TaxTrends
Recent Cases and Rulings
James Beavers, J.D., LL.M., CPA
Practice & Procedures
District Court Holds That Tax Accrual Workpapers Are Privileged Documents
A district court in the First Circuit held that a corporation did not have to turn over tax accrual workpapers to the IRS because the work-product privilege applied to the workpapers. The court also found that the attorney-client and tax-practitioner privileges could have applied to the workpapers, but the corporation had waived these privileges by sharing the work-papers with its independent auditors.
Background
Textron, Inc. (Textron) is a publicly traded conglomerate with approximately 190 subsidiaries. Like other large corporations, Textron’s federal tax returns are audited periodically. During the audits, the Service examines the returns for the tax years that are part of the audit cycle. In seven of its past eight audit cycles before the cycle at issue (which covered the years 1998–2001), Textron appealed disputed matters to the IRS Appeals Board; three of these disputes resulted in litigation.
On an annual basis, Textron and its subsidiaries prepare tax accrual workpapers. The subsidiaries’ workpapers were used in the preparation of Textron’s workpapers. The workpapers consisted of:
(1) A spreadsheet containing:
(a) Lists of items on Textron’s tax returns, which, in the opinion of Textron’s counsel, involved issues on which the tax laws were unclear and therefore might be challenged by the IRS;
(b) Estimates by Textron’s counsel expressing, in percentage terms, their judgments regarding Textron’s chances of prevailing in any litigation over those issues (hazards of litigation percentages); and
(c) The dollar amounts reserved to reflect the possibility that Textron might not prevail in such litigation (tax reserve amounts).
(2) Backup workpapers consisting of the previous year’s spreadsheet and earlier drafts of the spreadsheet together with notes and memoranda written by Textron’s in-house tax attorneys reflecting their opinions as to which items should be included on the spreadsheet and the hazard of litigation percentage that should apply to each item.
The tax accrual workpapers for Textron were prepared by attorneys and CPAs working for Textron. Textron’s subsidiary companies prepared their workpapers with some input from private law firms and outside accounting firms. According to Textron officials, Textron’s ultimate purpose in preparing the tax accrual workpapers was to ensure that Textron was “adequately reserved with respect to any potential disputes or litigation that would happen in the future.”
IRS Document Requests
In conducting its audit of Textron for the 1998–2001 audit cycle, the IRS followed its standard procedure for gathering relevant information by issuing information document requests (IDRs) to Textron. During the audit cycle, the Service issued more than 500 IDRs, and Textron complied with all of them, except for the ones seeking the tax accrual workpapers of Textron and one of its subsidiaries, Textron Financial Corporation (TFC). The IRS was interested in these workpapers because it believed they contained information on certain sales and leasing transactions by TFC that the IRS believed were tax shelter transactions. Under its general policy of restraint, the Service does not usually request tax accrual workpapers as part of an examination. However, this policy does not apply in an examination that involves listed transactions.
Because Textron did not provide the workpapers in response to the IDRs, the IRS issued an administrative summons for “all of the Tax Accrual Workpapers” for Textron’s tax year ending on December 29, 2001. Textron again refused to produce the workpapers, asserting that they were protected by attorney-client, tax practitioner–client, and work-product privileges. The IRS petitioned a district court to enforce the summons against Textron. As described below, the district court, after considering whether the privileges applied and whether Textron had waived the privileges, held that work-product privilege applied and had not been waived, so Textron did not have to give its tax accrual workpapers to the IRS.
Attorney-Client Privilege
The attorney-client privilege protects confidential communications between an attorney and a client relating to legal advice sought from the attorney. If the communications are not related to legal representation or to the provision of legal advice by an attorney, the communications are not covered by the attorney-client privilege.Therefore, communications between an attorney and a client in the course of an attorney’s providing accounting services are not privileged.
Textron argued that its tax accrual workpapers were privileged because they were prepared by attorneys and reflected their legal conclusions in identifying items on Textron’s return that might be challenged and assessing Textron’s prospects of prevailing in any ensuing litigation. The IRS argued that Textron’s tax accrual workpapers were not protected by the attorney-client privilege because, in preparing them, Textron’s attorneys were performing an accounting function by reconciling the company’s tax records and financial statements.
