United States District Court’s Decision Could Pave the Way to Thwart a Taxing Authority’s Request to Produce FIN 48 WorkpapersMichael Semes
December 13, 2007 — 1,473 views
On August 28, 2007, in U.S. v. Textron Inc.,1 the United States District Court for the District of Rhode Island denied an IRS petition for enforcement of a summons requesting a taxpayer’s tax accrual workpapers because the workpapers were protected by the attorney work product privilege (also commonly referred to as the “work product doctrine”). The federal district court held that the taxpayer waived the otherwise applicable attorney–client and tax practitioner–client privileges when it provided the workpapers to its independent auditors for examination as part of their audit. As discussed below, Textron highlights the significant advantages that may be obtained by utilizing legal counsel to assist in the preparation of tax accrual workpapers.
FASB Interpretation Number 48 (FIN 48) requires public and private companies issuing financial statements in accordance with generally accepted accounting principles to evaluate and document the merits of uncertain income tax positions under federal, state or local tax law. Absent some protection or privilege, a taxing authority may be able to compel a taxpayer to produce its FIN 48 workpapers, which may contain sensitive information, including the identification of the taxpayer’s uncertain tax positions and the legal theories the taxpayer expects to use in the defense thereof. Textron provides taxpayers with a shield with which to defend against a taxing authority’s request for the production of the taxpayer’s FIN 48 and other tax accrual workpapers.
In conjunction with Textron’s preparation of its audited financial statements to be filed with the Securities and Exchange Commission, Textron’s in-house counsel prepared workpapers that contained counsel’s opinions regarding positions that Textron anticipated to be challenged by the IRS. Textron prepared its tax accrual workpapers for the purpose of determining its reserve for contingent liabilities under GAAP in conjunction with the issuance of its financial statements, which were to be audited by Ernst & Young and filed with the SEC. While Textron did permit E&Y to examine the workpapers in conjunction with E&Y’s audit, the AICPA Code of Professional Conduct prohibited E&Y from disclosing any such information without Textron’s consent, and E&Y expressly agreed not to provide the information to any third party.
During the course of the IRS’s audit of Textron, the IRS issued more than 500 information document requests to Textron. Textron complied with all of the IDRs except those that requested “tax accrual workpapers,” asserting that they were privileged. The IRS then issued an administrative summons to Textron to produce its tax accrual workpapers.
Textron asserted that it prepared its workpapers in anticipation of litigation with the IRS regarding various items on its return. Textron pointed to the hazards of litigation percentages contained in its workpapers to support this assertion. The IRS countered that Textron’s workpapers were prepared in the ordinary course of business and to comply with GAAP (which mandate the creation of tax reserves to meet contingent liabilities).
Attorney–Client and Tax Practitioner–Client Privileges
The attorney–client privilege protects confidential communications between an attorney and client relating to legal advice sought from the attorney for the purpose of encouraging full and frank discussion necessary to provide the client with sound legal advice. The tax practitioner–client privilege, created by IRC § 7525, confers protection on tax advice in the form of confidential communications between a taxpayer and any federally authorized tax practitioner (i.e., attorney, CPA or enrolled agent) but not including communication simply for the purpose of return preparation. Both privileges may be waived upon the disclosure of otherwise confidential information to a third party (including disclosures made to independent auditors), even if the third party agrees not to disclose the information.
Work Product Doctrine
The work product doctrine applies to material prepared or gathered by an attorney “in anticipation of litigation” or preparation for trial and in certain instances may be invoked with respect to an IRS summons. Unlike the purpose of the attorney–client privilege, which is to encourage free communication between a client and counsel, work product protection is designed to prevent a potential adversary from discovering a party’s strategy or the party’s own assessment of the strengths and weaknesses of its case.
