Is the 'Work' in Tax Accrual Workpapers Considered Work Product?
Recently, the IRS has been denied the production of the taxpayer's tax accrual workpapers with respect to tax abusive transactions. Here's why.
August 14, 2008
by Colleen Feeney, JD and Thomas Wechter, JD
In stepping up its attack on tax abusive transactions, the IRS at the audit stage has sought the production of the taxpayer's tax accrual workpapers. See Regions Financial Corp. v. United States, 2008 WL 2139008 (N.D. Ala. 2008); and United States v. Textron, 507 F. Supp. 2d 138 (D.R.I. 2007). While the IRS has maintained a policy of restraint with regard to discovery of tax accrual papers, the IRS has announced that it would seek discovery of such workpapers for listed transactions disclosed in returns.
The work-product doctrine is distinct from the attorney-client privilege, broader in certain respects and narrower in others. The work-product doctrine is broader in that it is not limited to communications between a lawyer and client. The work-product doctrine extends to documents and work-product of non-lawyers hired by or working for the attorney in anticipation of litigation.
If a lawyer hires an accountant to assist in a tax investigation, for instance, the accountant's notes and interviews of witnesses are considered work-product under the doctrine. If the accountant acts as the primary representative of the taxpayer before the IRS, then efforts to shield his work-product and other client communications may be unsuccessful. Bernardo v. Comm., 104 T.C. 677 (1995). However, the work-product doctrine only applies if the work is prepared in anticipation of litigation.
Whether something is done in anticipation of litigation depends on the facts and circumstances involved. There is a split of authority among the various courts of appeal regarding what constitutes "prepared in anticipation of litigation." Regions, 2008 WL 2139008 at *3. The Second Circuit and Fourth Circuits apply the "because of litigation test" and the Fifth Circuit applies the "primary motivating purpose" test. Compare Nat'l Union Fire Ins. Co. of Pittsburgh v. Murray Sheet Metal Co., 967 F.2d 980, 984 (4th Cir. 1992) (applying the "because of litigation" test and stating "determining the driving force behind the preparation of each requested document is therefore required in resolving a work-product immunity question) with United States v. El Paso Co., 682 F.2d 530, 542 (5th Cir. 1982) (applying the "primary motivating purpose" test and stating "[b]usiness imperatives, not the press of litigation, call these documents into being").
The courts in Regions and Textron analyzed the limits of the work-product doctrine with respect to tax accrual papers, holding that the respective tax accrual workpapers were prepared in anticipation of litigation and therefore were protected by the work-product doctrine.
United States v. Textron
In Textron, the IRS had issued a summons for the tax accrual workpapers of Textron and its subsidiaries, because it believed a Textron subsidiary had engaged in a "listed transaction." The tax accrual workpapers, prepared by in-house accountants, were shown to Textron's independent auditors. The independent auditors were under a confidentiality agreement. The crucial issue before the court was whether the tax accrual workpapers were prepared "in anticipation of litigation" and therefore protected.
Following the First Circuit, the court rejected the "primary purpose" test, applying the "because of" test. "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 other adversarial proceeding." 505 F. Supp. 2d at 150. Under the court's reasoning, all tax accrual workpapers are per se protected by the work-product doctrine.
A waiver of the privilege occurs if the documents subject to the privilege are made available to an adversary or a third party who could serve as a conduit to an adversary. Id.(citing United States v. MIT, 129 F.3d 681, 687 (1st Cir. 1997) (disclosing material in a way inconsistent with keeping it from an adversary waives work-product protection). The Textron court held that the disclosure of the tax accrual workpapers to the outside auditors did not waive the work-product privilege because it did not substantially increase the opportunity that Textron's adversary would obtain the tax accrual workpapers (507 F. Supp. 2d at 152).
Regions Financial Corp. v. United States
Relying on Textron, the Regions' court held that tax reserve analysis is always prepared in anticipation of litigation reasoning the analysis would not be needed but for the possibility of disputes with the IRS. Regions Financial Corp. v. United States, 2008 WL 2139008. In response to IRS requests, Regions instructed its accountants to produce all responsive documents except 20, which related to a specific transaction in 2000. All of the documents withheld were created at the behest of Regions' general counsel and expressed opinions, evaluated legal theories and analyzed possible IRS attacks on the reporting of the transaction.
In analyzing the meaning of "in anticipation of litigation," the court reasoned that it did not matter which test was used. Citing Textron, the Regions court held that it was clear that Regions sought the opinions of its auditor and another law firm to determine the potential outcomes of litigation. "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, and this court cannot say that Regions' subjective belief was objectively unreasonable." The court found persuasive that Regions only sought protection on documents encompassing mental impressions and legal theories of its counsel. The court next addressed whether Regions had waived the privilege by forwarding the documents to its auditor. The court reasoned that the auditor was independent and not a potential adversary, noting also that there was a confidentiality agreement in place.
Both Textron (Note: Textron is currently being appealed by the IRS) and Regions involved tax years prior to the adoption of FIN 48 and the application of Sarbanes-Oxley. Despite well-reasoned opinions, the application of FIN 48 may undermine the decisions in both cases. Under FIN 48, a taxpayer's determination of its income tax reserve may not take audit risk into account. Consequently, a taxpayer must determine its tax exposure, regardless of whether it expects that the IRS will challenge or even examine its tax positions. For this reason, FIN 48 may undermine the courts' reasoning that tax accrual workpapers would not have been prepared but for the possibility of an IRS dispute.
Under the Sarbanes-Oxley Act, accountant confidentiality agreements now must contain an exception for the Public Company Accounting Oversight Board. As a result, a taxpayer's own auditors, despite a confidentiality agreement, will have to produce workpapers to a PCAOB investigator, upon request. Will this fact undermine the basis of the Textron court's finding that it was unlikely the tax accrual workpapers would be disclosed to an adversary of Textron or that such disclosure is inconsistent with keeping the tax accrual workpapers confidential? Could it be argued that disclosure to the Public Company Accounting Board being a quasi governmental body is tantamount disclosure to the IRS? See United States v. MIT, 129 F.3d 681 (1st Cir. 1997) (holding that disclosure of expenses to the Defense Contract Audit Agency with respect to work performed by MIT for the Pentagon was a waiver of the work-product doctrine).
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Thomas R. Wechter, JD, Partner, concentrates his practice in the area of tax planning for individuals, corporations, and partnerships and also handles matters involving tax controversies. Colleen M. Feeney, JD, Associate, concentrates her practice in taxation, including tax planning and litigation matters involving individuals, corporations and partnerships. Both work at the law firm Schiff Hardin LLP. The authors would like to thank Alan Boudreau, a summer associate in Schiff Hardin's summer program, for his help.