The court noted that the mere preparation of a tax return is viewed as accounting work and that a taxpayer could not change this simply by having an attorney perform the work. However, the court stated that it is equally true that communications containing legal advice provided by an attorney may be privileged even though they are made in connection with the preparation of a return. According to the court, in the context of an IRS audit, where representation by an attorney during an audit consists of verifying the accuracy of a return, the work is accounting work, but if an attorney participates in an audit to deal with issues of statutory interpretation or case law that may have been raised in connection with examination of the taxpayer’s return, the attorney is doing “lawyer’s work” and the attorney-client privilege may attach to that work.
The court found that Textron’s tax accrual workpapers essentially consisted of nothing more than its attorneys’ opinions regarding items that might be challenged due to uncertainty in the law and their assessments regarding Textron’s chances of prevailing in any ensuing litigation. Therefore, it held that the preparation of the workpapers was lawyer’s work that was protected by the attorney-client privilege.
Tax Practitioner–Client Privilege
The tax practitioner–client privilege is a statutorily created extension of the attorney-client privilege. Sec. 7525(a)(1) states that:
With respect to tax advice, the same common law protections of confidentiality which apply to a communication between a taxpayer and an attorney shall also apply to a communication between a taxpayer and any federally authorized tax practitioner to the extent the communication would be considered a privileged communication if it were between a taxpayer and an attorney.
Because the attorney-client privilege does not apply when an attorney performs accounting work (such as preparing a tax return), the tax practitioner–client privilege does not apply when a tax practitioner prepares a tax return. It also does not apply to written communications between the tax practitioner and a client “in connection with the promotion of the direct or indirect participation of the person in any tax shelter” (Sec. 7525(b)(2)).
The Service argued that to the extent that the workpapers reflected the advice of the CPAs working in Textron’s tax department, the tax practitioner–client privilege did not apply because the work the accountants performed did not qualify for attorney-client privilege or because the work involved the promotion of a tax shelter. Because, with respect to the workpapers, Textron’s tax accountants—like its attorneys—advised Textron regarding its tax liability on matters on which the law is uncertain and/or estimated the hazards of litigation percentages, the court ruled that they were performing work that would qualify for the attorney-client privilege. It rejected the IRS’s contention that the privilege did not apply under the promotion of a tax shelter exception because, looking at the legislative background of Sec. 7525, it determined that Sec. 7525(b) was meant to apply to outside accountants who were involved in the sale of tax shelters. Therefore, even though the workpapers discussed certain transactions that qualified as tax shelters, this exception to the privilege did not apply because they were prepared by Textron’s inside CPAs.
Work-Product Privilege
The work-product privilege (or work-product doctrine, as it is frequently called) is related to the attorney-client privilege. It applies to materials prepared or gathered by an attorney in anticipation of litigation. Under this privilege (codified in Federal Rule of Civil Procedure 26(b)(3)), a party seeking an attorney’s work product covered by the privilege is entitled to it only on a showing of a substantial need for it. The privilege can be invoked in response to an IRS summons.
Anticipation of litigation: Courts have applied two different tests to determine whether a document was prepared in anticipation of litigation, the “primary purpose” test and the “because of” test. For a document to be privileged under the primary purpose test, anticipation of litigation must be the primary purpose of the document’s creation. The Fifth Circuit, in El Paso Co., 682 F2d 530 (5th Cir. 1982), held that a taxpayer’s tax accrual workpapers (which contained information similar to Textron’s workpapers) were not work product because they were created primarily for use in its outside financial audit.
Under the because of test, documents are held to be prepared in anticipation of litigation if they were prepared or obtained because of the prospect of litigation. The practical difference between this test and the primary purpose test in the context of tax litigation is that, under this test, documents that include assessments of the potential and estimated cost of litigation can be considered to have been created in anticipation of litigation even if they were primarily created or used for purposes other than litigation. However, the party claiming the privilege must show that they subjectively believed that litigation was possible, and that belief must be objectively reasonable. (See Adlman, 134 F3d 1194 (2dCir. 1998).)
With respect to the work-product privilege, the Service tried to convince the court to adopt the primary purpose test. It asserted that Textron prepared the workpapers in the ordinary course of business in order to satisfy the securities laws’ requirements that financial statements filed by publicly traded companies comply with GAAP (which mandate the creation of reserves to meet contingent liabilities). The IRS contended that Textron had to provide its independent auditor with the kind of information contained in the workpapers in order to obtain a “clean” audit opinion. Because the documents were prepared in the ordinary course of business, the IRS argued that the anticipation of litigation requirement of the work-product privilege was not met.
