1. In this summons enforcement case, the district court ruled that Textron’s tax accrual workpapers qualify as attorney “work product,” within the meaning of Rule 26(b)(3) of the Federal Rules of Civil Procedure (the “FRCP”), and, as such, are protected against compelled disclosure to the Internal Revenue Service (“IRS”).
The Importance of Textron
2. Textron is the first judicial decision extending the protection of the attorney work product doctrine to any tax accrual workpapers, much less, as here, to all of them.
3. The attorney work product doctrine, moreover, usually is the only defense potentially available to a taxpayer for protecting tax accrual workpapers, together with the opinions of tax counsel that support the workpapers, against an IRS summons.
4. This is so because the defenses of the attorney client privilege, the tax practitioner privilege (IRC § 7525) and lack of relevance typically do not protect tax accrual workpapers.
5. As to the privileges, taxpayers waive those privileges upon disclosing the tax accrual workpapers and supporting tax opinions to their financial auditors, who, post-Sarbanes-Oxley, insist upon reviewing them.
6. As to the defense of lack of relevance, the Supreme Court has stated that tax accrual workpapers are “highly relevant” to an IRS income tax examination. Lack of relevance, then, is not a promising defense.
7. In the usual case, therefore, only the attorney work product doctrine potentially is available to protect tax accrual workpapers against disclosure pursuant to an IRS summons.
8. In these circumstances, taxpayers need to know how best to go about protecting tax accrual workpapers, and also other confidential tax documents, as attorney work product. Hence, this brief analysis of Textron.
The Textron Facts
9. In the course of examining the consolidated federal income tax returns of Textron and subsidiaries, the IRS issued a summons to Textron directing Textron to produce all of its tax accrual workpapers for 2001.
10. The IRS issued the summons for all tax accrual workpapers for 2001 because Textron Financial Corporation, a subsidiary of Textron, engaged in nine listed transactions for that year. According to IRS Announcement 2002-63, 2002-2 C.B. 72, the IRS will request all tax accrual workpapers for a year for which there is more than one listed transaction. The nine listed transactions are “sale-in, lease-out,” or “SILO,” transactions.
11. Textron’s tax accrual workpapers for 2001 include a spreadsheet containing:
(a) Lists of items reported on Textron’s consolidated return which in the opinion of Textron’s in-house tax counsel involve issues on which the tax law is unclear and which the IRS might challenge.
(b) Tax counsels’ estimates of Textron’s prospects for prevailing in litigation, expressed as a hazards-of-litigation percentage.
(c) The dollar amounts reserved.
12. Textron’s tax accrual workpapers for 2001 also include:
(a) The prior year’s spreadsheet.
(b) Prior drafts of the spreadsheet.
(c) Notes and memoranda of Textron’s in-house tax attorneys reflecting their opinions regarding which items to include on the spreadsheet and the hazards-of-litigation percentage for each such item.
13. Textron’s in-house tax attorneys, and the in-house CPAs assisting them, counseled Textron regarding proposed transactions and the merits of the tax law issues that the IRS could raise. They identified the tax issues potentially in dispute and prepared memoranda assessing the hazards of litigation on those issues.
14. The in-house tax attorneys also used those same memoranda and hazards-of-litigation percentages in the preparation of Textron’s tax accrual workpapers.
15. Textron is continuously under examination and in recent years has contested proposed adjustments before the IRS Office of Appeals and has litigated tax issues in federal court.
16. Textron’s financial statements combine the amount of the tax reserve with other contingent liabilities and report only the total amount as “other liabilities.”
17. Textron disclosed its tax accrual workpapers to its financial auditors, Ernst & Young, with the understanding that Ernst & Young must keep the information confidential. Textron did not furnish a copy of the tax accrual workpapers to Ernst & Young, and there is no copy of them in the files of Ernst & Young.
18. The IRS issued an Information Document Request (an “IDR”) to Textron requesting all of Textron’s tax accrual workpapers for 2001. Reluctant to turn over this detailed analysis of its most sensitive tax issues, Textron declined to do so. Textron, however, complied with all other IDRs, more than 500 of them.
19. The IRS therefore issued a summons for the tax accrual workpapers. When Textron still declined to produce the workpapers, the IRS petitioned the United States District Court for the District of Rhode Island to enforce the summons. Textron’s principal office is in Rhode Island.
The Textron Opinion
20. In district court, Textron defended against enforcing the summons on two grounds:
(a) First, that the tax accrual workpapers are protected as privileged attorney-client communications or as privileged tax practitioner communications and,
(b) Second, also are protected as attorney work product.
21. Although the district court agreed that the tax accrual workpapers were privileged communications when made, it ruled that Textron waived those privileges when it disclosed the workpapers to its financial auditors. Hence, the tax accrual workpapers lost the protection of the attorney-client privilege and the tax practitioner privilege.
22. That ruling is unremarkable. The cases uniformly hold that disclosing privileged communications to one’s auditors waives the attorney-client privilege and, by extension, the tax practitioner privilege.
23. The district court’s remarkable ruling is that the tax accrual workpapers are attorney work product and, therefore, need not be disclosed to the IRS.
