A panel of three judges in the First Circuit last Wednesday affirmed a U.S. District Court decision applying the work-product privilege to tax accrual workpapers. Download Textron, N0.07-2631, First Circuit.012109, 2009-1 USTC ¶50,167, affirming in part, vacating in part, and remanding 507 F. Supp. 2d 138 (D. R.I. 2007).
Textron, a multibillion dollar multinational conglomerate, prepares tax accrual workpapers, using attorneys and CPAs hired by Textron and some assistance from outside law firms and accounting firms. Those tax accrual workpapers are a required step in the financial statement preparation process under Generally Accepted Accounting Principles (GAAP), in that accountants must determine a company's tax status to ensure that it has set aside adequate reserves to cover potential tax costs if the tax positions it has taken on its returns are ultimately found to be wrong. The following paragraph in the First Circuit opinion describes the tax accrual workpapers.
Like other companies, Textron prepares 'tax accrual workpapers' which, generally speaking, list the questionable positions Textron took on its tax returns, estimate the likelihood that those positions will not withstand scrutiny, and calculate the amount of additional tax liability that would result from revision of those positions. Textron prepares these estimates so that it can maintain an adequate reserve fund, properly report its assets and liabilities, and obtain independent certification of its financial statements. As part of the auditing process, Textron showed these tax accrual workpapers to Ernst & Young (E&Y) an independent auditor.
The tax accrual workpapers are prepared each year shortly after the corporation's tax return is filed.
During an audit of the company covering its 1998-2001 tax years, the IRS requested Textron's tax accrual workpapers, but the company refused to provide them, claiming that they are protected by various privileges, including the work-product privilege, even though they were at the least "dual purpose documents". The First Circuit upheld the privilege, and even concluded that the company had not waived the protection by showing the internal workpapers to its outside auditor, Ernst & Young, calling the auditor-client relationship a "cooperative not adversarial relationship" that was unlikely to lead to litigation. Even so, the court acknowledged that E&Y's own workpapers, which likely incorporate and even reveal Textron's analyses, may be discoverable on remand, under the Arthur Young Supreme Court opinion (excerpted in detail, below). The court's determination that the company's internal tax accrual workpapers may not be summonsed is manifestly inconsistent with the court's conclusion that the outside auditor's workpapers incorporating the same analysis may be.
Now, folks, this is a very weak decision. It demonstrates how poorly many judges do when analyzing tax issues. Partly, I suspect, this is because the bench is loaded with corporatist judges who share the "free marketarian" animosity to the taxes that make government functioning possible, and partly, I suspect, it is because neither the judges nor their clerks did much to learn anything about the tax system (or accounting) when they were in law school. Most top law schools don't require their students to learn anything about the tax law. It's a shame, of course, since tax law is the one topic that every single lawyer will have to deal with, no matter what his or her specialty. Worse, clerks who have been raised in the non-doctrinal tradition of many of today's top law schools think they can apply the vague theoretical understanding of how the law works that they received in law school and arrive at the appropriate answer. But Textron, my friends, is wrongly decided. It is about as bad as the decision in Murphy, where the court simply didn't know how to read a tax statute.
I wrote about evidentiary privileges and tax practice in "Tax Advice Before the Return: The Case for Raising Standards and Denying Evidentiary Privileges," 25 Virginia Tax Review 583 (2006). Much of the following material is adapted from that article.
The work product privilege is a court-created doctrine that applies only to documents that are created in preparation for litigation. It is intended to be much narrower than the attorney-client privilege, and to protect only items prepared in anticipation of a particular litigation. Even so, documents prepared for litigation are often accessible, if they provide the only source of information. There is one type of document that is generally not accessible under work-product privilege, even if the other side cannot otherwise get the information--that is, "opinion work product" that relates to the attorney's opinion product in preparation for the case. Work-product privilege is based on the nature of the litigation context--two adversarial parties duking it out. The truth is supposed to come out of the struggle between the litigants.