Textron argued that the court should use the because of test. It asserted that its tax accrual workpapers were prepared because it anticipated the possibility of litigation with the IRS regarding various items on its return, pointing to the hazards of litigation percentages contained in the workpapers as evidence that the possibility of such litigation was the reason they were prepared. It pointed to the unsettled nature of the law surrounding the issues discussed in the workpapers and its history of controversy and litigation with the IRS as evidence that it actually believed litigation was possible and that this belief was reasonable.
The district court, which lies in the First Circuit, applied the because of test because the First Circuit had adopted that standard in an earlier nontax case (Maine v. Dept. of the Interior, 298 F3d 60 (1st Cir. 2002)). Applying the test, the court reasoned that while it might be accurate to say that the workpapers helped Textron determine what amount should be reserved to cover any potential tax liabilities and that the workpapers were useful in obtaining a clean opinion from its outside auditors, there would have been no need to create a reserve if Textron had not anticipated a dispute with the IRS that was likely to result in litigation or some other adversarial proceeding. Therefore, the reserve for liabilities and, by extension, the tax accrual workpapers were created because of anticipated litigation with the IRS. The court also agreed with Textron that due to the unsettled state of the law and Textron’s previous history with the IRS, Textron’s anticipation of litigation in this case was well founded.
Substantial need: In addition to arguing that the work-product privilege did not apply, the Service argued that if it did apply, it should be disregarded because the IRS had a substantial need for the information in the tax accrual workpapers. The district court stated that although the workpapers were relevant to the IRS’s audit, they provided only the opinions and conclusions of Textron’s attorneys and accountants and did not provide any factual information that would assist the Service in determining Textron’s tax liability. Because the information in the workpapers had little bearing on the determination of Textron’s tax liability, the court held that the IRS had no substantial need for the information that would override the privilege.
Waiver of the Privileges
The Service further argued that by sharing the workpapers with its independent auditors, Textron had waived all three privileges. The court agreed with the IRS about the attorney-client and tax practitioner–client privileges but disagreed about the work-product privilege. According to the court, the purpose of the attorney-client and tax practitioner–client privileges is to insure that confidential communications between a client and an adviser remain confidential, while the work-product privilege’s purpose is to prevent an adversary from obtaining an unfair advantage in litigation by obtaining documents prepared in anticipation of litigation. Because any dissemination of documents to a third party necessarily destroys confidentiality, the court held that Textron had waived the attorney-client and tax practitioner–client privilege by giving the documents to its auditors. However, because giving the workpapers to the independent auditors was not inconsistent with the purpose of the work-product privilege (i.e., in this case, keeping the documents from the IRS), the court held that Textron had not waived the work-product privilege by doing so.
Textron, Inc., D. R.I. (8/28/07)
IRS Announces Its Nonacquiescence to Roxworthy Decision
The IRS issued an action on decision (AOD) announcing its nonacquiescence to the Sixth Circuit’s decision in Roxworthy, 457 F3d 590 (6th Cir. 2006). In that case, the Sixth Circuit held that certain memos a corporation received from an outside accounting firm were privileged under the work-product privilege. In the AOD, the Service stated that it intends to continue to vigorously pursue the enforcement of its summons and to challenge taxpayers’ privilege claims where appropriate.
Background and District Court Litigation
As part of an audit, the IRS issued an informal document request to Yum! Brands, Inc. (Yum). Yum claimed that seven of the items requested were protected by the work-product privilege. An administrative summons seeking the production of these documents was served on Patrick J. Roxworthy (Roxworthy) in his capacity as vice president of tax at Yum. Roxworthy refused to produce two of these documents, which were memos prepared by a Big Four accounting firm analyzing the tax consequences of certain transactions entered into by Yum pertaining to the creation of a captive insurance company and the subsequent sale of the captive’s stock at a substantial loss; they included arguments that the IRS might assert against Yum’s treatment of the transaction and possible counter-
arguments.
The IRS filed a petition in district court to enforce the summons as it related to the two opinion letters, arguing that the documents were not created in anticipation of litigation, so the work-product privilege did not apply. The case was referred to a magistrate judge. In his defense, Roxworthy filed affidavits from an in-house Yum attorney and a partner from the accounting firm asserting that the documents were produced in anticipation of litigation and therefore were privileged under the work-product privilege.