24. For documents to qualify as attorney work product, they must be “prepared in anticipation of litigation or for trial.” FRCP 26(b)(3). Given that tax accrual workpapers are not prepared “for trial,” the relevant inquiry in Textron is whether they were prepared “in anticipation of litigation.”
25. In determining whether documents are “prepared in anticipation of litigation,” federal courts generally apply one of two tests:
(a) The “primary motivation” test or
(b) The “because of” test.
26. Some courts require that a document is prepared in anticipation of litigation only if the primary motivating force for creating the document is to assist in possible future litigation.
27. This is the more difficult of the two tests for tax accrual workpapers to satisfy. In the usual case, the primary reason for creating tax accrual workpapers is to document and support tax reserves, not to assist with litigation.
28. Other courts apply the more inclusive “because of” test to determine whether documents are prepared in anticipation of litigation. Those courts ask 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 because of the prospect of litigation.
29. Under either test, however, a document generally is not attorney work product if it is prepared in the ordinary course of business.
30. In some courts, furthermore, a document is not attorney work product if it would have created in substantially similar form irrespective of litigation.
31. Textron asserted that it prepared its tax accrual workpapers because it anticipated the possibility of litigation with the IRS regarding various items on its return. Textron relied upon its hazards of litigation percentages as evidence that the possibility of such litigation was the reason for preparing the tax accrual workpapers.
32. The IRS asserted that Textron prepared its tax accrual workpapers in the ordinary course of business and was primarily motivated by the need to support tax reserves.
33. The district court agreed with Textron. To begin with, the Textron court sits in Rhode Island, and its judgments are reviewable by the First Circuit. The First Circuit uses the more inclusive “because of” test, and so, necessarily, the Textron court did so as well.
34. The court also concluded that Textron would not have prepared the tax accrual workpapers at all but for the fact that Textron anticipated the possibility of litigation with the IRS.
35. In that same vein, the court stated that, even if it is accurate to say that the workpapers were used to establish tax reserves and to obtain a clean opinion from Ernst & Young -
#* * * there would have been no need to create a reserve in the first place, if Textron had not anticipated a dispute with the IRS that was likely to result in litigation or some other adversarial proceeding.
36. The court also was impressed that the tax accrual workpapers “dealt with issues on which the law was unclear” and that in seven of Textron’s eight previous audit cycles it had contested tax adjustments before the Office of Appeals and had litigated three tax issues in federal court.
37. The district court also ruled that, even though disclosing the tax accrual workpapers to the financial auditors waived the privileges, that disclosure did not waive the protection of the attorney work product doctrine.
(a) Although a disclosure of privileged communications to any third party waives the privilege, a disclosure of attorney work product to a third party waives the protection of the attorney work product doctrine only if the third party is “adverse” or is likely to disclose the attorney work product to a person who is adverse.
38. Here, the district ruled that Textron’s auditors are not adverse to Textron, and so by disclosing the tax accrual workpapers to its auditors Textron did not waive the protection of the attorney work product doctrine.
39. Most courts that recently have considered the question have ruled that auditors are not adverse to their clients, but that result is far from assured.
40. The district court did not address the question whether, even if Textron had not anticipated litigation, it would have prepared the tax accrual workpapers in a substantially similar form. As mentioned above, even if the “because of” test is otherwise satisfied some courts will deny protection as attorney work product for documents that would have been prepared in substantially similar form even if the taxpayer were not concerned about litigation.
41. Nor did the district court address a question that some other courts have considered, viz., whether documents that have a “dual purpose” may qualify as attorney work product.
42. Courts that apply the “primary motivation" test have no need to consider whether there may be a dual purpose, because only the primary purpose counts.
43. Some courts that apply a “because of” test have ruled that documents may be attorney work product even if they are prepared for dual purposes, such as both to serve a business purpose and also in anticipation of litigation.
(a) If one of the dual purposes for preparing a document is because of anticipated litigation, the document is attorney work product even if the business purpose if primary and the litigation purpose is secondary.
Implementing the Lessons of Textron
44. Textron demonstrates the value of the attorney work product doctrine in protecting sensitive and confidential tax advice. This demonstration is especially useful in this post-Sarbanes-Oxley era when companies must disclose all privileged tax opinions to their financial auditors, thereby waiving the attorney-client privilege and the tax practitioner privilege.
45. Textron’s defense against the IRS summons benefited from the following favorable facts, which are worth emulating to the extent feasible:
(a) Textron relied upon tax lawyers to create the work product.
(i) To be sure, “work product” need not be “attorney work product” to be protected against compelled disclosure, so long as the work product is prepared by or for a party in anticipation of litigation or for trial.
(ii) However, it is much easier to prove that a document is prepared in anticipation of litigation if an attorney prepares it or directs its preparation.
(iii) In the context of protecting tax information, the better practice is that the attorney be an experienced tax attorney.
(b) Textron’s tax lawyers reviewed proposed transactions and, prior to preparing tax accrual workpapers, identified the risky tax issues, wrote memoranda of law and fact, and assessed the prospects for success in litigation.
