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Two Recent Opinions Shape IRS Access to Work Product
This article raises serious concerns for all business lawyers and, specifically, for tax lawyers. The IRS wants to see your files and those of the accountants with whom and for whom you work!
If the IRS wants your files, these cases and the IRS's after-action comments define an institutional commitment. For our friends and sometimes collaborators, the business litigators, the two principal cases merit attention as meaningful application of the tests to determine when "dual purpose" documents were prepared in anticipation of litigation.
1. Tax accrual workpapers prepared specifically for review by the outside auditor ("auditor") were also prepared "because of" anticipated litigation with the IRS.
2. Even where the attorney-client privilege has been waived by disclosure of protected communications to an unrelated third party, the protection of attorney work product was not waived when the "friendly" unrelated third party received the protected communications under an agreement, or understanding of confidentially and non-disclosure.
Context: Audited Financial Statements and Tax Accrual Workpapers
Any business enterprise that wants a clean "audited" financial statement must provide "tax accrual" workpapers to the auditor. Such enterprises include public companies, privately held businesses, nonprofits and any other entity that wants an audited financial statement. Those workpapers define litigation hazards for positions reported on tax returns that might be challenged by the IRS: areas where the tax law is unclear. Those hazards are assigned a dollar value. Those dollar values constitute "tax accruals." Since the proverbial bottom line benefits from the decreased tax expense, the auditors must determine what damage could be done if the IRS were to disallow that benefit. Just how "murky" were those uncharted tax waters?
Over the past decade, many of those "unclear areas" of tax law were packaged (including the obligatory independent legal opinion), wrapped with bright red bows, sold (perhaps for a percentage of the tax savings) and found their way to a number of tax returns. The IRS has various names for these bright shiny packages (abusive transactions, listed transactions and tax structured transactions). We know them as "tax shelters." Here's the rub.
The tax accrual workpapers explain the "weaknesses" of the shelters. Why? An audited financial represents to the world, as a practical matter, that all potential liabilities have been reviewed. Thus the audited entity must fully disclose all potential liabilities, including tax issues. From that information, the auditor decides how such liabilities will be treated in the financial statement. An entity will never fail to disclose fully, to the preparer of the audited financial statement, the potential for failure of an aggressive tax position; the consequences, criminal and civil, are too severe. The entity's lawyers and tax staff will obviously disclose as little as possible to satisfy their obligations to the auditor. Their discussions will still set out a clear "road map" of every weakness in the tax reporting positions. The taxpayer delivers those workpapers to an unrelated third party, the auditor, an accounting firm from which a clean audited financial statement is expected. How that information is transferred and the scope of the information transferred will be critical in determining if that information can be protected from an IRS summons.
A Change in Direction: The IRS Challenge
Historically, the IRS decided, quite deliberately, not to force production of tax accrual workpapers during the course of a tax audit. That policy recognized that any effort by the IRS to compel production of tax accrual workpapers could seriously inhibit a full discussion of the tax issues, to the detriment of the financial statement. That policy noted, appropriately, that the IRS's voluntary nonenforcement did not constitute a waiver or recognition that such communications were protected from a compulsory disclosure. Times changed.
In the latest wave of tax shelters, the IRS has aggressively pursued tax accrual workpapers. The IRS states it still exercises restraint. Tax accrual workpapers will not be required unless "listed transactions" are present (or suspected). That restraint might be withdrawn. The IRS believes the decision of United States v Arthur Young & Co., 465 U.S. 322 (1973), removes all privileges from tax accrual workpapers. See Internal Revenue Manual 18.104.22.168.2. Tax accrual workpapers and opinions of counsel or accountants represent a tempting target " the weaknesses ("soft spots") on the taxpayer's return coupled with a legal analysis. Any lawyer representing the IRS wants those documents to leverage his negotiating position at the earliest possible stage, not to mention the IRS agent trying to complete his examination.
Tax opinions and tax accrual workpapers are relevant and material in ascertaining the correctness of the reported liability for an internal revenue tax. If the IRS issues a summons during an IRS audit, those documents must be produced. In response to the summons, the taxpayer will assert, among other things, how the documents sought by the IRS are protected.