But folks, tax accrual workpapers are in no way documents prepared in anticipation of litigation. They are documents prepared on an annual basis by every public company for financial reporting purposes to comply with the securities laws, regardless of whether they expect their aggressive tax positions to be caught by the IRS on audit or not. They are no more work product than any other document that a company prepares throughout its existence, with an eye towards the "what if" of some potential future litigation always shaping the way things are phrased. Tax accrual workpapers are business documents that are not protected by attorney client privilege or the tax practitioner privilege and they are not work product.
The court, like several of its peers, doesn't understand the difference between business documents and tax litigation documents. It ridiculously held, following Textron's argument, that a difference of opinion in the context of an IRS audit satisfies the definition of litigation for purposes of work produce documents. But an audit is not litigation. It is not even similar to litigation. The IRS is always outgunned and outmanned at the audit stage. It is looking for needles in haystacks. The taxpayer knows where the information is, and the IRS doesn't. The court even noted in the opnion that often there is no dispute about IRS proposed adjustments or disputes may be resolved through conferences with the audit tem. In the last fifty years, Textron and the IRS have only litigated three disputes, even though Textron is a public company whose every return is audited by the IRS. Furthermore the court acknowledged that "the initial processing of these disputes in the audit process may not be adversarial." Yet it concluded that "the disputes themselves are essentially advesarial -because] the subject to these disputes will become the subject of litigation unless the dispute is resolved."
The First Circuit here has created a version of the work-product doctrine that is so braod that it would, as the IRS argued, "afford a 'blanket' protection" that would "swallow the attorney-client privilege". It is a version of the work-product doctrine that applies with special force to tax, where every item must be reported on a tax return, and every item reported on a tax return that is not 100% certain is potentially subject to becoming an issue on audit. It is as though the First Circuit judges were trying to make sure that the IRS could not use its summons power to get any information in the taxpayer's hands that would be relevant, since this blanket work-product protection would leave almost no document having to do with tax positions on a return unprotected!
This is the epitome of poor legal reasoning. The court's logic would make any discussion of any item that could ever become the subject of litigation an adversarial discussion merely because it might become adversarial if the issue is not agreeably resolved by the discussion! If I raise an issue you about something (did you pay me the ten you owe me or not) and we talk nicely about it to try to resolve it, that is not litigation. Perhaps you can show me the receipt I gave you when you paid me, and I say--Oh, yes, I remember now, and so our discussion is resolved without ever becoming a dispute. If the issue that I have raised is not resolved by the cooperative interchange, then it may change in nature to a dispute that I choose to take to court. At that point, the dispute becomes litigational. As the dissent in Textron noted, it is not the subject matter discussed in materials that controls applicability of the doctrine, but whether documents are prepared in the ordinary course of business or specifically because of litigation potential.
The court went on to hold, with even less connection to reality, that since tax accrual workpapers determine the amount of reserve necessary in the event that an audit leads to a deficiency notice, they must be prepared in anticipation of disputes with the IRS (audits) that are treated as litigation. That's simply the wrong conclusion. Tax accrual workpapers take the taxpayer's transaction into account and arrive at conclusions about how aggressive they were and whether that means that there is some likelihood of a potential tax charge in the future. They are explicitly required as part of the financial auditing process. That is their clear, non-tax business purpose. They are not prepared to assist with litigation with the IRS and they are not prepared in contemplation of litigation with the IRS. They are prepared for accounting purposes to determine what the accounting books should say about the possibility of litigation with the IRS.
I. Neither test applied by federal circuit courts to tax issues results in protection for tax accrual workpapers.
The work product doctrine was first set out in the seminal Hickman case, Hickman v. Taylor, 329 U.s. 495 (1947). The court held that an attorney's notes from investigation of a ship's sinking should be protected from discovery by the adverse party, because the company reasonably expected that the sinking would result in litigation, and the attorney's investigation was intended to timely capture information that would be needed to defend that litigation. For work product doctrine to apply, the imminent existence of an adversarial process is central.
