Taxpayers have new cause to worry that aggressive federal and state tax auditors may be able to obtain taxpayer-produced roadmaps to their most sensitive and controversial tax exposures. On Aug. 13, in a divided decision, the U.S. Court of Appeals for the First Circuit reversed itself and held that the attorney work-product doctrine does not shield tax accrual workpapers from disclosure. U.S. v. Textron Inc. (en banc decision). In this Alert, we summarize the case and suggest protective steps taxpayers may wish to consider in the wake of this disappointing and poorly reasoned decision.
Corporate taxpayers and their advisors know that the preparation of tax accrual workpapers has a dual purpose: first, they provide documentation regarding the appropriate amount the company should reserve in its audited financial statements for each potential future tax liability; second, they provide contemporaneous documentation of the analysis and conclusions of the company regarding those liabilities – documentation that can later serve as a starting point for the analysis of those charged with defending each exposure in anticipated subsequent audit litigation. Thus, tax accrual workpapers are of interest to three parties: the attest firm, the company's tax controversy personnel and litigators, and government tax auditors.
The Textron case involved a summons the IRS had issued for Textron's tax accrual workpapers in connection with an audit. (The IRS had determined that Textron had participated in multiple listed transactions, so its usual "policy of restraint" in requesting tax accrual workpapers did not apply.) The district court denied the IRS's petition for enforcement, holding that the workpapers were protected by the work-product doctrine, because these dual-purpose documents – admittedly prepared to support its financial statements – would not have been prepared "but for" the reasonable anticipation by Textron and its attorneys that exposure items covered by the workpapers could end up in audit litigation. On appeal, the First Circuit panel initially upheld the District Court decision, and then later granted the federal government's request for a rehearing.
In its en banc decision on rehearing, the First Circuit gave short shrift to the important public policy considerations underlying the work-product doctrine, and appeared to lean over backwards to provide the government with more powerful tools for "detecting and disallowing abusive tax shelters." The court adopted a new standard for determining whether dual-purpose documents, like tax accrual workpapers, are protected by the work-product doctrine. Instead of applying the "but for" standard – the reasonable standard that had previously been applied by the First Circuit to dual-purpose documents – the court ignored past precedent and went on to create and apply a new standard based on the intended use of the documents. Under the court's new approach, documents are protected by the work-product doctrine only if they are prepared for use in potential litigation. This new standard would exclude virtually all dual-purpose documents from work-product protection.
Judge Torruella's dissent went to the heart of the matter: "In straining to craft a rule favorable to the IRS as a matter of tax law, the majority has thrown the law of work-product protection into disarray." The First Circuit's decision serves only to further muddle the authority in what was already a complex issue, and highlights the already existing division between the circuits on the proper standards for applying the work-product doctrine. This division will likely need to be resolved by the U.S. Supreme Court.
While taxpayers hope that the U.S. Supreme Court may weigh in and correct the First Circuit's error in Textron, state taxing authorities are not likely to sit still. Many state taxing authorities will likely view the First Circuit's decision as a green light to take a more aggressive approach in requesting tax accrual workpapers as part of the audit process. Taxpayers should prepare themselves for this aggressive approach now. Potential preparation may include:
- Implementing clear standards for labeling workpapers as work product prepared in anticipation of litigation. (Although labeling a document will not, by itself, cause a document to be protected, it may at least prevent accidental waiver of work-product protection.)
- Segregating work papers so that material relating to hot button issues (where litigation is clearly anticipated) 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 counsel (both in-house and external) early in the process of preparing tax accrual workpapers.