Tax-accrual workpapers prepared by a company to determine how much cash it should reserve in case the IRS disputed its tax returns were protected by the work-product doctrine, the 1st U.S. Circuit Court of Appeals has ruled.

The government argued that the work-product privilege was inapplicable because tax disputes with the IRS do not constitute litigation and because the workpapers were prepared to meet business and regulatory requirements and not solely in anticipation of litigation.

But the 1st Circuit disagreed, affirming a ruling in U.S. District Court in Massachusetts.

“[T]he resolution of disputes through adversary administrative processes, including proceedings before the IRS Appeals Board, meets the definition of litigation,” wrote Judge Juan R. Torruella for a 2-1
majority.

“Like in the case where a company analyzes pending litigation for the purpose of setting aside a reserve, … here the business purpose [for the workpapers] derives from and is inextricably related to anticipating litigation,” Torruella continued. “That the anticipation of such disputes (and corresponding potential litigation) also triggered certain business and accounting obligations does not bar the protection of the work-product doctrine.”

The 50-page decision is United States v. Textron Inc. and Subsidiaries, Lawyers Weekly No. 01-015-09.

Comfort for companies

The decision should “give comfort” to companies that they can thoroughly analyze their tax positions without having their internal thought processes used against them later, said Brian D. Bixby of Burns & Levinson in Boston, chairman of the Massachusetts Bar Association’s Taxation Section Council.

“[The ruling] is consistent with supporting the idea of the legitimacy of tax avoidance as opposed to the illegitimacy of tax evasion,” he added. “In other words, there’s nothing wrong with assessing whether a questionable position is supportable and, if so, what type of risks there are to the bottom line.”

Bixby also suggested that companies place the words “work product” directly on an internal memorandum like the one in Textron in order to show that the document is intended for internal use, and not for an independent outside auditor.

Further, he said, the 1st Circuit’s decision leaves another issue for attorneys to ponder: whether a company could ultimately choose to provide such work product to defend itself in litigation by showing that it truly believed it was taking a reasonable position.

John A. Tarantino of Adler, Pollock & Sheehan in Providence, R.I., who represented the company, declined to comment pending ongoing litigation in the matter.

A spokesperson for the U.S. Department of Justice’s Tax Division, which handled the case for the government, also declined to comment.

Disclosure dispute

Defendant Textron Inc. is a $12 billion Providence-based corporation that serves the defense, aviation and aerospace industries.

In conjunction with its 2001 tax returns, Textron prepared a series of “tax accrual workpapers” that listed questionable positions it took on its returns, estimated the likelihood these positions would be disputed by the IRS and calculated the amount of additional tax liability that would result if it was forced to revise its positions.

Textron prepared these estimates so it could maintain adequate cash reserves in order to cover any additional liability and so it could obtain independent certification of its financial statements from its outside auditor, Ernst & Young, in compliance with securities law.

When the IRS noticed potential tax shelter transactions on the part of Textron, it issued an administrative summons to the company pursuant to §1602 of the Internal Revenue Code seeking discovery of the workpapers for its 2001 returns.
Textron refused to comply, asserting a number of defenses, including the work-product privilege.

The government subsequently sued the company in U.S. District Court in Rhode Island,
seeking to enforce the IRS’ subpoena.

The government’s expert testified that securities law requires public companies to obtain a letter from an outside auditor approving the company’s financial statements. Part of this audit, the expert stated, is an analysis of the company’s reserves for covering tax loss.

Accordingly, the government argued, Textron prepared the documents as part of its regular course of doing business, rather than in anticipation of litigation, and thus the documents are not protected by the work-product privilege.

Textron’s expert, meanwhile, testified that the company prepared the workpapers to determine whether it was adequately reserved regarding any potential disputes or litigation that might occur with the IRS in the future.

The company argued that the documents were indeed prepared in anticipation of litigation.

Judge Ernest C. Torres found that while Textron had prepared the papers in order to obtain a favorable opinion letter from Ernst & Young regarding the accuracy of its financial statements, there would have been no need for such reserves if the company did not anticipate a dispute with the IRS likely to result in an adversarial proceeding.
As a result, the judge ruled, Textron was not required to produce the workpapers to the IRS.

The government appealed.

Shielded by privilege

The government argued that the preparation of tax returns is intended to be a “self-reporting regime” relying on taxpayers’ good faith rather than an adversarial process, and that in seeking the workpapers, the IRS was not trying to gain an unfair litigation advantage but to verify a company’s self-assessment of tax liabilities in a setting where the company held all relevant information.

But the court was not convinced.

“[G]ood faith disputes regarding the proper application of tax law … arise during the audit process,” said Torruella. “Thus, though the initial processing of these disputes in the audit process may not be adversarial, the disputes themselves are essentially adversarial; the subject of these disputes will become the subject of litigation unless the dispute is resolved.”

The 1st Circuit also rejected the government’s contention that because Textron did not prepare the workpapers solely in anticipation of litigation, but in the ordinary course of business to meet regulatory requirements, the papers are not shielded by the privilege.
In doing so, the court turned to the “because of” standard used in addressing documents prepared for multiple purposes.

As Torruella explained, the privilege won’t apply where the preparer of a document simply had the prospect of litigation in mind when creating it; rather, the “because of” test “really turns on whether it would have been prepared irrespective of the expected litigation with the IRS.”

In this case, the function of the documents was to analyze litigation for the purpose of creating and auditing a reserve fund, and, therefore, the “driving force” behind the documents was the need to reserve money in anticipation of a dispute with the IRS, Torruella said.

“In this way, we read the district court’s ‘but for’ reasoning as a way of expressing its conclusion that the documents would not have been prepared irrespective of the prospect of litigation, but rather were prepared ‘because of’ the risk of disputes and litigation which gave rise to a need to compute and report tax reserves,” he said.
Torruella further pointed out that if the court adopted the government’s position that documents created to satisfy audit-reporting requirements are not protected, “opposing counsel in the litigation might be able to discover such a memo, effectively disclosing counsel’s ultimate mental impression of the case.”

Thus, the 1st Circuit concluded, the judge below correctly determined that the workpapers are protected. The court did, however, remand the case back to the lower court for a determination as to the discoverability of Ernst & Young’s workpapers stemming from its audit of Textron.

Judge Michael Boudin dissented.

“The central issue is whether Textron’s tax-accrual work papers are protected from IRS summons because they are attorney work product,” he said. “Any lawyer might be unnerved to find that his potential adversary could obtain the lawyer’s own estimate of his chances of success. But under our own precedent and consistent with other circuits, tax-accrual work papers are not protected because they are prepared for reasons independent of the need to prepare for or conduct litigation.”

Eric T. Berkman, formerly a reporter for Massachusetts and Rhode Island Lawyers Weekly, is a freelance writer.