Textron ruling may put limits on practitioner privilege
Persistence has paid off for the Internal Revenue Service in its quest to acquire a corporation's tax-accrual workpapers.
Despite losing the first two rounds in a test case against aerospace and defense contractor Textron Inc., it has won the third round at the First Circuit's en banc level, which in a 3-2 ruling decided that the work-product privilege does not protect a company's tax-accrual workpapers from IRS discovery.
The case may eventually be heard by the Supreme Court, observers suggested.
The IRS wants to look at workpapers because they document what a company considers its questionable tax positions.
As the Supreme Court explained in the 1984 Arthur Young case, tax-accrual workpapers provide a resource for the IRS by "pinpointing the 'soft spots' on a corporation's tax return by highlighting those areas in which the corporate taxpayer has taken a position that may, at some later date, require the payment of additional taxes" and providing an "item-by-item analysis of the corporation's potential exposure to additional liability."
In 2002, the service said that it would modify its historic policy of restraint with respect to tax-accrual workpapers. In the wake of Enron and other corporate scandals, it announced that it would, under certain circumstances, seek tax-accrual workpapers if the taxpayer has claimed the benefits of a listed transaction on a return.
In Textron's case, the listed transaction was a sale-in, lease-out, or SILO, transaction involving telecommunications and rail equipment. The IRS classifies these as listed transactions because they consider them a potential tax shelter subject to abuse.
Although the district court ruled that the workpapers were protected by the tax practitioner privilege and the attorney-client privilege, it found that both these privileges had been waived by disclosure to Ernst & Young, the company's external auditor. However, the court decided that a third privilege - the work-product privilege - did apply and was not waived by the disclosure. The work-product privilege shields materials prepared by a party in anticipation of litigation or preparation for trial.
On appeal, a divided three-judge panel upheld the district court's decision. The court then granted the IRS petition for a rehearing en banc (by the entire court). It concluded that the Textron workpapers were independently required by statutory and audit requirements and that the work-product privilege does not apply.
The court concluded that the work-product privilege is aimed at protecting work done for litigation, not in preparing financial statements. "Textron's workpapers were prepared to support financial filings and gain auditor approval; the compulsion of the securities laws and auditing requirements assure that they will be carefully prepared, in their present form, even though not protected; and IRS access serves the legitimate, and important, function of detecting and disallowing abusive tax shelters," the court stated.
NOT OVER YET?
Joe Kristan, a tax shareholder at Des Moines, Iowa-based Roth & Co. PC, was not surprised by the decision. "I expected it to be overturned at some point because it was too good to be true," he said. "It seemed too easy to avoid IRS access to workpapers just by having lawyers involved."
However, there is a division among the circuits that may lead to eventual consideration by the Supreme Court, noted Michael Jacobs, a partner in the Philadelphia office of Reed Smith. "It seems ready-made for the Supreme Court," he said. "Even though it doesn't rise to a constitutional level, it's an important issue. There's definitely a division among the courts. Overwhelmingly, they favor the three-judge panel decision which was reversed."
In reversing itself, the First Circuit ignored past precedent and went on to create and apply a new standard based on the intended use of documents, he observed.
"Under the court's new approach, documents are protected by the work-product doctrine only if they are prepared for use in potential litigation," he said. "This new standard would exclude virtually all dual-purpose documents [such as tax-accrual workpapers] from work-product protection."
"It's a much tougher test," he observed. "Tax-accrual workpapers will never satisfy the test as put forward by the new Textron decision, because you have to prepare for actual use in litigation. The mere fact that litigation was anticipated is not enough - there may be underlying issues where you anticipate litigation but the proximate cause is to support the tax reserve."
The decision is especially of interest in the state tax area, said Jacobs. "There are so many uncertainties in state income tax that there are pretty extensive workpapers in that area," he said. He warned that state tax authorities may view the decision as a green light to take a more aggressive approach in requesting tax-accrual workpapers as part of the audit process.
He suggested that taxpayers prepare for a more assertive stance by the states by doing the following:
* Implementing clear standards for labeling workpapers as work product prepared in anticipation of litigation. (Although labeling will not, by itself, cause a document to be protected, it may at least prevent accidental waiver of work-product protection.)
* Segregating workpapers so that material relating to hot-button issues (where litigation is clearly anticipated) is separate from materials related to less sensitive tax exposures. This may help limit any battle over work-product protection to the material that is most crucial and most likely to be covered by the work-product doctrine.
* Involving both in-house and external counsel early in the process of preparing tax-accrual workpapers.
Kristan agreed that states would be emboldened. "It will encourage the states to take a bolder approach," he said. "Tax-accrual workpapers lay out a nice roadmap to state tax issues, so you can expect states to aggressively seek them. It's asking too much of the states to show restraint as they try to pay for their spending binges."
"Taxpayers will continue to fight in this arena until more circuits go along with the decision, or the Supreme Court decides the issue," he said.
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