(c) All or substantially all of the tax accrual workpapers are the work of tax attorneys or persons working for them.
(d) On the assumption that the tax accrual workpapers are attorney work product, they are a type of attorney work product – “opinion work product” – that, if disclosed, reveals the attorneys’ mental impressions, conclusions, opinions and legal theories. Opinion work product enjoys greater protection than other attorney work product:
(i) Unlike the attorney-client privilege, which affords nearly absolute protection against compelled disclosure, the attorney work product doctrine affords only qualified protection.
(ii) An adverse party is entitled to obtain attorney work product upon demonstrating a substantial need for the materials and, in addition, that it will be a substantial hardship to obtain that information in any other way.
(iii) FRCP 26(b)(3) and the courts, however, afford greater protection to opinion work product than to ordinary work product. The rationale is that one’s adversary is not entitled to know what one’s lawyers think about the case.
(e) Textron is under continuous examination.
(f) Textron often takes contested issues to the Office of Appeals and to court.
(g) Ernst & Young must keep the tax accrual workpapers confidential.
(h) Textron did not give a copy of the tax accrual workpapers to Ernst & Young, where the PCAOB and, by extension, the SEC or DOJ might see them.
(i) Textron did not disclose the tax accrual workpapers to any other third parties.
(j) Textron complied with all other of the more than 500 IDRs, thereby demonstrating both its cooperation with the IRS and that the IRS already possessed all of the business and transactional records that it requested.
(k) Textron’s tax accrual workpapers consist, essentially, of tax counsels’ opinions about doubtful tax positions and assessments of the litigation risks. The workpapers do not include business or transactional records.
46. Favorable factors that are not mentioned in Textron include:
(a) It is helpful if the tax lawyers’ memoranda, in addition to finding and assessing risk, advise about ways to prepare for litigation or to re-structure a transaction so as to increase the prospects in litigation.
(b) It is likely that the issues to which the tax accrual workpapers relate are ones that the IRS will spot during the examination.
(c) The IRS has stated that the tax issue or issues to which the tax accrual workpapers relate is a listed transaction or a Tier 1 transaction or, otherwise, is a transaction that the IRS likely will challenge and litigate. Perhaps the IRS has litigated the issue before.
(d) The auditors – or any person or agency to whom attorney work product is disclosed – agree in writing to keep the attorney work product confidential.
Prospects on Appeal
47. The United States doubtless will appeal to the First Circuit, and the appeal will be a close contest. Expect the United States to make the following arguments:
(a) The tax accrual workpapers are not attorney work product because they are prepared in the ordinary course of business.
(b) The tax accrual workpapers are not attorney work product because they would be prepared in substantially the same form if Textron did not anticipate litigation.
(c) The district court erred in concluding that, just because a taxpayer identifies a tax issue as risky and reserves for it, it is reasonable to anticipate litigating that issue.
(d) It is not reasonable for Textron to anticipate that every issue identified in its tax accrual workpapers is destined for litigation.
(e) Textron waived the protection of the attorney work product doctrine by disclosing the tax accrual workpapers to its financial auditors. That is, the auditors are adverse to Textron or are likely to disclose the workpapers to persons who are adverse.
(f) The tax accrual workpapers are highly relevant to an income tax examination, and so, even if they are attorney work product, the IRS’s need to review them outweighs Textron’s need to keep them confidential.
A Cautionary Note About Variations in the Law
48. Because the various United States Courts of Appeals variously analyze and apply the “in anticipation of litigation” language of FRCP 26(b)(3), the prospects for protecting tax accrual workpapers as attorney work product depend in part on where the taxpayer is located. The majority of our tax clients are located within the Second, Fourth, Fifth and Eleventh Circuits.
49. The Second Circuit – which handles appeals arising in Connecticut, New York and Vermont – tests for attorney work product using the “because of” test. That court, however, denies protection for documents that a party would have prepared in substantially similar form if it did not anticipate litigation.
50. The Fourth Circuit – which handles appeals arising in the Carolinas, Maryland, Virginia, and West Virginia – also applies a “because of” test, but litigation must be the “driving force” behind preparing the documents. The party claiming protection as work product must show that it faced an actual claim or a potential claim following an actual event or series of events that reasonably could result in litigation.
51. The Fifth Circuit – which handles appeals arising out of Louisiana, Mississippi and Texas – applies a “primary motivation” test, and it has declined to protect tax accrual workpapers as attorney work product.
52. The Eleventh Circuit – which handles appeals arising out of Alabama, Florida and Georgia – has not adopted any particular test for applying the “in anticipation of litigation” language of FRCP 26(b)(3).
53. There is debate, however, whether the former Fifth Circuit, from which the Eleventh Circuit was formed in 1981 and whose opinions bind the Eleventh Circuit, adopted the “primary motivation” test. If so, then the “primary motivation” test is the law in the Eleventh Circuit.
Regardless of where appellate venue lies, to protect tax accrual workpapers – or any documents – as attorney work product requires undertaking purposeful acts at the time of preparing the documents to do all that is feasible to qualify them as attorney work product.