Protected Communications: The Tax World
Materials provided by and communications from a taxpayer, whether to an accountant or lawyer, to prepare a tax return are not protected communications. Legal advice to a taxpayer on the tax law and risks associated with litigation but not used in the preparation of the tax return can be protected by the (i) attorney-client privilege; (ii) practitioner privilege of IRC §7525 (unless involving the promotion of tax shelters or a criminal summons), and (iii) work product privilege. The attorney-client privilege and the practitioner privilege are waived if the materials are disclosed to a third party such as the auditors of the company's financial statements. Although the IRS does not apparently believe it, disclosure of materials to the auditors in the context of the audit of financial statements does not automatically waive the work product privilege. The circumstance of each disclosure must be carefully examined.
Two recent cases rejected the IRS's assault. In U. S. v. Textron, 507 F. Supp.2d 138 (D.R.I. 2007), the court applied work product protection when the IRS issued a summons to obtain tax accrual workpapers. In United States v. Roxworthy, 457 F.3d 590 (6th Cir. 2006) (Non-acquiesce AOD 2007-004, Oct. 1, 2007), the Sixth Circuit held that a tax opinion rendered by an accounting firm, prior to and unrelated to preparation of the tax return, was entitled to the work product protection. A little surprisingly, the IRS Chief Counsel, in recent public comments, has been harshly critical of both decisions, even though both appear well reasoned.
In Textron, tax accrual workpapers developed by Textron's in-house accountants and finalized by in-house counsel were "work product" even though disclosed to Textron's auditors as part of the financial audit. Textron, a large corporation, was under continuous audit and had a history of tax controversies with the IRS. During the years under examination by the IRS, Textron engaged in several "sale in lease out" ("SILO") transactions. The IRS classified SILOs as "listed transactions" while auditing Textron.
Via information document requests ("IDRs"), a standard IRS examination tool, the IRS requested and received the transaction documents and other factual information. The tax accrual work-papers requested by the IRS consisted of spreadsheets (and drafts of spreadsheets) containing (i) lists of items on Textron's tax return for which the tax law was unclear and on which Textron could be expected to be challenged by the IRS; (ii) counsel's estimates, expressed in percentage terms, of Textron's hazards in such litigation; and (iii) the dollar amounts reserved to reflect the possibility Textron might lose. The workpaper package requested also included back-up workpapers for prior spreadsheets and memoranda written by Textron's in-house attorneys or items to be addressed and hazards of litigation percentage. The workpapers did not contain the underlying transactional documents and factual materials. The IRS did not argue that the workpapers were prepared to assist in the tax return preparation. The workpapers were transmitted to the Textron's auditors with an express understanding of confidentiality.
1. Dual Purpose Documents: The U.S. Supreme Court has ruled that "the work product doctrine" does apply in tax summons enforcement proceedings. Upjohn v. U.S., 449 U.S. 383, 386 (1981). To obtain "work product" protection, a taxpayer must establish (i) the existence of the privilege and (ii) that the privilege has not been waived. It is commonly stated that the work product privilege does not apply to documents that are prepared in the ordinary course of business or that would have been created in essentially similar form irrespective of litigation. In dealing with dual purpose documents, one business and the other litigation, the United States Circuit Courts of Appeal, with two exceptions, apply the "because of" test. Was the document prepared or obtained "because of" the prospect of litigation, as well as another nonlitigation purpose? That theory was adopted by the First Circuit in Maine v. Dept. of the Interior, 298 F.2d 60 (1st Cir. 2002) and applied in Textron.
The other test for dual purpose documents requires that the "primary purpose" of the document be to aid in future litigation, a much more restrictive test. At this writing, only the Fifth Circuit maintains that test. The Eleventh Circuit has not adopted either test. Unfortunately, the Fifth Circuit applied the test in a case dealing with tax accrual workpapers. Naturally enough, the taxpayer failed the primary purpose test; the primary purpose was not to aid in future litigation but to satisfy accounting requirements for an audited financial statement. In the words of the Fifth Circuit, "... as long as the primary purpose behind creation of the document was to aid in future litigation ..." work product applied. U.S. v. El Paso Co., 682 F.2d 530, at 542 (5th Cir. 1982) [emphasis added].
