosure. Others merely require that the document be prepared or obtained "because of" the prospect of litigation (U. S. v. Adlman, 134 F.3d 1194 (2d Cir. 1998); Maine v. Dept. of the Interior, 298 F.3d 60 (1st Cir. 2002)).
Textron being in the Second Circuit, this more liberal standard was applied. The IRS argued that the work papers were prepared in the ordinary course of business in order to get a clean opinion that Textron’s reserves for taxes satisfy GAAP requirements. However, the Court noted that the work papers in question dealt with evaluating items that might be challenged by the IRS and estimated hazards of litigation. Thus, the 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. This suggests that work papers documenting “soft spots” typically would be privileged.
This approach might not apply to taxpayers without a history of actual tax litigation. The Court did note that in seven of Textron's eight previous audit cycles, issues had been appealed and three separate cases were actually litigated in Federal courts. But actual litigation has not been required in other cases, e.g., Simon v. G. D. Searle & Co., 816 F.2d 397 (8th Cir. 1987) (individual case litigation reserves prepared by company's attorney were protected opinion work product).
More importantly, this privilege is not waived merely because the work papers might be disclosed to the firm’s financial statement auditors. U. S. v. Massachusetts Institute of Technology, 129 F.3d 681 (1st Cir. 1997). For example, in Lawrence E. Jaffe Pension Plan v. Household Int'l, Inc., 237 F.R.D. 176 (N.D. Ill. 2006) documents assessing pending litigation were protected by the work product privilege even though the securities laws required that the letters be provided to the corporation's independent auditor.
ConclusionThe bottom line is that some documents included in a firm’s tax accrual work papers can be shielded from IRS scrutiny. Even those prepared by non-lawyers, which are shared with the firm’s financial statement auditors or the Securities Exchange Commission (SEC), may be protected if they contain “legal” analyses of the hazards of “soft spots” in the firm’s returns. It is better if documents like these are independent of more mechanical work papers, and also if they are provided to counsel.
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John E. Karayan, JD/PhD is Professor & Chair of Accounting at Woodbury University, and a testifying Expert Witness in complex business litigation on accounting and tax issues.