In 1984, the IRS announced that it would not request tax accrual workpapers from taxpayers during an examination except in unusual circumstances (referred to as the “policy of restraint”) (Announcement 84-46). In 2002, the IRS identified listed transactions as an unusual circumstance warranting an exception to its policy of restraint and began routinely requesting tax accrual workpapers when it believed the taxpayer had participated in a listed transaction (Announcement 2002-63; see also Internal Revenue Manual Section 18.104.22.168).
Since then, taxpayers have challenged IRS requests for tax accrual workpapers, claiming various protections against disclosure, including protection under the work-product doctrine. A significant case focusing on application of the work-product doctrine to tax accrual workpapers is Textron Inc., 507 F. Supp. 2d 138 (D.R.I. 2007). As litigation on this question enters its fourth year, it remains unclear to what extent the work-product doctrine protects tax accrual workpapers and how to effectively invoke that protection.
Request for Tax Accrual Workpapers
During an examination, the IRS determined that a Textron subsidiary participated in several sale-in, lease-out (SILO) listed transactions described in Notice 2005-13, 2005-1 C.B. 630, and requested Textron’s tax accrual workpapers. When Textron refused to produce the documents, the government issued a summons and subsequently sought to enforce the summons. The lower court found that Textron’s tax accrual workpapers for the year in question consisted entirely of a spreadsheet listing items on the return that Textron’s counsel believed might be challenged by the IRS, counsel’s estimate of the percentage likelihood of prevailing, and the dollar amount of financial statement reserves to reflect the possibility of not prevailing, along with backup workpapers for the spreadsheet.
Textron challenged the IRS request to produce these documents, claiming that they are protected by the work-product doctrine. The taxpayer also claimed that the attorney-client privilege applied. The lower court held and the appellate court affirmed that although the attorney-client privilege applied in this case, it was waived. Waiver of attorney-client privilege is not determinative with respect to waiver of work-product protection. The lower court agreed with Textron that the tax accrual workpapers in question were created in anticipation of litigation and that, as a result, the work-product doctrine protects the document from disclosure to the IRS.
The IRS appealed the case to the U.S. Court of Appeals for the First Circuit. A panel majority originally affirmed the lower court’s decision that the workproduct protection applied to the tax accrual workpapers, but it vacated the portion of the lower court decision relating to waiver and remanded that portion of the case to the lower court for additional factual development and consideration (see Textron Inc., 553 F.3d 87 (1st Cir. 2009)). The First Circuit decision was withdrawn and judgment in the case was vacated when the First Circuit agreed to have the full panel for the court rehear the case.
In Anticipation of Litigation
Many commentators have stated that the district court decision in Textron was a big win for taxpayers, and in some respects it was. One question in the case was the extent to which the document in question was prepared “in anticipation of litigation,” a prerequisite for the workproduct doctrine to apply. The IRS argued unsuccessfully that a document cannot be treated as prepared in anticipation of litigation if it can also be used for another business purpose (in this case preparation of financial statements). Although the IRS previously prevailed on this argument more than 25 years ago in the Fifth Circuit (El Paso Co., 682 F.2d 530 (5th Cir. 1982)), the district court rejected the IRS’s limited interpretation of the phrase “in anticipation of litigation.” Whether the IRS can persuade the entire First Circuit on this point remains unclear, but it is central to whether Textron will ultimately prevail on this issue.
Waiver of the Work-Product Doctrine
Unlike waiver of attorney-client privilege, disclosure to a third party will not necessarily waive protection under the work-product doctrine. Waiver for purposes of the work-product doctrine occurs if disclosure is made to an adverse party. The district court concluded that there was no waiver of the work-product doctrine in the Textron case. If the First Circuit agrees with the district court that the work-product doctrine protects Textron’s tax accrual workpapers from disclosure to the IRS, it will then be asked to address the government’s argument that Textron waived protection under the work-product doctrine when it showed the tax accrual workpapers to its financial auditor.
Impact of Uncertainties
Given the legal maneuvering in this case, it is possible that it will remain in litigation for quite some time. Until the litigation has concluded, the extent to which the work-product doctrine protects tax accrual workpapers and how to effectively invoke that protection remains unclear. In light of such uncertainty, practitioners should keep abreast of developments in the Textron litigation and be prepared to work with clients as they try to navigate this unsettled area.
John Miller is a faculty instructor at Metropolitan Community College in Omaha, NE. Rochelle Hodes and Corina Trainer are with PricewaterhouseCoopers LLP in Washington, DC. Mr. Miller and Ms. Hodesare members of the AICPA Tax Division’s IRS Practice and Procedures Committee. For further information about this column, contact Mr. Miller at firstname.lastname@example.org.