IRS Announcement 2010-9 proposes requiring business taxpayers with total assets of more than $10 million to file a new schedule with their income tax returns that would provide a concise description of each of their “uncertain” tax positions along with the maximum amount of potential tax liability attributable to each position. Uncertain tax positions generally include positions for which the taxpayer or a related entity have created a reserve on their financial statements. The Announcement contains the qualification that “[e]xcept as described in this Announcement, the Service intends to retain the existing policy of restraint for requesting tax accrual workpapers during the course of examinations . . . .” However, the proposed filing requirement would directly undermine much of the basis for the policy of restraint, which is to afford taxpayers some degree of privacy when analyzing their tax positions in the process of preparing certified financial statements. This proposal, taken together with the First Circuit’s recent ruling in United States v. Textron that the work product doctrine does not protect from disclosure even those tax accrual workpapers that contain a taxpayer’s estimate of litigation hazards associated with its uncertain tax positions, should give taxpayers grave concern.1 It is now more important than ever to take the steps necessary to prevent sensitive legal analysis and memoranda from being unintentionally dragged into a disclosure of tax accrual workpapers.
The IRS has observed the “policy of restraint” since 1981, and the Supreme Court’s 1984 decision in United States v. Arthur Young cited this policy in support of the Court’s holding that tax accrual workpapers are subject to the administrative summons authority of the IRS.2 The policy of restraint provides that tax accrual workpapers (including the existence of a tax reserve for a specific position) should be requested by the IRS only in “unusual circumstances” (with more recently added exceptions related to listed transactions).3 Now, however, the IRS proposal would require business taxpayers to disclose the existence of each reserve position as a matter of course—in effect, providing a road map for the IRS of the taxpayer’s hot button issues and directly undermining the very reason for restraint with respect to requests for tax accrual workpapers. In the wake of the First Circuit’s recent ruling in Textron, sensitive legal analysis is increasingly exposed to the risk of summons by the IRS.
The IRS states that the purpose of its proposed schedule is to improve “tax compliance and administration.” The Announcement recognizes that “[e]xisting business tax returns do not currently require that taxpayers identify and explain uncertain tax positions underlying their returns,” but states that “[t]o discharge its obligation to fairly and uniformly administer the tax laws, the Service must be able to identify quickly and efficiently significant issues (including uncertain tax positions) underlying the tax return.” Although IRS Announcement 2010-9 does not refer to the First Circuit’s Textron decision, the policy considerations stated in the IRS announcement echo those expressed by the First Circuit:
The practical problems confronting the IRS in discovering under-reporting of corporate taxes, which is likely endemic, are serious. Textron’s return is massive—constituting more than 4,000 pages—and the IRS requested the work papers only after finding a specific type of transaction that had been shown to be abused by taxpayers. It is because the collection of revenues is essential to government that administrative discovery, along with many other comparatively unusual tools, are furnished to the IRS.4
Textron is currently seeking review by the Supreme Court of whether its tax accrual workpapers, including a spreadsheet of its tax positions that details the dollar amount of each position subject to dispute and a percentage estimate of the IRS’ chances of success, are protected from IRS summons by the work product doctrine.
Without awaiting the outcome of this process, however, the IRS has proposed a filing requirement that would effectively eviscerate the policy of restraint by requiring taxpayer disclosures that will allow the IRS to quickly identify large dollar “uncertain” tax positions for which sensitive legal analysis and memoranda will almost certainly exist, quite possibly mixed in with tax accrual workpapers that are subject to administrative summons. Thus, the proposed filing requirement would further diminish the already little remaining privacy allowed to taxpayers engaged in the process of weighing litigation hazards for uncertain tax positions that is a necessary part of preparing certified financial statements in compliance with FIN 48.
Considering the IRS’ increasingly aggressive approach toward obtaining taxpayers’ legal analysis and its victory in Textron, taxpayers should proactively address the potential exposure of sensitive legal analysis by putting in place protocols that will minimize the risk of unintentional disclosure of that legal analysis.