The pressure point on tax accrual workpapers, and perhaps certain opinions, is whether they were prepared in anticipation of litigation or merely to make the auditors happy and receive a "clean" audit report on their financial statements. The IRS maintains flatly that the tax accrual workpapers are prepared exclusively for the business purpose of obtaining an audited financial statement. That point factually cannot be denied. Therefore, in the IRS's view the work product doctrine did not apply. The Textron court disagreed, focusing on why the auditor had to have the workpapers. The tax opinions and the analysis estimating litigation hazards would not have been prepared "but for" the fact that Textron anticipated litigating with the IRS. Textron had litigated tax issues over the years. The affidavit stating that fact was not challenged by the IRS. The court noted the actual tax litigation. The Textron court followed the view expressed in Long-Term Capital Holdings, et al. v. United States, 90 AFTR 2d. 7446 (D. Conn. 2002) (tax opinion furnished after the return was filed and disclosed to the financial accountants, was opinion work product) and, perhaps more on point, Jaffe Pension Plan v. [Household Int'l., Inc.] 237 F.R.D. 176 at 183 (N.D. Ill. 2006):
Plaintiffs insist that "[t]he documents at issue here were created pursuant to public requirements unrelated to litigation, and in fact, would have been created regardless of the litigation."... The court disagrees. In the absence of any pending or threatened litigation, Household's counsel would have had no need to advise [the independent auditor] regarding such non-existent matters. Thus the Opinion Letters were prepared "because of" pending or threatened litigation and are protected by the work product doctrine.
2. Waiver of Work Product Protection: The next step is whether Textron's delivery of the workpapers to its auditors waived work product protection. To waive work product protection, the product must be transferred to a party that will, directly or indirectly, permit inspection of the document by an adverse or potentially adverse party. The protection cannot be maintained when the document has been exposed to other adverse parties. Textron's transfer to its auditors was expressly conditioned on confidentiality of the materials transferred. No waiver occurred and that result discloses nothing new or unique in the law on waiver of work product protection. In contrast, the attorney-client privilege can be lost by transmitting a document to a nonlawyer unrelated third party, no matter how friendly. The Textron court found that the attorney-client privilege applied but had been waived by delivery to the auditor. The fact that the very same transmittal does not waive work product protection has great value, as noted in Textron.
3. The IRS's Rule 26 Need: The "work product doctrine" does not create absolute protection. Under Rule 26(b)(3), the protection will be removed when (i) a substantial need for the protected documents, and (ii) an inability to otherwise obtain the information contained therein or substantial equivalent without "undue hardship," can be shown by the requesting party. The Textron court reviewed the IRS's "need." The IRS's adjustments would be based on factual information, none of which was in the workpapers and all of which had been previously furnished to the IRS. The IRS and their lawyers would not experience any difficulty in defining the IRS litigating position based on the facts disclosed. The opinions of Textron's counsel had nothing to do with that determination. A forced disclosure of those opinions would put Textron at an unfair disadvantage in any potential dispute with the IRS. The court found, without any forced reasoning, that the IRS had not proven a "need." The parties were on equal footing.
(c) Roxworthy: A Tax Opinion and The Sixth Circuit's Very Useful Dual Purpose Analysis
Roxworthy concerned a specific and limited tax opinion prepared by KPMG, an accounting firm. Prior to the filing of a return, KPMG analyzed the tax consequences of a corporate transaction involving the creation of a captive insurance company and the subsequent sale of the captive stock at a substantial loss. KPMG's opinion was a dual purpose document, one a business purpose and the other in anticipation of litigation.
In reversing the District Court, the Sixth Circuit found that the tax opinion was "work product," even though prepared for a business purpose.
The court applied and adopted the "because of" test. The Sixth Circuit's factual analysis asked if (i) the document was created because of a party's subjective anticipation of litigation, as contrasted with an ordinary business purpose, and (ii) the subjective anticipation of litigation was objectively reasonable. The court specifically left open the question of whether an IRS audit constituted litigation for this purpose. The court stated:
Although not every audit is potentially the subject of litigation ... a document prepared in anticipation of "dealing with the IRS" ... may well have been prepared in anticipation of an administrative dispute and this may constitute "litigation" within the meaning of Rule 26, Hodges, Grant & Kaufman v. IRS, 768 F.2d 719. 719-22 (5th Cir. 1985). [457 F.3d at 600]
The court's analysis easily fits a tax opinion on a large transaction with significant losses, as to subjective and objective "anticipation of litigation." To be plain spoken, not the least doubt should exist that the IRS intends to litigate when a summons is issued. Certainly the taxpayer under examination fully expected and, therefore, anticipated that litigation.
IRS Chief Counsel's office issued an action on decision (AOD) on Roxworthy on Oct. 1, 2007. The IRS stated that it disagreed with the Roxworthy opinion and will continue to litigate that issue in the Sixth Circuit. No petition for certiorari was filed.
Indeed, the IRS's current hard attitude, as evidenced by the Roxworthy AOD and the new return preparer penalties, makes "subjective anticipation of litigation" a fact, particularly if significant dollars are at stake. Actual litigation " either in court and/or administratively " will occur.
