On August 13, 2009, the United States Court of Appeals for the First Circuit, sitting en banc, decided 3-2 that the attorney work product doctrine does not shield the tax accrual workpapers prepared by a corporate taxpayer's accounting staff (with the assistance of in-house and outside counsel) and reviewed by its independent auditors from an Internal Revenue Service ("IRS") administrative summons. The First Circuit en banc majority held that tax accrual workpapers are "independently required by statutory and audit requirements," are not prepared for use in litigation, and would not "in fact serve any useful purpose ... in conducting litigation if it arose." United States v. Textron Inc., 577 F.3d 21, 26-30 (1st Cir. 2009) ("Textron").
The en banc decision completely reversed the holdings of the trial court and the original appellate panel. Before the trial court, Textron argued successfully that the workpapers were prepared to ensure that Textron was "adequately reserved with respect to any potential disputes or litigation" with the IRS over its returns. U.S. v. Textron Inc., 507 F. Supp. 2d 138, 143 (D.R.I. 2007). The original First Circuit panel agreed, finding that the workpapers were created in anticipation of litigation and, therefore, were protected attorney work product. 553 F.3d 87 (1st Cir. R.I. 2009). Both the district court and the original First Circuit panel determined that the applicable test was whether the tax accrual workpapers had been prepared "because of" the possibility of litigation with the IRS, and it did not matter that the tax accrual workpapers were also prepared for independent business purposes. As a result, the en banc Textron decision has raised serious concerns about the possible loss of attorney work product protection for documents that are prepared for a dual business/litigation purpose, but which are not prepared for actual use at trial.
Textron is a publicly traded aerospace and defense contractor, whose consolidated tax return is audited by the IRS on a regular basis. Textron, 577 F.3d at 22. The dispute arose from an IRS determination that a Textron subsidiary had engaged in a series of transactions that the IRS had identified as a potential tax shelter subject to abuse by taxpayers. Id. at 23-24. As a publicly traded company, Textron is required by federal securities laws to have its public financial statements certified by an independent auditor. See 15 U.S.C. §§ 78l, 78m (2006); 17 C.F.R. § 210 et seq. (2009). To prepare its financial statements, Textron must show that it has adequate contingency reserves, including estimates of potential liability if the IRS decides to challenge positions taken in its return. Textron, 577 F.3d at 22. Tax accrual workpapers include the backup e-mails, spreadsheets or notes supporting the total reserve figure. Only the total reserve figure is reflected in a company's final financial statement. However, if the IRS can summon them for use in conducting its audit, the tax accrual workpapers provide a clear roadmap to the soft spots in the corporation's tax return.
For many years the susceptibility of a corporate taxpayer's tax accrual workpapers -- the corporation's internal assessment of the merits of its tax positions, the likelihood of a challenge by the IRS and whether or not it will prevail -- to an IRS administrative summons has raised serious legal questions about privilege as well as policy concerns about fairness and revenue collection. An administrative summons allows the IRS, in determining the accuracy of any tax return, to "examine any books, papers, records, or other data which may be relevant or material to such inquiry." 26 U.S.C. § 7602(a) (1) (2006). The IRS generally seeks tax accrual workpapers when it believes the taxpayer may have engaged in certain types of designated tax avoidance transactions, including certain tax shelters and sale and leaseback transactions. Seeking to quash section 7602 summonses, corporate taxpayers have so far been unsuccessful in invoking the attorney-client privilege and the tax practitioner's privilege to protect their tax accrual workpapers. See also, United States v. Arthur Young & Co., 465 U.S. 805 (1983) (rejecting an accountant work product privilege).
Textron showed its workpapers to its independent auditors as part of the audit process but refused to produce them to the IRS in response to a summons. Textron claimed that the workpapers were covered by the qualified privilege available for litigation materials under the attorney work product doctrine. Textron, 577 F.3d at 24.