There are two standards for the doctrine that have been applied in the federal courts in deciding work product doctrine issues in the tax context: neither standard, applied properly, would protect tax accrual workpapers. Some courts apply a narrow view that correctly sets the timeline for protection of tax documents at the point when litigation is reasonably anticipated or expected and the primary purpose for the documents is to aid in possible future litigation. This approach rests closely on the evidentiary rules and Hickman case. Other circuits, including the First Circuit, apply a much broader and harder to justify work product doctrine. For example, the Second Circuit in United States v. Adlman, 134 F.3d 1194 (2d. Cir. 1998), ruled that work product protection could apply for a document that was prepared "because of" litigation possibilities. That test, however, still does not protect documents prepared in the ordinary course of business or documents that would have been created in the same form if there were no prospect of litigation. A remote prospect of future litigation would be insufficient to provide protection. This test is unduly broad in any case, but particularly in the tax context. Even so, it clearly would not apply to tax accrual workpapers, which are not prepared "because of" litigation possibilities but rather "because of" financial accounting standards that require consideration of the strength of the tax positions taken by companies on returns. Tax accrual workpapers are also prepared in the ordinary course of business and not prepared in the extraordinary circumstance "because of" litigation possibilities. Tax accrual workpapers are clearly not protected under this broader "because of" test any more than they are protected under the "in anticipation of litigation" test.
The dissent in Textron understood the test. Judge Boudin of the First Circuit stated flatly that the majority opinion (made up of one judge, Torruella, from the First Circuit and one judge, Schwarzer, a mere district judge from the Northern District of California who was sitting in to assist the First Circuit with its caseload) went against established First Circuit precedent in Maine v. United States Dep't of the Interior, 298 F.3d 60 (1st Cir. 2002).
The majority acknowledged that the case it cited for considering an audit like litigation merely held that "documents created to analyze specific areas of likely dispute may be protected. Textron at 14, citing Roxworthy. Nonetheless, the court said, it concluded that even though "not all 'dealing with the IRS' during an audit is 'litigation,' the resolution of disputes through adversary administrative processes, including proceedings before the IRS Appeals Board, meets the definition of litigation."
The Textron court completely misunderstands the context here. It said that because the documents had to analyze the possibility of litigation to determine the extent of reserves necessary, it meant that the "driving force" behind the documents was expected disputes with the IRS over tax positions on the return, and therefore the documents were created in anticipation of litigation. It has it backwards. Because the company had reported some positions with less than 100% certainty on its tax returns, it was necessary for the company to calculate appropriate reserves on its books. The driving force behind the documents was the need to calculate reserves for financial accounting purposes, and therefore the documents were not created in anticipation of litigation.
II. Various other reasons strongly argue against work-product protection for tax accrual workpapers.
I argued in the article mentioned above that there are strong arguments for eliminating (or strongly limiting) evidentiary privileges for any pre-return tax advice. Those reasons, as well as others, apply to show that there is no justification whatsoever for providing work-product protection to tax accrual workpapers. Let's set out those reasons against work-product protection clearly here.
A. Tax is a non-coercive system, in which audits are non-adversarial, cooperative interchanges that do not permit or require litigation protections
Tax is a set of rules that characterize the results of taxpayer transactions for purposes of determining appropriate assessment, They are not like other legal regimes that provide prohibitory rules intended to draw a line between legal and illegal conduct, so that the regulated entity must either avoid sanctioned activities or implement prescribed activities. In contract, the only coercive element in taxation is the requirement that the taxpayer report his transactions (by filing a return) and pay the appropriate taxes. As a result, as I noted in the article, "the process during the tax return, audit and even proposed adjustment phase is cooperative rather than adversarial. A clearly adversarial relationship arises only at the point that a dispute cannot be resolved through the cooperative give and take of the audit process and a notice of deficiency is issued, forcing the taxpayer to choose between compliance with the government's characterization of the transaction or litigation." This regime does not support the traditional attorney-client and work-product privileges, which originated in the adversarial litigation context.