A Summary and Some Suggestions
Textron should and has troubled the IRS. Roxworthy obviously troubles the IRS. The IRS response ignores what all of the Circuit Courts of Appeals have held. Taxpayers should take Textron and Roxworthy together, not alone, to understand the limits of protected communications when dealing with accountants. Despite the IRS's concern, the Sixth Circuit in Roxworthy did nothing more than adopt the current test for work product in a tax case. The IRS now has only the Fifth Circuit to support the primary purpose test in tax matters.
Candidly, the Supreme Court's Arthur Young decision appears to have been undermined by the "because of" test adopted by all of the other Circuits, excepting the Fifth and Eleventh. The Young decision itself suffers not; but the expansion of the decision to work product, as apparently urged by the IRS, has not happened since 1982 in the Fifth Circuit's El Paso Co. opinion.
For tax accrual workpapers, taxpayers would be well advised to consider seriously a Roxworthy approach for the legal memorandum and opinions: transmit only the percentages and reserve numbers in the accrual workpapers to the auditors and leave the legal opinions with the lawyers. Whether the auditors can live with such workpapers raises different questions. More significantly, will compliance lawyers, or the auditor's lawyers, be comfortable with the auditor relying on conclusions without having access to a detailed legal analysis of the hazards of litigation? The work product doctrine allows a client to obtain a lawyer's assessment of what might happen in litigation, without fear of disclosure to the world. In the tax world, a similar freedom should be expected if not connected to return preparation. When a taxpayer seeks a candid review of its chances in defending a tax position, fear of disclosure to the IRS should not be a concern, if appropriate steps were taken in restricting access to the work product.
Documenting custody of those workpapers and tax opinions, as well as restricting access, must be carefully monitored. Preparation and drafting the tax litigation hazards for accrual workpapers should be assigned only to administrative and/or court tax controversy personnel. Any substantial transaction, with tax hazards, should be reviewed by outside counsel and that analysis should never be delivered to the auditor. The auditors should be required to execute documents agreeing to keep the information reviewed confidential. The auditor's file should have the minimum documentation possible. When and to what extent the auditor should have access to opinions and memorandums discussing the risk analysis, becomes a real issue.
Stay tuned. Today, the IRS's use of a summons to obtain tax opinions and tax accrual workpapers probably will be limited to cases involving more aggressive reporting positions, generally listed transactions or worse. Unfortunately, IRS summons enforcement efforts can easily migrate to the more mundane returns of any entity having audited financial statements. An agent's view of aggressive may also migrate downward as well.
A Final Caution
IRS Chief Counsel Don Korb told reporters questioning him about Textron: "This victory may be short-lived." At a conference on Oct. 10, 2007, Korb said the IRS had not yet decided whether to appeal Textron, referring to, but not identifying, potential consequences beyond its specific facts. On Oct. 22, 2007, a notice of appeal was filed by the United States. Now the IRS will find how the First Circuit applies the "because of" test to tax accrual workpapers. The IRS views Arthur Young and U. S. v. El Paso as the gold standard.
Strategically, the IRS might have waited for a case, with better facts, in the Fifth Circuit, assuming that El Paso Co.'s primary purpose test will be applied. Going to the First Circuit seems to ensure a trip to the United States Supreme Court. The First Circuit will apply the "because of" test, which it has previously adopted. That assumes a number of issues. As with all appeals, we wait.
Chief Counsel's Roxworthy AOD and Korb's public comments on Textron confirm, a bit dramatically, the IRS's unwavering full-scale attack on any perceived tax shelter or abusive transaction. In those areas, the routine issuance of a summons for tax accrual workpapers will be the rule and not the exception. As to other taxpayer's, access to opinions on the hazards of litigating with the IRS, whether in tax accrual papers or as part of a business transaction, must be restricted and the restrictions enforced. Otherwise, a real risk exists that the IRS will be inspecting your lawyer's legal analysis. Be careful.
1. Yes, we understand the difference between trial lawyers and litigators.
2. How tax accruals have been determined and disclosed in the past will be radically altered by FASB Interpretation No. 48, ("FIN 48"), "Accounting for Uncertainty in Income Taxes," issued by the Financial Accounting Standards Board, FIN 48 currently applies only to public companies. Application to private companies has been deferred for a year.
3. Much like pornography, formulating a simple definition of an "aggressive" tax position defies meaningful articulation; yet, we all know them when we see them.