There are two tests to determine whether material was prepared or gathered “in anticipation of litigation.” The first is the "primary purpose” test, which requires that the primary motivating purpose behind the creation of the document was to aid possible future litigation. The second test is the “because of” test, which requires that the document be prepared or obtained because of the prospect of litigation.
Work product protection is qualified and generally may be overcome if the opposing party establishes a “substantial need” for the protected documents or that the information contained in the protected documents (or their substantial equivalent) cannot be obtained without undue hardship. Additionally, the protection may be waived if the material in question is disclosed in a way that is inconsistent with the purpose of keeping it from an adversary.
- Attorney–client and tax practitioner–client privileges apply but Textron waived them by sharing its workpapers with E&Y. Even though the workpapers were protected by the attorney-client and tax practitioner–client privileges, Textron waived these privileges when it presented the workpapers to E&Y for examination on audit, because of the well-established rule that disclosure to a third party waives these privileges.
- Work product protection precludes the IRS from obtaining Textron’s tax accrual workpapers. Notwithstanding that the attorney–client and tax practitioner–client privileges did not protect Textron from producing its workpapers to the IRS, the district court held that Textron’s workpapers were the work product of its attorneys and, therefore, not discoverable. The district court stated the purpose of protecting attorney work product as follows:
The purpose of the work product privilege is to prevent a potential adversary from gaining an unfair advantage over a party by obtaining documents prepared by the party or its counsel in anticipation of litigation which may reveal the party’s strategy or the party’s own assessment of the strengths and weaknesses of its case.
- Textron prepared its tax accrual workpapers in anticipation of litigation. The district court held that the workpapers in question were protected attorney work product because they contained the opinions of Textron’s counsel and accountants related to: (a) items that might be challenged by the IRS; (b) estimated hazards of litigation percentages; and (c) calculation of tax reserve amounts that would not have been prepared “but for” the fact that Textron anticipated the possibility of litigation of these issues with the IRS. The court also found that Textron would not have needed its tax accrual workpapers and would not have had a tax reserve if it had not anticipated a dispute with the IRS. Moreover, in seven out of Textron’s previous eight audit cycles, Textron had appealed unresolved audit issues — three of which were resolved in federal court.
- Sharing the workpapers with E&Y did not waive work product protection. Textron did not waive work product protection by sharing its tax accrual workpapers with E&Y because: (a) E&Y’s professional code of conduct prohibited E&Y from disclosing confidential client information; and (b) E&Y expressly agreed not to provide such confidential information to any other party.
- IRS did not establish a “substantial need” to warrant the production of protected work product. The court held that the IRS was unable to demonstrate a “substantial need” for the workpapers. The workpapers contained opinions and conclusions of Textron’s tax counsel, which would have little bearing on the determination of Textron’s tax liability. Further, the workpapers did not contain any factual information that could not be obtained from Textron’s tax returns, and disclosure of Textron’s counsel’s opinions would unfairly disadvantage Textron in the event of any dispute that might arise with the IRS.
Blank Rome Observations
- As a result of Textron, companies should revisit their FIN 48 protocols and standards, because that decision may serve to protect a taxpayer’s FIN 48 workpapers if the taxpayer:
- Uses an attorney to assist it in preparing workpapers that are produced in anticipation of litigation; and
- Obtains express consent from its auditors not to disclose the content of those workpapers.
- The rationale of Textron may also be extended to apply to requests for production of documents by state and local taxing authorities. The Multistate Tax Commission has recently stated that it is exploring how state taxing authorities might obtain and utilize the wealth of detailed information contained in taxpayers’ FIN 48 workpapers. Because many FIN 48 issues involve uncertain multistate tax positions, Textron provides a valuable road map for multistate taxpayers to protect their workpapers.
- The decision of the United States District Court in Rhode Island may not be the last word on the subject. It is possible that the IRS could appeal this case and/or pursue similar cases in other circuits.
- U.S. v. Textron Inc., 100 A.F.T.R.2d. 2007-5848 (D.R.I. 2007).
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