The En Banc Majority Decision
Sitting en banc, the First Circuit appeared to announce a new, restrictive test for invoking the attorney work product doctrine. According to the First Circuit majority, since its derivation from Hickman v. Taylor, 329 U.S. 495, 510-511 (1947), the attorney work product doctrine has "focused ... on the materials that lawyers typically prepare for the purpose of litigating cases." Textron, 577 F.3d at 26. The majority found that the "immediate motive of Textron in preparing the tax accrual workpapers was to fix the amount of the tax reserve on Textron's books and to obtain a clean financial opinion from its auditor." Id. at 27. The majority also noted that even if the prospect of litigation were "remote," Textron would still have to prepare workpapers to support its judgment. Id. at 28. The majority concluded that it "is not enough to trigger work product protection that the subject matter of a document relates to a subject that might conceivably be litigated." Id. at 29. Rather, the materials must have been prepared for "use" in "current or possible" litigation or trial. Id. at 30. However, the majority did not set forth a litmus test for determining when such materials are protected attorney work product other than to adopt a version of Justice Stewart's famous definition of pornography: "Every lawyer who tries cases knows the touch and feel of materials prepared for a current or possible ... lawsuit," and moreover, "[n]o one with experience of lawsuits would talk about tax accrual workpapers in those terms." Id.
The en banc majority also emphasized that "work product protection does not extend to 'documents that are prepared in the ordinary course of business or that would have been created in essentially similar form irrespective of the litigation.'" Id. (citing Maine v. U.S. Dep't of the Interior, 298 F.3d 60, 70 (1st Cir. 2002)). Also, appearing to rely on the Fifth Circuit "primarily motivated" to assist in litigation test, United States v. El Paso, 682 F.2d 530, 543 (5th Cir. 1982), cert. denied, 466 U.S. 944 (1984), the majority concluded that "the work product privilege is aimed at protecting work done for litigation, not in preparing financial statements" or other documents required by the securities laws and accounting standards Id. at 31.
The En Banc Dissent
Circuit Judge Torruella, who authored the original panel's decision, issued a passionate dissent. He castigated the majority for misapplying the "because of" the possibility of litigation test that the First Circuit had announced in Maine and for creating a new "prepared for use in litigation" test. According to the dissent, the proper application of the "because of test" in Maine asks whether "'in light of the nature of the document and the factual situation in the particular case, the document can be fairly said to have been prepared or obtained because of the prospect of litigation;'" it does not require that the document be prepared for use in litigation. Id. at 32 (citing Maine, 298 F.3d at 68). Judge Torruella added that the First Circuit in Maine had specifically declined to follow the Fifth Circuit "primarily motivated" to assist in litigation test set forth in El Paso, and had adopted the Second Circuit's "because of" existing or anticipated litigation test in United States v. Adlman, 134 F.3d 1194 (2nd Cir. 1998). Id. Further, the dissent relied upon Rule 26(b) (3) which refined Hickman and explicitly states that the work-product privilege not only applies to documents "prepared ... for trial," but also to documents prepared "in anticipation of litigation." Id. at 34. The dissent emphasized that many documents prepared by counsel and containing legal analysis serve the dual purpose of anticipating litigation and satisfying business needs and should be protected. Id.
Public Policy Considerations
The Textron majority focused only on public policy concerns affecting the IRS and not those supporting the attorney work product doctrine and protecting the integrity of the adversarial process. The majority made it clear that "tax collection is not a game," and that courts should not stand as an obstacle between the IRS and its ability to maximize revenue collection. Id. at 31. Indeed, the court noted that "[u]nderpaying taxes threatens the essential public interest in revenue collection." Id. Further, the "practical problems confronting the IRS in discovering under-reporting of corporate taxes, which is likely endemic, are serious." Id. According to the Textron majority (as well as the unanimous Supreme Court in Arthur Young), fairness to the corporate taxpayer must yield to the necessity of protecting the public fisc.
In the First Circuit, the Textron decision has strengthened the IRS's hand in conducting audits and has reduced the scope of attorney work product protection for documents that corporate taxpayers must prepare in the ordinary course of the audit process. However, beyond IRS access to tax accrual papers, there is significant uncertainty about the impact of the Textron decision on the meaning of the "in anticipation of litigation" requirement and the scope of attorney work product protection in civil litigation. This is especially so in connection with the many types of documents recording an attorney's evaluation of the possible outcomes of litigation that are prepared for business purposes rather than for direct use in litigation and that may be sought in discovery by aggressive adversary counsel.
The judicial circuits are now divided on the issue of whether the attorney work product doctrine protects documents that are prepared for dual business and litigation purposes. This circuit conflict may invite ultimate resolution of the issue by the Supreme Court. Textron has announced that it intends to file a petition for certiorari.