The First Circuit’s decision to uphold the district court’s ruling that the taxpayer's tax accrual workpapers are protected work product should be viewed as a significant taxpayer victory, but the decision raises as many questions as it answers.

On January 21, 2009, the U.S. Court of Appeals for the First Circuit issued the much-anticipated decision in Textron Inc. v. United States.  In a majority decision drafted by Judge Juan Torruella, the First Circuit upheld the U.S. District Court for the District of Rhode Island’s decision that tax-accrual workpapers prepared by a taxpayer are protected by the work product doctrine.  However, the majority held that waiver of the protection afforded by the work product doctrine may occur if the taxpayer’s analysis is reflected in its auditor’s workpapers, which are not protected by the work product doctrine.  The court remanded the case to the district court for further proceedings to determine whether the auditor’s workpapers would reveal the information contained in Textron’s own workpapers, and whether the auditor’s workpapers are discoverable on the grounds that the taxpayer has the legal right or ability to obtain these documents.  A dissenting opinion by Judge Michael Boudin argues that “tax-accrual work papers are not protected because they are prepared for reasons independent of the need to prepare for or conduct litigation.”

The First Circuit’s decision should be viewed as a significant taxpayer victory with respect to the principal issue of whether tax-accrual workpapers are protected by the work product doctrine.  However, the Court’s holding regarding waiver is troubling and arguably incorrect.

IRS History of Restraint in Requesting Tax Accrual Workpapers

Tax accrual workpapers provide support for a taxpayer’s financial statement tax reserves. They are sensitive documents because they identify the taxpayer’s judgment about the issues for which the results under the tax laws are unclear (so-called “soft spots” on the return).  Tax accrual workpapers generally reflect the evaluation of the taxpayer’s counsel or in-house accountants as to the likelihood of success if the issues were litigated.  In other words, in any dispute with the Internal Revenue Service (IRS), tax accrual workpapers provide the taxpayer’s evaluation of its hazards of litigation.  Because of their sensitive nature, access to these workpapers has been an area of long-standing controversy between the IRS and taxpayers.

In United States v. Arthur Young Inc., 465 U.S. 805 (1984) the Supreme Court of the United States upheld the right of the IRS, under its broad summons authority, to obtain tax accrual workpapers prepared by the taxpayer’s independent auditors, and rejected the taxpayer’s position that the workpapers were not relevant to an IRS audit.  In 1981, the IRS adopted a policy of restraint under which it would not seek tax accrual workpapers absent “unusual circumstances,” such as if the examiner has not been able to obtain the necessary facts from the taxpayer.  The IRS adopted this policy in response to serious concerns that unlimited access by the IRS to tax accrual workpapers would have an adverse effect on the preparation of accurate financial statements.  Under unusual circumstances, the IRS examiner must obtain written approval from the chief of examination, and the request is limited to only the portion of the workpapers believed to be material and relevant to the examination.

In 2002, the IRS announced that it was modifying its historic policy of restraint with respect to asking for a company’s tax accrual workpapers.  Under the modified policy, the IRS examiner must request the taxpayer’s tax accrual workpapers if the taxpayer claimed a tax benefit from a “listed” transaction on the return under review.  Moreover, if a taxpayer claimed tax benefits from two or more listed transactions on a return under review, the IRS examiner must request the tax accrual workpapers for all items reported on the return.

The Relevant Facts of Textron

The IRS issued an administrative summons to Textron pursuant to I.R.C. § 7602 seeking tax accrual workpapers in the actual or constructive possession, custody or control of Textron or its accountants for Textron’s 2001 tax returns.  Textron refused to comply and asserted, among other defenses, that the tax-accrual workpapers sought were protected by the work product doctrine because the documents were prepared in anticipation of litigation, i.e., in preparation for a tax dispute with the IRS.  The IRS sued to enforce the subpoena.

Historically, IRS audits of Textron had been contentious.  The IRS audits every Textron return, in multi-year cycles. In seven of the last eight audit cycles, Textron and the IRS have brought at least one issue to the IRS Office of Appeals.  Between 1959 and present, Textron and the IRS have litigated three disputes in the federal courts.

At an evidentiary hearing before the district court, the IRS’s expert witness testified that tax accrual workpapers are prepared to satisfy securities law requirements that public companies obtain a letter from an independent auditor approving the company’s financial statements, including the company’s reserves for tax issues.  The IRS’s expert also testified that public companies prepare tax-accrual workpapers to comply with securities law regardless of whether they expect litigation, and that workpapers are necessary in all events to handle deferred taxes or to justify setting aside no tax reserve.

