Judge Ernest Torres, writing for the District Court of Rhode Island, concluded that Textron Inc's tax accrual workpapers prepared by accountants, with review and changes by tax attorneys for the company, are protected by the attorney-client privilege, the tax-practitioner privilege and the work product doctrine. However, the attorney-client privilege and tax-practitioner privilege were waived when the company shared the papers with its external auditor (the doing of which, though the court glosses over it in the opinion, is almost certainly the PRIMARY reason that the papers were created in the first place, since the auditor is required to assess tax reserves for GAAP and the company needs a document trail to establish the rationales for the amount of its tax reserves). But the court concluded that work product protection was not waived, and that the IRS had not shown substantial need, so the papers were not discoverable.
The First Circuit, where RI sits, has regretably adopted the overbroad work product "because of" test, first set forth in the Second Circuit's Adlman opinion. That test is so easy to satisfy that any document that provides a rationale for its being created connected with the word 'litigation' would probably qualify. It is a wrong-headed test that turns the purpose of work-product protection on its head, especially in the tax context. Work product protection is supposed to give an attorney a "zone of privacy" when he is preparing a case for trial, so that he can work through strategies and approaches without revealing his every hand to his adversary. Preparation of tax accrual papers to make the determination of how much funds should be considered reserved in the eventuality that the tax positions taken over time by a company on its returns are not held up after an audit is not an activity at that stage of an adversarial process--in fact, it should not be viewed as adversarial at all at that stage. As the court clearly shows, the purpose of the workpapers at issue was to set aside reserves based on the positions taken on the tax return just filed. The assessments of success on the merits provide the basis for the positions taken in the return, which is a document that is disclosed to the IRS. Accordingly, protection seems inappropriate for a document that sets those assessments out on an item by item basis in order to determine the reserves that should be reserved based on the positions taken on the tax return.
Courts do not seem to understand that the "because of" test for work product protection is too flimsy a reed on which to provide protection in the tax context, at least. Determinations of the merits of an uncertain tax position REQUIRE the CPA or attorney or taxpayer to consider the possibility of success on the merits before a court. Such consideration is required for two reasons--the "realistic possibility of success on the merits" and "more likely than not" standards set forth in the Code for evaluating positions to determine whether they are strong enough to be advised or reported on a return and the fact that there are judicial doctrines (substance-over-form, step transaction, economic substance, business purpose) that must be evaluated to determine whether a position may be reported on a return. The First Circuit did not seem to take that into consideration. It treated the workpapers sought as privileged and work-product protected simply because they consisted of lists of items that were considered uncertain because they were based on unclear tax law and a percentage estimate of the likelihood of each of those items' being upheld in litigation (apparently determined in the first place by the company's CPAs, but reviewed and sometimes changed in consultation with the company's internal tax counsel).
Textron admitted that it provided these documents to its external auditor and that these documents were necessary for the auditor to prepare its opinion that the financial statements conformed to GAAP requirements. And the company's Vice President of Taxes claimed that "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 could happen in the future." The court concluded that it was "reasonable to infer" that Textron's preparation of the work papers was "also prompted in part to satisfy the independent auditor."
The IRS made the correct arguments--that preparation of such documents do not constitute legal advice but are merely an aspect of an accounting function. Let's face it--either lawyers are doing primarily business work when they engage in such activities with CPAs to help the CPAs assess the proper amount of reserves, or the CPAs are practicing law without a license when they assess the potential risks of litigation and make determinations about tax reserves. There's a fairly strong argument that the kind of tax advice provided by CPAs should not be considered legal advice but business advice, and that when lawyers provide that kind of advice, it should neither be privileged nor entitled to work product protection.
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