|Tax Work Paper Privilege and the Surprising Reversal in Textron
When can tax work papers be shielded from IRS scrutiny? The First Circuit in Textron gave tax practitioners another indication of what factors the court would weigh.
September 10, 2009
On August 13, 2009, an en banc majority of the First Circuit Court of Appeals handed down a surprise decision in U.S. v. Textron, Inc. The full panel not only overturned an earlier decision by the Court's three judge panel, but arguably created a new standard for determining when tax work papers are protected from the Internal Revenue Service's (IRS) scrutiny. The decision effectively makes it tougher for taxpayers to shield internal documents addressing aggressive or questionable tax positions from authorities such as the IRS. This summary provides a brief overview of the Textron case as well as the factual issues decided on by the Court.
U.S. v. Textron Inc.
Textron, Inc. is a large, publicly-traded conglomerate with over 100 subsidiaries. As part of its financial statement preparation, Textron's lawyers and others prepare estimates of the company's exposure to IRS adjustments of uncertain tax positions taken on the federal tax return. The work papers include an analysis of the estimated probability of IRS success challenging various positions, and in some instances the company's representatives estimated IRS success at 100 percent. The parties agree that one purpose for the work papers was to assist internal management and auditors in assessing the company's tax reserves.
Due to its size and complexity, Textron is audited on a regular basis by the IRS. IRS policy at the time was to only request copies of a taxpayer's tax accrual work papers in cases where the taxpayer engaged in multiple listed transactions. During the audit of Textron's 2001 return, the IRS determined that Textron had entered into nine listed transactions and therefore, the IRS requested complete copies of its tax accrual work papers. Textron refused, citing a variety of privilege claims, including the work product privilege.
Whether the work-product privilege applied boiled down to the purpose of the work papers. If the work papers are prepared in the ordinary course of business, they are not protected. If, on the other hand, they are prepared in anticipation of litigation or for trial, they are protected. The court summarized the case as follows:
"To sum up, the work product privilege is aimed at protecting work done for litigation, not in preparing financial statements. Textron's work papers were prepared to support financial filings and gain auditor approval; the compulsion of the securities laws and auditing requirements assure that they will be carefully prepared, in their present form, even though not protected; and IRS access serves the legitimate, and important, function of detecting and disallowing abusive tax shelters."
General Rules for Privilege
The Federal Rules of Civil Procedure Rule 26(b)(3) states that privilege is extended to documents that "are prepared in anticipation of litigation or for trial." Note that the definition includes two terms — 1) in anticipation for litigation or 2) for trial. There is little difficulty identifying documents prepared for trial purposes. The problems arise for those documents prepared for dual purposes and those arguably prepared in anticipation of litigation — really in anticipation of any adversarial proceeding including a trial.
The courts have used a variety of tests to determine privilege, but a common theme runs through each one. In all cases, including the Textron decision, courts inquire about why the document in question was prepared, not about the content of the document itself. Therefore, the question of privilege is not dependent on whether the document would be useful if litigation arises, but the reason for the document's preparation. The issue before the First Circuit was how to weigh the dual purposes of the tax accrual work papers and to decide which purpose controlled for purposes of privilege.
The narrowest of the tests, and the test adopted by the Fifth Circuit, is referred to as the "primary purpose" test and asks about the "primary motivating purpose" of the document's preparation. If the document was prepared primarily for a business or other non-litigation purpose, the document generally will not be protected even if a secondary purpose might be to prepare for potential future litigation. In contrast other circuits that have addressed the issue, including the First Circuit, have adopted a "because of" test. This broader inquiry asks merely whether "in light of the nature of the document and the factual situation in the particular case, the document can fairly be said to have been prepared or obtained because of the prospect of litigation."
The primary difference between the two approaches is the "because of" test does not require a weighting of the purposes, only a finding that the document was prepared in part because of the prospect of litigation or trial. A business decision could rest, for example, on the prospects for an issue at trial should such a trial or litigation commence. Documents prepared to assist that decision have a dual purpose and are arguably protected under the rule.
In Textron, the dissenters forcefully contended that under the "because of" test, the tax accrual work papers had such a dual purpose and should be protected from IRS scrutiny. The Textron majority for its part went to great lengths to claim that the work papers requested by the IRS had only one substantive function — to estimate an amount necessary for the company's financial statements that it prepared in conformity with U.S. Generally Accepted Accounting Principles (GAAP) to fulfill the requirements of relevant regulatory authorities. This "prepared for" analysis, which ignores the dual purpose of tax accrual work papers, is arguably a third and novel approach to the work product question.
Under most analyses, the First Circuit narrowed the situations in which protection would be granted to tax accrual work papers. More troubling perhaps for accountants is Financial Accounting Standards Board (FASB) Interpretation No. 48 (FIN 48) requires a company falling under its rules to formally estimate the prospects of surviving an IRS challenge of each position identified by auditors and tax counsel as doubtful (that is, less than or equal to 50 percent certain). This essential element of FIN 48 may increase the risk that tax accrual work papers will not survive a challenge under any of the tests in use by the courts because there may be little doubt that such work papers were prepared primarily for a business purpose.
Rate this article 5 (excellent) to 1 (poor). Send your responses here.
LeAnn Luna is an Associate Professor of Accounting and holds a dual appointment with the Department of Accounting and Information Management and the Center for Business and Economic Research, both at The University of Tennessee.