Can You Shield Work Papers From the IRS? Understanding the Boundaries of the "Work Product Doctrine"

September 21, 2009 — 1,660 views  
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A controversial new court case has led to anxiety at some corporations around the country. The decision, by the First Circuit U.S. Court of Appeals, stated that the IRS can peruse a company's internal tax accrual work papers created to determine if it could withstand an IRS audit.

Before the ruling, it was widely believed that these papers could be kept secret under a longstanding legal principle. Under the "work product doctrine," a business does not have to provide materials used "in anticipation" of litigation. However, the federal court ruled that the company was not protected by this doctrine because the documents were not specifically prepared for use in litigation.

With the "work product doctrine" now in question, some are worried that increased IRS access to business work papers will lead to more scrutiny from tax authorities and ultimately, more taxes, penalties and interest. As a result, companies may even record fewer details in their financial documents.

Facts of the case: Textron is a manufacturing conglomerate that produces Cessna airplanes and Bell helicopters, as well as other products. In 2006, the IRS asked to review all of Textron's work papers for 2001, in addition to the work papers prepared by its outside auditor, to determine the accuracy of the company's tax reserves for the year.

On their financial statements, publicly traded corporations must calculate tax reserves to account for contingent tax liabilities. In other words, they estimate how much money they will need if the IRS challenges debatable positions on tax returns.

The IRS issued an administrative summons requesting Textron's tax accrual work papers.

The documents in question included notes, a spreadsheet itemizing issues that could result in disagreements with the IRS, percentage estimates of how likely it would be that Textron would prevail in these disputes and the amount of money that the company should set aside in the event it was assessed additional tax in an IRS audit.

However, Textron refused to share this information with the IRS. In court, it challenged the summons by claiming that the work papers were protected by one or more of the following: the attorney-client privilege, the tax practitioner-client privilege, and the work product doctrine.

The district court ruled that Textron waived any applicable client privilege by disclosing the work papers to an independent auditor. However, it found that the documents were protected by the work product doctrine because they were prepared for the prospect of litigation. Undaunted, the IRS appealed.

Initially, the First Circuit Court upheld the district court ruling in a decision with a small panel of judges. It ruled that tax accrual work papers were protected under the work product doctrine as "dual-purpose" documents -- prepared both in anticipation of litigation and for valid business reasons. But, amidst growing controversy, the First Circuit subsequently agreed to rehear the case "en banc" (with all the judges sitting on the panel).

Result: The judges in the majority noted that the work product doctrine is intended to protect work papers created for litigation purposes, not those used for preparing financial statements. The court concluded that the work papers in the case were created to support financial filings and gain auditor approval.

According to the ruling, the work product doctrine is not a privilege designed to help corporate advisers "prepare corporate documents or other materials in the ordinary course of business."

There is little concern that Textron would be discouraged from adequately preparing for a lawsuit, the court stated. And any such concern is outweighed by the practical problems facing the IRS in uncovering tax abuses by corporations.

Conversely, in a strongly worded statement, the dissenting judges argued that the new ruling is a "dangerous aberration" and has thrown the existing law for work product protection "into disarray." Detractors also say there could be a domino effect if tax practitioners must worry about that internal documents may later become available for governmental scrutiny.

With access to certain information, the dissenting judges stated, "the IRS will be able to immediately identify weak spots and know exactly how much Textron should be wiling to spend to settle each item." (Textron Inc. and Subsidiaries, 1st Circuit 07-2631, 8/13/09)

This latest development in the three-year dispute between the IRS and Textron raises serious issues about the protection afforded to internal work papers. It will take awhile for the full impact of the new decision to be felt. In the meantime, consult with your professional business advisers concerning any potential problems for your firm.

What's Ahead?

Tax accrual work papers are likely to garner more future attention in corporations and courts.

  • In recent years, the IRS has been more likely to request work papers in cases when it suspects a taxpayer of engaging in tax shelter transactions considered abusive.
  • The accounting standard "FIN 48" requires businesses and not-for-profits to disclose information about their potential tax liabilities and the financial risks they pose. There is some concern that the IRS could obtain a company's FIN 48 work papers to use in routine audits.
  • Court decisions, such as the Textron case described in this article, have come down on both sides of the argument involving the protection of tax work papers. Some tax experts say the issue may ultimately be decided by the U.S. Supreme Court.

Rea & Associates, Inc.