B. Tax is a self-assessment system, in which disclosure of full and accurate information is central to a fair process.
The Code establishes a system of self-assessment, whereby the taxpayer files a return disclosing the relevant facts necessary to determine tax liabity and pays over the tax due. "Because a return requires disclosure of all relevant tax facts, any records, documents, and other information or analyses used to arrive at the particular information included are directly relevant and material. They are impliedly available for review to ascertain whether the taxpayer has followed the rules appropriately." Self-assessment depends on taxpayers providing accurate information on their returns: the government cannot be expected to reconstruct every return, and the public at large bears the burden of higher taxes for every taxpayer who cheats and inputs inaccurate information. In such a system requiring self-assessment, there is no justification for any type of evidentiary shield that inhibits investigation, impedes the search for truth and encourages taxpayers to litigate.
C. Work-product protection is inappropriate for information that resides solely in the taxpayer's hands that does not relate to litigation strategies
As I noted in the Before the Return article, "A taxpayer who can control planning for its activities behind closed doors remains in sole possession of the critical information relevant to assessment of its tax liabilities. The government--in this case not an adversary but merely the transactional counterpart in the tax determination process--remains essentially at the mercy of the taxpayer to provide it sufficient information so that it may, in the few returns actually audited, come to its own determination as to tax liability and evaluate the taxpayer's assessment effort. "
D. Accounting workpapers are simply not eligible for work-product protection.
The Supreme Court has been quite clear that accounting workpapers are not protected. They are not considered made in confidence because they are expected to be disclosed in accordance with security regulations and upon the Service's requrest. See United States v. Arthur Young & Co., 465 U.S. 805 (1984) (link available to Lexis subscribers). Following are key statements about tax accrual workpapers and the Service's authority to examine the books and records of taxpayers from the Supreme Court. They show that the Court clearly does not consider the audit process to be one of litigation, and does not consider tax accrual workpapers to be eligible for work-product protection.
An important aspect of the auditor's function is to evaluate the adequacy and reasonableness of the corporation's reserve account for contingent tax liabilities.This reserve account, known as the tax accrual account, the noncurrent tax account, or the tax pool, represents the amount set aside by the corporation to cover adjustments and additions to the corporation's actual tax liability. Additional corporate tax liability may arise from a wide variety of transactions.[footnote omitted] The presence of a reserve account for such contingent tax liabilities reflects the corporation's awareness of, and preparedness for, the possibility of an assessment of additional taxes. ... In exploring the tax consequences of certain transactions, the auditor often engages in a "worst-case" analysis in order to ensure that the tax accrual account accurately reflects the full extent of the corporation's exposure to additional tax liability. ... In short, tax accrual workpapers pinpoint the "soft spots" on a corporation's tax return by highlighting those areas in which the corporate taxpayer has taken a position that may, at some later date, require the payment of additional taxes.
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The filing of a corporate tax return entails much more than filling in the blanks on an IRS form in accordance with undisputed tax principles; more likely than not, the return is a composite interpretation of corporate transactions made by corporate officers in the light most favorable to the taxpayer. It is the responsibility of the IRS to determine whether the corporate taxpayer in completing its return has stretched a particular tax concept beyond what is allowed. Records that illuminate any aspect of the return -- such as the tax accrual workpapers at issue in this case -- are therefore highly relevant to legitimate IRS inquiry.
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Our complex and comprehensive system of federal taxation, relying as it does upon self-assessment and reporting, demands that all taxpayers be forthright in the disclosure of relevant information to the taxing authorities. Without such disclosure, and the concomitant power of the Government to compel disclosure, our national tax burden would not be fairly and equitably distributed. In order to encourage effective tax investigations, Congress has endowed the IRS with expansive information-gathering authority; §7602 [IRS summons authority] is the centerpiece of that congressional design.
"The purpose of § 7602 is not to accuse, but to inquire. Although such investigations unquestionably involve some invasion of privacy, they are essential to our self-reporting system, and the alternatives could well involve far less agreeable invasions of house, business, and records."
