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Michelle Henkel
Michelle Henkel
Announcement 2010-9 Raises Concerns for Preserving Work-Product Privilege

Here's why.

April 15, 2010
by Michelle Henkel, JD

Taxpayers will face new challenges preserving work-product privilege if and when the IRS finalizes a proposal made on January 26, 2010 to require large corporations to disclose information regarding uncertain tax positions taken on their tax returns. Announcement 2010-9, 2010-7 I.R.B. 408. Specifically, a large corporate taxpayer would be required to attach a schedule to its return describing each uncertain tax position and the maximum tax exposure attributable to each position if it were fully disallowed on audit. Historically, this information has been available only in a corporation’s tax accrual workpapers, which are potentially protected by the work-product privilege.

The Work-Product Privilege

The Supreme Court recognized the work-product privilege in Hickman v. Taylor, which established a zone of privacy for actions taken with an “eye toward litigation.” The privilege’s purpose is to allow counsel to work “without undue and needless interference” in “the historical and the necessary way in which lawyers act within the framework of our system of jurisprudence to promote justice and to protect their clients’ interests.” Fed. R. Civ. P. 26(b)(3) codifies the privilege by protecting from discovery in civil-litigation documents that are “prepared in anticipation of litigation or for trial by or for another party or by or for that other party’s representative.”

The Circuit Courts of Appeals have developed different standards on the scope of the work-product privilege based on the meaning of “in anticipation of litigation.” Under the minority Fifth Circuit view, a document is privileged only if the “primary motivating purpose” in creating the document is to aid in possible future litigation. Under the majority view, which has been expressly adopted by all the Circuit Courts of Appeals except the Fifth, 10th and 11th, a document is protected work product if it is “prepared or obtained because of the prospect of litigation.” This standard allows a document to be prepared for dual purposes and still be privileged.

If the privilege applies, a tax authority can obtain the information only if it proves that:

  1. It has a “substantial need” for the information in the preparation of its case and

  2. It is “unable without undue hardship to obtain the substantial equivalent of the materials by other means.”

Even where this showing has been made, “the court shall protect against disclosure of the mental impressions, conclusions, opinions or legal theories of a party’s attorney or other representative of a party concerning the litigation.”

Unlike the attorney-client and federal tax practitioner privileges, the work-product privilege is not automatically waived if the document is shared with a third-party. Instead, it is waived “only if the disclosure ‘substantially increases the opportunity for potential adversaries to obtain the information.’” In other words, the test is if the third party is or should be considered an adversary or it shares a common interest with the corporation.

The Privilege Debate for Tax-Sensitive Documents

In 2002, the IRS changed its policy for seeking tax accrual workpapers, which can provide a roadmap to the “soft spots” in a tax return. Since this change, the IRS has sought these workpapers not only in “unusual circumstances” but also when a taxpayer has engaged in one or more listed transactions. This change triggered litigation involving the hotly-debated issue of whether tax accrual workpapers are protected from disclosure to tax authorities by the work-product privilege and, if so, whether the privilege is waived by disclosure of the workpapers to a corporation’s financial statement auditors. Compare United States v. Textron, Inc., 577 F.3d 21 (1st Cir. 2009) (tax accrual workpapers are not privileged work product), petition for cert. filed, 78 U.S.L.W. 3375 (U.S. Dec. 24, 2009) (No. 09-750), with Regions Fin. Corp. v. United States, 2008-1 U.S. Tax Cas. (CCH) ¶ 50,345, WL 2139008 (N.D. Ala 2008) (tax accrual workpapers are privileged work product and no waiver occurs upon disclosure to financial statement auditors).

The arguments in privilege disputes over tax accrual workpapers are predictably similar. Because workpapers contain litigation risk assessments, taxpayers resist disclosure based primarily on the work-product privilege. In response, the government contends that the workpapers are prepared in the ordinary course of business or to comply with SEC requirements and, therefore, are not privileged work product. The IRS also contends that, even if tax accrual workpapers are privileged, all privilege is waived upon disclosure of the workpapers to the outside auditors. The IRS won an important victory in Textron, where the First Circuit held that the work-product privilege did not apply to Textron’s tax accrual workpapers because they were not prepared “for use” in litigation. If not reversed by the U.S. Supreme Court, the Textron decision could ultimately extend beyond the First Circuit and, even more importantly, beyond tax documentation.

Disclosure Proposal

As a practical matter, up to now the IRS’ policy of restraint in seeking tax accrual workpapers has meant that the IRS generally obtains such information only from those taxpayers who are required to self-identify certain “listed transactions.” The proposal in Announcement 2010-9 would impose a new reporting requirement on each business taxpayer that has more than $10 million in total assets and at least one uncertain tax position:

  1. For which it or a related entity has a recorded tax reserve in the financial statements or
  2. For which no reserve is recorded because they have decided to litigate or because the IRS has an administrative practice of not examining such position.

Except for the new reporting requirement, the IRS claims that, for now at least, it will “otherwise” maintain its policy of restraint with respect to tax accrual workpapers. Yet, the new schedule will indisputably provide the IRS with a significant amount of information that historically has not been made available by taxpayers to the IRS. Specifically, under the current proposal, the description of an uncertain tax position must include the rationale for the position and a concise general statement of the reasons for determining that the position is an uncertain tax position. To be sufficient, the description must contain:

  1. The Code sections potentially implicated by the position;
  2. A description of the taxable year or years to which the position relates;
  3. A statement that the position involves an item of income, gain, loss, deduction or credit against tax;
  4. A statement that the position involves a permanent inclusion or exclusion of any item, the timing of that item or both;
  5. A statement whether the position involves a determination of the value of any property or right; and
  6. A statement whether the position involves a computation of basis.

Conclusion

The IRS has emphasized that it will not require disclosure of a corporation’s risk assessment or tax reserve amounts. Nevertheless, a description that contains the “rationale” for the conclusion that a tax position is uncertain and the identification of the Code sections “potentially implicated” by the position, threaten to reveal counsel’s mental impressions, conclusions and opinions, which are at the very core of what is protected and intended to be protected by the work-product privilege. If privileged information is included on the new schedule, such disclosure would result in a waiver of such privilege, because the IRS must be considered an adversary or potential adversary and certainly does not share a common interest with the taxpayer in regard to the uncertain tax position. As a result, corporations and their return preparers must consult with knowledgeable advisors on the implications that compliance with rules promulgated to implement the proposal set out in Announcement 2010-9 could have on the applicability of work-product privilege.

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Michelle M. Henkel, JD is a tax controversy partner in the Atlanta office of Alston & Bird LLP. She represents taxpayers at all stages of the tax disputes including audit, administrative appeals, mediation, trial and appellate litigation. Henkel has participated in more than 100 cases in the IRS Appeals offices around the country and more than 40 cases in the U.S. The author expresses her appreciation for the contributions of Terence J. Greene, a tax partner at Alston & Bird, in the preparation of this article.
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