On January 21, 2009, a split panel of the First Circuit held that the attorney work product privilege applied to documents which a company had prepared “because of” litigation it anticipated with the IRS, even though the documents were also created to serve other business or regulatory purposes. While the Court further ruled that the company had not waived the privilege merely by disclosing these documents to its independent auditor, the Court remanded the case to determine: (i) if production to the IRS of the auditor’s non-privileged workpapers would effectively reveal the contents of the company’s documents, thereby effecting a waiver of the work product privilege, and (ii) to determine if the company could be deemed in control of the auditor’s workpapers for discovery purposes.
Textron, Inc. submitted to the IRS a 4,000 page tax return for 2001 accompanied by nine four-drawer file cabinets of supporting documentation. When the IRS audited Textron returns several years later, it noticed apparent tax avoidance transactions and issued an investigative subpoena for Textron’s tax accrual workpapers. These workpapers listed debatable positions Textron had taken on its tax returns that might require a tax liability reserve be set aside; contained an analysis by Textron attorneys of the likelihood that it would not prevail on each position if challenged by the IRS; expressed that likelihood in percentage terms; and calculated a reserve requirement based on that percentage. Since Textron is a publicly traded company and securities laws require that its financial statements be certified by an independent auditor, Textron also showed its tax accrual workpapers to Ernst & Young (“E&Y”), but did not let E&Y retain copies of them.
Textron refused to comply with the subpoena, so the IRS sued to enforce it. Textron did not assert attorney-client privilege because the workpapers had been disclosed to E&Y. It did, however, assert work product privilege on the grounds that the workpapers had been prepared by attorneys in anticipation of litigation with the IRS. A district court judge agreed and found that Textron’s disclosure of the documents to E&Y did not waive the work product privilege.
While not all facets of dealing with the IRS during an audit constitute “litigation,” the First Circuit concluded that “the resolution of disputes through adversary administrative processes, including proceedings before the IRS Appeals Board, meet the definition of litigation.” The Court agreed with the district court that one of the purposes behind the creation of the workpapers was anticipation of just such litigation. It also rejected the IRS’ contention that the mere presence of a business or regulatory purpose for generating the documents rendered the work product privilege inapplicable. It reiterated prior rulings that “dual purpose” documents created “because of” the prospect of litigation are protected notwithstanding another, non-litigation reason for their creation. The Court distinguished its “because of” test from the “primary purpose” test for determining whether documents were prepared in anticipation of litigation. By a 2-to-1 majority, the Court concluded that the analysis contained in Textron’s workpapers was undertaken “because of” the real prospect of litigation with the IRS. Application of the work product privilege was not defeated by the existence of other reasons for the creation of the documents.
However, the First Circuit remanded the case on the issue of whether Textron had waived the work product privilege when it disclosed its workpapers to E&Y. Noting that the work product privilege could be waived by disclosing protected documents either to an adversary or to a conduit to an adversary, the Court agreed with the district court that Textron and E&Y had enjoyed “a cooperative not adversarial relationship” and that E&Y had confidentiality obligations that made its own disclosure of the workpapers to third parties highly unlikely. Nevertheless, during its audit, E&Y had generated non-privileged workpapers of its own which reflected the analysis contained in Textron’s privileged workpapers and which the IRS also had subpoenaed from Textron. The Court remanded the case to determine if Textron had sufficient ability to obtain copies of E&Y’s workpapers from E&Y such that Textron should be deemed to have control of those documents for discovery purposes. If so, the district court also should determine if production of E&Y’s workpapers would effectively constitute disclosure of Textron’s own protected analysis, thereby stripping Textron’s workpapers of any work product protection.
The First Circuit’s full decision can be found at United States v. Textron, Inc., ___ F.3d ___, 2009 U.S. App. LEXIS 1538, No. 07-2631 (1st Cir. January 21, 2009).