The magistrate judge applied the because of test to determine whether the memos were created in anticipation of litigation. In addition to proving that the documents in question were created for litigation purposes, under the because of test, the party claiming privilege must show that it subjectively believed that litigation was possible, and the belief must be objectively reasonable. The magistrate judge found that the affidavits did not include any information to back up the assertions that the memos were created in anticipation of litigation and that the other evidence surrounding the memos’ creation suggested that the documents were not created in anticipation of litigation. In particular, the magistrate judge stated that several issues regarding the timing of the actual transaction and the creation of the memos, as well as some language in the memos, suggested that it was likely the memos were created to support the positions taken in Yum’s tax return. Furthermore, the court found that because the memos were created before the IRS even initiated an audit of Yum, the prospect of litigation was so remote that the creation of the documents could not be reasonably said to be in anticipation of litigation.
Roxworthy objected to this finding and requested that the district court include additional affidavits in the record. The district granted the request. The affidavits described in more detail Yum’s reasons for anticipating litigation: the huge difference between its book and tax loss due to the transaction, the certainty of audit due to Yum’s size, the unsettled nature of the law in the area, and Yum’s belief that the IRS was inclined to litigate over the transaction. In his objection, Roxworthy also pointed out several factual errors made by the magistrate judge in his report. However, after considering the new affidavits and the errors’ effect on the magistrate judge’s findings, the district court decided to adopt the magistrate’s report and recommendation as the court’s opinion. Roxworthy appealed the decision to the Sixth Circuit.
Sixth Circuit Decision
The Sixth Circuit reversed the district court and held that the work-product privilege applied to the memos. Like the district court, the circuit court focused on the function that the documents served in determining whether the anticipation of litigation standard was met. However, the circuit court held that Yum’s additional affidavits were sufficient to prove that the memos were created in anticipation of litigation, unless they were shown to be false by other evidence, because they were made by individuals with personal knowledge of the situation and provided plausible reasons for Yum’s anticipation of litigation. Contrary to the district court, the circuit court also found that the timing of the memos’ creation did not necessarily suggest that the memos were not created in anticipation of litigation. It further concluded that the errors in the magistrate judge’s report cited by Roxworthy invalidated the report’s other conclusions. Having effectively eliminated all the evidence in the magistrate judge’s report, the circuit court found that there was no evidence in the record that disproved the affidavits of Yum personnel that Roxworthy had provided. Therefore, it held that the affidavits proved that the memos were created in anticipation of litigation and were protected by the work-product privilege.
IRS Nonacquiescence
The IRS has announced that it does not acquiesce to the Sixth Circuit’s decision in Roxworthy and “will continue to aggressively seek the enforcement of summonses, challenging unjustified assertions of the work-product doctrine (and other privileges) in all appropriate cases, including those that would be appealable to the Sixth Circuit.” In agreement with the district court, the Service argues that the possibility of litigation was too remote for the work-product privilege to apply. Further, the IRS contends that the district court correctly determined that the evidence in the record, particularly regarding the timing of the memos’ creation, suggested that they were not created in anticipation of litigation and that this evidence was sufficient to controvert the “after-the-fact, self-serving statements of Yum personnel involved in planning and executing the transaction.” In addition, according to the IRS, the circuit court should have remanded the case to the district court for further consideration rather than substituting its evaluation of the evidence in place of the district court’s evaluation.
Action on Decision 2007-04, 2007-40 IRB (10/1/07)
Tax Court Holds That IRS Litigation Memos Are Protected Work Product
The Tax Court held that the IRS did not have to turn over memos prepared by IRS personnel during the course of litigation because the memos were protected by the work-product privilege and the IRS had not waived the privilege with respect to the documents.
Background
Thomas and Bonnie Ratke (the taxpayers) timely filed their 1993 federal tax return. In 1996, the IRS sent the taxpayers a notice of deficiency for additional taxes and penalties for 1993. On March 29, 1996, the taxpayers filed suit in the Tax Court disputing the entire amount of the deficiency. On the same day, they also sent the IRS an amended return for 1993 that showed an additional deficiency for the year. In May 1996, the IRS made an assessment for the deficiency amount the taxpayers reported on the amended return plus interest.