Textron adduced testimony that its accrual workpapers were created “to determine whether Textron was adequately reserved with respect to any potential disputes or litigations that would happen in the future,” and that the tax accrual workpapers listed positions Textron was taking on its tax returns that might require that a reserve be set aside.  These positions were then analyzed by Textron lawyers who estimated a “hazards of litigation percentage,” i.e., the percentage likelihood that the position would not prevail if challenged by the IRS.  The reserve was calculated as the product of the “hazards of litigation percentage” and the tax benefit claimed.  The tax accrual workpapers were prepared under the assumption that issues identified would be challenged by the IRS and would need to be defended.  If Textron did not anticipate any disputes, the tax accrual workpapers would be blank.  

Tax-Accrual Workpapers Are Protected Work Product

The work product doctrine protects materials prepared by a party or the party’s representative in anticipation of litigation or preparation for trial.  The doctrine first was articulated by the Supreme Court in Hickman v. Taylor, and later was codified in Rule 26(b)(3) of the Federal Rules of Civil Procedure.

In addressing whether tax-accrual workpapers are protected by the work product doctrine, the First Circuit in Textron first held that “the resolution of disputes through adversary administrative processes, including proceedings before the IRS Appeals Board, meets the definition of litigation.”  The First Circuit reasoned that good-faith disputes regarding the proper application of tax law arise during the audit process and, although the initial processing of these disputes in the audit process may not be adversarial, the disputes themselves are essentially adversarial and “the subject of these disputes will become the subject of litigation unless the dispute is resolved.”

Second, the First Circuit held that the tax-accrual workpapers in issue were “prepared in anticipation of litigation.”  The First Circuit upheld the district court’s finding that one of the purposes behind the creation of the tax-accrual workpapers was the anticipation of litigation:  “the need to estimate the likelihood of success in litigation was a result of the need to set up a reserve fund to cover tax positions for which Textron could foresee disputes with the IRS.”  The First Circuit then concluded that these facts satisfy the “because of the prospects of litigation” test adopted by the First Circuit in the State of Maine v. United States Dep't of the Interior, 298 F.3d 60, 70 (1st Cir. 2002), explaining:

But, here, the function of the documents was to analyze litigation for the purpose of creating and auditing a reserve fund.  It can be fairly said that “?the driving force behind the preparation’” of the documents, Roxworthy, 457 F.3d at 595 (quoting Nat'l Union Fire Ins. Co. v. Murray Sheet Metal Co., 967 F.2d 980, 984 (4th Cir. 1992)), was the need to reserve money in anticipation of disputes with the IRS.

The First Circuit rejected the IRS’s argument that “the mere presence of a business or regulatory purpose defeats work-product protection,” on the grounds that “dual purpose documents created because of the prospect of litigation are protected even though they were also prepared for a business purpose.”

Although not necessary to its holding that tax accrual work papers are protected by the work product doctrine, the First Circuitmade two interesting observations.  First, the First Circuitnoted that a contrary holding could lead to “undesirable results” in other civil litigation:

Consider a document prepared to analyze a specific litigation in order to compute for an auditor how much must be retained in a litigation reserve fund.  Were we to adopt the IRS position that documents created to satisfy audit reporting responsibilities were not protected, opposing counsel in the litigation might be able to discover such a memo, effectively disclosing counsel’s ultimate mental impression of the case.

Second, the First Circuit stated that a particular taxpayer’s history of disputes and litigation with the IRS should not be determinative of whether the taxpayer anticipated litigation.

If we were only to afford work product protection over documents of this sort by requiring a showing, as the IRS suggests, that there was some specific quantum of expectation that the position at issue would mature into full-fledged litigation, we would essentially be offering protection only to the cantankerous and combative taxpayer who intends to thoroughly litigate every position.

Waiver of Work Product Protection

The First Circuit then turned to the issue of whether Textron had waived work product protection by showing its tax accrual work papers to its independent auditor, Ernst & Young LLP (E&Y).  Unlike the attorney-client privilege, the work product privilege can be waived by disclosure of otherwise protected work product to a litigant’s (real or potential) adversary.  The First Circuit acknowledged that several courts have found no such waiver upon a taxpayer’s disclosure of its tax accrual workpapers to its independent auditor. 

The IRS argued that E&Y could be a potential adversary.  The First Circuit disagreed, finding that E&Y occupied a “cooperative” position, not an adversarial one, explaining:

While it is possible to imagine circumstances where E&Y’s professional obligations could cause E&Y and Textron to come into conflict on some legal question, the IRS can point to no “conceivable scenario in which E&Y would file a lawsuit against [Textron] because of something E&Y learned from [Textron’s] disclosures.”  (Citing Regions Financial Corp v. United States , 2008 U.S. Dist LEXIS 41940, at * 27-28.) 

