A recent full court First Circuit decision held that the taxpayer's tax accrual workpapers are not protected under the work product privilege and must therefore be released to the Internal Revenue Service. The taxpayer, Textron, Inc., and the IRS have been embroiled in litigation over the discoverability of Textron's tax accrual workpapers ever since the agency commenced an audit of the company's 1998-2001 tax returns and requested the company's tax accrual workpapers for 2001.
This Update offers a summary of the key issues in the Textron case.
Background and Holding in the Textron Case
Work product privilege is traditionally granted to material prepared by an attorney either in anticipation of litigation or in preparation for trial—in either case, the goal is to protect the integrity of the trial process. Tax accrual workpapers are prepared to support the reserves that a company sets aside for potential tax liabilities that may arise if the IRS challenges any debatable tax positions in a company's returns.
In the 1984 case, Arthur Young & Co., the U.S. Supreme Court ruled that because of the public function that independent certified public accountants perform, work product privilege could not be attached to tax accrual workpapers prepared by them. Since accountants are essentially public fiduciaries, the Court did not deem it appropriate to extend work product protection to workpapers prepared by them. In Arthur Young, while the Court distinguished an accountant's role from a lawyer's, it only discussed work product protection in the context of workpapers prepared by accountants, not by lawyers.
In the Textron case, the government argued that these workpapers were not created in anticipation of litigation, but rather in the ordinary course of business to comply with regulatory requirements. On the contrary, Textron argued that if it were not for the possibility of litigation with the IRS, the papers would not be prepared at all because no reserves would be needed.
The Textron case relied on Arthur Young for some guidance but identified its own issue that is distinct from any previously decided cases in this area in large part because lawyers were involved in the preparation and review of the workpapers. The court framed the current issue as one in which the "document is not in any way prepared 'for' litigation but relates to a subject that might or might not occasion litigation." The court stated, "[i]t is not enough to trigger work product protection that the subject matter of a document relates to a subject that might conceivably be litigated." Rather, the work product privilege was designed to protect "materials prepared for use in litigation, whether the litigation was underway or merely anticipated."
The court also stated that much of the corporate material prepared by outside lawyers or reviewed by them falls into the vast category of materials that reflect legal thinking. Nevertheless, that material is not prepared in anticipation of or for trial and is therefore not protected under the work product privilege.
The Textron court decided that the tax accrual workpapers at issue were not produced for the dual purpose of preparation for litigation as well as to meet a legal obligation, a formulation that would have almost certainly allowed these workpapers to be covered by the privilege. Calling them "tax documents" and not "case preparation materials," the court instead decided that the workpapers were prepared for a non-litigation purpose and were, for that reason, not entitled to work product protection.
Textron Decision Clarifies That Just Involving Attorneys in Workpapers Does Not Protect Them From IRS Discovery
The IRS has traditionally exercised a policy of restraint when requesting tax accrual workpapers, typically requiring them in "unusual circumstances" only. This restraint was formulated as an IRS policy after the decisions of lower courts in Arthur Young when taxpayers complained that regular IRS review of tax accrual workpapers could cause the workpapers to be less than absolutely forthright. In 2002, the IRS expanded its policy to request tax accrual workpapers when a taxpayer has benefited from a listed transaction, which is identical to or closely related to transactions that the IRS has identified as tax avoidance transactions. Typically, where the taxpayer has engaged in one listed transaction, the IRS asks to see the tax accrual workpapers relating to that transaction; if the taxpayer has not disclosed a listed transaction or has benefited from multiple listed transactions, the IRS seeks all tax accrual workpapers for the year under review.
The IRS policy of restraint dates back to before Arthur Young and was only altered in 2002 to include the renewed emphasis on listed transactions. The view of the IRS is that its policy has not depended on tax accrual workpapers receiving work product protection. Accordingly, in the view of the IRS, this decision does not directly expand the agency's power to summon tax accrual workpapers. However, the First Circuit's opinion that these workpapers are not protected by the work product privilege does clarify the fact that simply having lawyers prepare or review the workpapers will not protect them from discovery by the IRS.
Additional Information
This update is only intended to provide a general summary of the First Circuit's decision in United States v. Textron, Inc., No. 07-2631 (1st Cir. Aug. 13, 2009)(en banc). You can read the full text of the decision here. You can find discussions of other recent cases, laws, regulations and rule proposals of interest to public companies on our website.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