In March 1997, the taxpayers settled with the IRS, and the Tax Court entered a decision that they owed a small deficiency for 1993 and no penalties. In May 1997, the Service assessed the deficiency agreed to in the settlement. However, it also sent the taxpayers a notice and demand for the amount they had reported as due on their amended return for 1993.
The taxpayers filed a petition in the Tax Court challenging the IRS’s attempts to collect the amount reported as due on the 1993 amended return. The case eventually went to trial and the Tax Court held that the Service could not collect the amount reported as due on the amended return. While preparing for trial, the IRS attorney assigned to the case prepared a memo to the National Office asking for its advice. The memo described the facts in the case and several arguments that the attorney would make in the litigation with the National Office’s approval. A National Office representative sent a reply memo to the attorney that set out the National Office’s opinion on the attorney’s proposed legal arguments.
After the Tax Court issued its decision, the taxpayers moved for an award of costs under Sec. 7430 and later moved for sanctions under Sec. 6673(a)(2). In the course of this further litigation, the IRS provided the taxpayers with a redacted copy of the National Office’s reply memo. The taxpayers later made a discovery request for the trial attorney’s memo and a full copy of the National Office memo. The Service objected to the request on the ground that the opinion information in the memos was protected by the work-product privilege and that the factual information in them was well known to the taxpayers.
The taxpayers argued that although the memos were work product, they were prepared for the “case in chief” and were not privileged for purposes of the “post-decision application for litigation costs and sanctions.”They also argued that they had a substantial need for the information in the memos and they could not obtain the information elsewhere. Finally, the taxpayers argued that the IRS had used the National Office memo as evidence in its defense to the taxpayers’ motions for costs and sanctions and therefore had waived the work-product privilege.
Tax Court’s Analysis
After reviewing the memos in camera, the court found that the memos discussed the intended arguments to be made in the case and that both were prepared in the course of litigation, so they were privileged work product prepared for use in the litigation. The court dismissed the taxpayers’ argument that the memos were not work product for purposes of the taxpayers’ motions for costs and sanctions. The court stated that the taxpayers had failed to point to any precedent for the proposition that the litigation should be separated for work-product purposes into a case in chief and an application for costs and sanctions, as the taxpayers suggested. It noted that the Tax Court and all appeals courts that have addressed the issue had previously held that, to a limited degree, the work-product privilege extends to subsequent litigation.Also, on the basis of its review of the memos, the court found that there was no factual evidence in the memos that would be of use to the taxpayers that they did not already have, so they had no substantial need for the memos that could overcome the work-product privilege.
The court also found that the IRS had not waived the work-product privilege by using the memos’ contents as evidence in the litigation. The court agreed that a use of otherwise privileged documents as evidence in a case (a “testimonial use” of the documents) could be held to be a waiver of privilege in order to prevent a party from unfairly using favorable parts of the documents while not revealing the unfavorable parts. However, the court found that while the IRS had referred to the documents in its response to the taxpayers’ motion for costs, it had not used them as evidence to support its position, so it had not waived the work-product privilege.
Thomas J. Ratke, 129 TC No. 6 (2007)
Reflections
In applying the “because of” test, the district court in Textron focuses on the contents of the tax accrual workpapers rather than their function. This approach essentially changes the “in anticipation of litigation” standard to a “where there is any possibility of litigation” standard. If this interpretation is followed by other courts using the because of test, it will be virtually impossible in these courts for the IRS to obtain documents that contain legal opinions or hazards of litigation assessments, whether the documents are tax accrual workpapers or other memoranda. While this interpretation of the anticipation of litigation standard yields the correct practical result (i.e., the IRS does not get the taxpayer’s opinion-based work product that is irrelevant to the purposes of the audit), it arguably stretches the protection of the work-product privilege beyond its proper bounds. IRS Chief Counsel Donald Korb has stated on the record several times that the IRS believes Textron was wrongly decided. The Justice Department has filed a notice of intent to appeal the decision, but, according to Korb, a final decision on whether to pursue an appeal has not been made.
In Roxworthy, the Sixth Circuit holds that the key issue in the work-product privilege determination is the function the documents are created to serve. Taking this approach in applying the because of test, the court treated the contents of the memos only as evidence that indicates the memos were created in part in anticipation of litigation. This made it at least possible for the IRS to prove through other evidence that the memos were not created in anticipation of litigation. However, as the case shows, it will not necessarily be easy for the IRS to prove that documents containing legal opinions or arguments were not created in part for use in litigation.