4. Internal Revenue Manual 4.10.20. That policy was adopted on June 12, 1980, see U.S. v. El Paso Co., 682 F.2d 530 (5th Cir. 1982) at 539.
5. Announcement 2002-63
6. LMSB (IRS-speak for "Large and Midsize Business") Commissioner Memorandum dated May 10, 2007, "FIN 48 and Tax Accrual Workpapers (TAW) Policy Update: "LMSB is evaluating its TAW Policy to ensure that it is still appropriate in today's environment. Meanwhile the current policy should be followed."; See also 2007 TNT 147-3 (7-30-2007), "There are voices within the IRS that want to change this policy. After all, the IRS won its case in the Supreme Court."
7. In Textron Inc. et al v. U.S., the examining agent in the evidentiary hearing admitted as much.
8. At the audit level, there is no pending litigation, only an "examination of the tax returns." The summons authority allows the IRS to obtain documents before any additional tax is determined. When the taxpayer declines to produce the "requested" documents, the IRS files a complaint in a federal district court to show cause why the taxpayer should not be held in contempt for failing to comply with the summons.
9. U.S. v. Frederick, 182 F.3rd 496, at 500 (7th. Cir. 1999). U.S. v. Lawless, 709 F.2d 485 (7th. Cir. 1983); In Re Grand Jury Proceedings, 727 F.2d 1352 (4th. Cir. 1984); U.S. v. Cote, 456 F.2d 1972. Tennessee has a statutory accountant-client privilege. Tenn. Code Ann. § 62-1-116. There is no federal accountant-client privilege.
10. Frederick, footnote 10 above, discusses exactly why and when the attorney-client privilege cannot be allowed when any accounting advice was sought by the client. An excellent discussion! That opinion addresses two U. S. Supreme Court cases and a decision of the Fifth Circuit. Each case dealt with an accounting firm doing accounting work. The new cases involve lawyers and tax practitioners doing legal work that served an accounting purpose. The IRS sees no difference. Pity. The courts have.
11. FSA 200042007 and the government's arguments in Textron.
12. United States v. M.I.T., 129 F.3d 681 (1st. Cir. 1997); Merrill Lynch v. Allegheny Energy Inc., 229 F.R.D. 441 (S.D.N.Y. 2004). Medinol Ltd. v. Boston Scientific Corp., 214 F.R.D. 113 (S.D.N.Y. 2002). Both decisions focus carefully on the information disclosed and the relationship of the audit to that information. Judge Hellenstein, in Medinol, addresses the "public duties" of the auditor. In today's Sarbanes-Oxley world, the "public duties" of an auditor certainly can be argued to make the auditor more of an adverse party to whom a disclosure of work product would constitute a waiver. That issue was not addressed by either court in Textron or Roxworthy.
13. The accounting firm that prepared the opinion did not assist in preparing the tax returns and had never assisted in preparing tax returns.
14. As Roxworthy illustrates, the workpapers do not have to be prepared after the return is filed, but it is important that the taxpayer be able to establish that the workpapers were not shared with the persons preparing the returns.
15. See U. S. v. Roxworthy, 457 F.3d 590 (6th Cir. 2006) at 593 and In re Grand Jury Subpoena, 350 F.3d 1010 (9th. Cir. 2003) at 1016.
16. See Developers Surety and Indemnity Company v. Harding Village Ltd., Slip Copy, 2007 WL 2021939 (S.D. Fla., July 11, 2007), fn 1 at page 2.
17. The term "common interest doctrine" can be used to describe the relationship. Care should be taken to explore what relationships exist with other parties. Should an adversarial party gain access though a party with a common interest, the protection will be lost.
18. Federal Rules of Civil Procedure.
WILLIAM ROBERT POPE JR. is a member of the Nashville firm of White & Reasor PLLC. After graduating from the University of Tennessee College of Law, he was a trial attorney with the IRS Chief Counsel’s Office in Nashville for six years. Pope’s practice focuses on tax controversy/litigation, insolvency and bankruptcy matters. He was the first chair of the Bankruptcy and Workout Committe of the American Bar Association Tax Section. He is listed in the Mid-South Super Lawyers and Best Lawyers for Taxation.
J. LEIGH GRIFFITH is a partner at the law firm of Waller Landsden Dortch & Davis LLP. An attorney and certified public accountant, he has extensive experience in state and federal tax law and estate planning. He has been recognized in The Best Lawyers in America for more than a decade.