What You Say Can and Will Be Used Against You …
A recent court decision impacts what work papers the IRS may be able to obtain in connection with an audit or related proceedings.
October 13, 2009
This past August a federal appellate court ruled that the IRS was entitled to a corporation’s work papers used to determine the adequacy of the company’s tax liability reserves in the event of an IRS audit. The decision is United States v. Textron Inc., issued in August 2009 by the United States Court of Appeals for the First Circuit (No. 07-2631).
The background of the case is as follows: Textron Inc., as a publicly traded company, was required to calculate reserves to account for contingent tax liabilities. This included estimates of potential liability if the IRS challenged deductions taken by the corporation on its tax return. Textron’s tax department listed items in the tax return that, if challenged by the IRS, could result in additional tax liability.
In an audit of Textron’s 2001 return, the IRS determined that a Textron subsidiary engaged in several transactions that were similar to a type of transaction the IRS generally had determined to be a tax avoidance transaction. Among other things, Textron purchased equipment from a foreign utility and leased it back on the sale day (known as a “sale-in, lease-out” or SILO transaction).
Textron’s tax department had previously prepared spreadsheets listing each debatable item, including the dollar amount subject to dispute and a percentage estimate of the IRS’s chance of a successful challenge. With respect to certain entries, the spreadsheet estimated the success of an IRS challenge at 100 percent. Tax lawyers in Textron’s tax department, as well as its outside counsel, advised Textron on its tax reserve requirements. Textron showed the reserve spreadsheets to its outside accountants Ernst & Young, but refused to show them to the IRS.
The IRS issued a summons seeking all “tax accrual work papers” use to support Textron’s calculation of reserves for its audited financial statements. This included documents prepared by Textron’s lawyers, its outside accountants and others in Textron’s internal tax department. Textron refused and the IRS sought to enforce the summons in federal court. The issue made its way through the U.S. District Court and up to the First Circuit Court of Appeals, where ultimately the issue was decided by an en banc (full bench) court. (En banc refers to a hearing where all the sitting judges of the court (rather than a panel of say, three judges) hear argument and render an opinion. En banc hearings are typically reserved for matters of significant importance of first impression.)
If the IRS obtained the spreadsheets, the spreadsheets would essentially serve as a roadmap for the IRS to identify weaknesses in the corporation’s claimed deductions. In other words, it would identify those items that the corporation itself thought were most subject to scrutiny for further tax liability. This would make it easy for the IRS to determine what, if any, deductions to target.
Textron’s attorneys argued that the papers were protected by the work product doctrine. This well-recognized legal doctrine is aimed at protecting individuals or businesses from having to turn over legal work done in anticipation of litigation.
In support of Textron’s position, both the Chamber of Commerce of the United States and the Association of Corporate Counsel filed briefs in the case, arguing that the work papers should be protected from disclosure. They reasoned that if attorneys who identify good faith questions in their clients’ tax returns know that putting those opinions in writing will result in the IRS obtaining access to those opinions, attorneys may avoid making such statements in writing to clients, thereby diminishing the quality of their representation.
The appellate court held that “the Textron work papers were independently required by statutory and audit requirements and that the work product privilege does not apply.” In doing so, it explained that the primary purpose of the work papers sought by the IRS was to make book entries, prepare financial statements and obtain a clean audit. The fact that the documents might be useful in litigation did not mean that they were prepared in anticipation of litigation and afforded work product protection.
While Textron argued it would be unfair for the IRS to gain access to its spreadsheets, the court reasoned that “tax collection is not a game.” And “[i]f a blueprint to Textron’s possible improper deductions can be found in Textron’s files, it is properly available to the government unless privileged.” Because the court found the documents were not privileged or otherwise protected, Textron would be required to give the documents to the IRS.
Textron is seeking leave to appeal this decision to the United States Supreme Court. Recognizing the potential importance of the decision and the possibility that the Supreme Court may hear the appeal, on September 16 the First Circuit essentially stayed the order requiring disclosure until further action is taken by the Supreme Court.
Currently, the decision is only binding on federal courts within the First Circuit, which includes Maine, Massachusetts, New Hampshire, Rhode Island and Puerto Rico. But it could have implications beyond these jurisdictions as persuasive authority. And it could be binding authority across the country if the Supreme Court were to hear an appeal and affirm the First Circuit’s ruling. In the meantime, corporations will need to pay close attention to statements they are making — including even internal statements never intended for third parties — with respect to tax liability. And tax preparers and auditors may need to exercise caution about what type of information they request or gather in connection with their work.
Some commentators believe this ruling could be a catalyst to more aggressive action by the IRS to seek this type of information from public companies. The ruling could also have implications beyond tax issues. If the decision’s impact were to spill over beyond tax issues, as some predict it could, companies would need to be wary of internal assessments and other statements made regarding all sorts of potential legal liabilities, not just tax liabilities. For all sorts of opposing litigants — not just the IRS — will typically want to get their hands on any internal assessments or communications they can through the legal discovery process.
How big an impact this decision has remains to be seen, but particularly CPAs performing work for public companies should keep it in mind. And even if this decision does not have the impact some predict, it is a good reminder to all corporate executives and their advisors that private information never intended to be revealed to the outside world can end up in the public domain.