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"[This] Court has consistently construed congressional intent to require that if the summons authority claimed is necessary for the effective performance of congressionally imposed responsibilities to enforce the tax Code, that authority should be upheld absent express statutory prohibition or substantial countervailing policies." (citing United States v. Euge, 444 U.S. 707, 711 (1980)).
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Nor do we find persuasive the argument that a work-product immunity for accountants' tax accrual workpapers is a fitting analogue to the attorney work-product doctrine established in Hickman v. Taylor, 329 U.S. 495 (1947) (link available to Lexis subscribers). The Hickman work-product doctrine was founded upon the private attorney's role as the client's confidential adviser and advocate, a loyal representative whose duty it is to present the client's case in the most favorable possible light. An independent certified public accountant performs a different role. By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public. This "public watchdog" function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust. To insulate from disclosure a certified public accountant's interpretations of the client's financial statements would be to ignore the significance of the accountant's role as a disinterested analyst charged with public obligations.
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Respondents urge that the enforcement of an IRS summons for accountants' tax accrual workpapers permits the Government to probe the thought processes of its taxpayer citizens, thereby giving the IRS an unfair advantage in negotiating and litigating tax controversies. But if the SEC itself, or a private plaintiff in securities litigation, sought to obtain the tax accrual workpapers at issue in this case, they would surely be entitled to do so. [footnote omitte] In light of the broad congressional command of § 7602, no sound reason exists for conferring lesser authority upon the IRS than upon a private litigant suing with regard to transactions concerning which the public has no interest.
The First Circuit "distinguished" Arthur Young by claiming that the tax accrual workpapers were created because of both business and litigation so were not covered by Arthur Young's broad and strong statement that work of independent auditors is not protected because it is designed to be disclosed to the public.
Note that the Fourth and Fifth Circuits have considered tax preparation work not privileged because it is primarily accounting work. United States V. El Paso Co., 682 F.2d 530 (5th Cir. 1982). The Eighth Circuit concluded that an attorney who fills out tax returns is merely acting as a scrivener, not giving legal advice. Canaday v. United States, 354 F.2d 849, 857 (8th Cir. 1966).
Yet the First Circuit in Textron found that the business purpose for the documents didn't defeat work-product protection. The fact that the accrual workpapers also could be used as a litigation hazards summary was sufficient to protect them, the court said, even though they functioned to satisfy a regulatory requirement. The court completely misses the boat--tax accrual documents are prepared for financial accounting purposes. The fact that they are based on information that is taken from the tax returns of the company doesn't result in their being prepared "because of " litigation.
E. Work-product doctrine does not appropriately apply to materials solely because they relate to tax determinations, since any tax determination, other than one made at a 100% confidence level, is potentially subject to litigation.
The fact that the tax treatment of any transaction that would not garner a "will" opinion for tax purposes carries with it some concern that the treatment may be subject to litigation is not sufficient to cause the work-product doctrine to apply. If that were the case, any document prepared that mentions any tax issue would be "prepared in anticipation of litigation", since litigation is always potentially a possibility (though a very unlikely one) for any tax determination that isn't made with a 100% confidence level. Applying work-product protection merely because a document dealt with a less than 100% certain tax determination would swallow the rule about what work-product protection is supposed to protect.
F. The underlying rationale for creating a work-product privilege is not evident in the tax accrual workpaper context (or in tax planning in general).
The rationale for work product protection--to allow litigants to strategize and collect information to support their case in court without permitting the adversary to get a free ride by using his adversary's work product to prepare his side of the case--doesn't apply to tax accrual workpapers. These workpapers are prepared long before the audit process results in a notice of deficiency that might lead to a court case. They relate to business processes that are undertaken to ensure that the company is being prudent in its use of cash and its plans for the future. Clients will not avoid having accountants prepare tax accrual workpapers if the work product doctrine doesn't apply--in fact, they cannot avoid it because the workpapers are required to support the accountants' audit work.
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