Additionally, the IRS argued that E&Y was a conduit for a potential adversary—the IRS, since E&Y may be required to disclose the information under a valid subpoena.  Although the record indicated that E&Y did not retain a copy of Textron’s workpapers, E&Y did use the putatively protected information (together with its own expertise) in preparing its own assessment of Textron’s reserve tax liability.  “Therefore, the only remaining documents which could be subjected to a risk of discovery are E&Y’s own assessments, which incorporate Textron’s analysis.”  The First Circuit acknowledged that under the Supreme Court’s decision in Arthur Young, E&Y’s workpapers may be discoverable.  So whether Textron waived work-product protection by disclosing them to E&Y then depends to what extent E&Y’s workpapers evidence the contents of Textron’s workpapers.  Since the district court did not address this issue, the First Circuit remanded the case for an in camera inspection or to take testimony on the issue.

The First Circuit’s ruling on waiver is curious and arguably incorrect since it misconstrues the meaning of a “conduit.”  For example, it is well established, that under the “conduit theory” communications made to a lawyer, though made in private, are not privileged if they were made with the understanding that the lawyer would disclose  them to third parties.  Under those circumstances, the lawyer is considered a conduit for the third party.  See United States v. Tellier, 255 F.2d 447 (2d Cir. 1958), United States v. Edison, 2008 U.S. Dist. LEXIS 6825, *6 (N.D. Cal. 2008).  Similarly, E&Y might be treated as a conduit to a potential adversary if, at the time of the disclosure to E&Y, it was understood that E&Y would disclose the information to the IRS or to another potential adversary.  In Textron, however, the evidence established that E&Y had professional confidentiality obligations limiting disclosure and a separate agreement memorializing its intent to maintain the confidentiality.  Accordingly, there is no basis for treating E&Y as a conduit to the IRS and disregarding the district court’s finding that “since E&Y agreed to treat the workpapers as confidential, disclosure to E&Y did not substantially increase the likelihood that the workpapers would be disclosed to the IRS or another potential adversary.” 

The First Circuit’s ruling also assumes, arguably in error, that E&Y would not be able to claim privilege on selective portions of its workpapers that might possibly reflect Textron’s work product.  In a typical case where an independent auditor is subpoenaed by the IRS to disclose a taxpayer’s workpapers, the IRS is required to give the taxpayer notice to preserve any and all privileges (such as work product protection) it may have over such documents.  Although the auditor might be required to turn over taxpayer documents, typically the auditor and taxpayer work together to ensure that any privileged material is redacted prior to disclosure. 

Here the First Circuit seems to be saying that despite E&Y’s “cooperative,” non-adversarial position vis-à-vis Textron, if any of the protected information finds its way into E&Y’s files, then there is waiver as to Textron’s workpapers.  This is an unworkable position and raises more questions than it answers.  For example, what is the threshold of spillage for the protection to be waived?  Must the auditor’s workpapers have the taxpayer’s information verbatim to be subject to waiver?  Or is it sufficient that looking at the documents side-by-side, a reasonable person could proclaim that the substance of the protected material has found its way into the auditor’s files and thus the protection is waived.  Lastly, the First Circuit’s formulation continues to obscure what should otherwise be a bright line test.  The First Circuit’s reasoning may well require an in camera inspection of the auditor’s and taxpayer’s workpapers in each case where work-product protection is claimed.  Without setting forth standards to determine how much spillage is too much, courts, taxpayers and the IRS will continue to wander in the dark. 

Discovery of E&Y’s Workpapers Via Subpoena to Textron

The First Circuit also addressed whether the IRS could subpoena E&Y’s workpapers that were “within the possession, custody, or control of Textron or its accountants.”  The First Circuit held that the district court erroneously failed to rule on this issue.  On brief, Textron argued that it could not produce documents it did not physically have.  The First Circuit disagreed, stating that there was “no evidence showing that it did not have the ability to demand” E&Y’s documents.  Since Textron offered no evidence to meet its burden showing lack of control over E&Y’s documents, the First Circuit remanded the issue to the district court to determine whether “Textron can obtain E&Y’s workpapers.”

Conclusion

The First Circuit’s decision in Textron will surely be hailed as a major victory against the IRS’s ability to end-run a taxpayer’s right to keep confidential its strategy with regard to tax positions taken on its return.  The fact that Textron’s 2001 income tax return was 4,000 pages did not appear to impress the First Circuit to permit the IRS to obviate its normal examination procedures.  But this decision leaves open as many questions as it answers.  The First Circuit’s discussion on waiver may eventually swallow the protection seemingly afforded by the affirmation of the district court.