District Court Holds That Tax Accrual Workpapers Are Privileged Documents

By James Beavers, J.D., LL.M., CPA

A district court in the First Circuit held that a corporation did not have to turn over tax accrual workpapers to the IRS because the work-product privilege applied to the workpapers. The court also found that the attorney-client and tax-practitioner privileges could have applied to the workpapers, but the corporation had waived these privileges by sharing the work-papers with its independent auditors.


Textron, Inc. (Textron) is a publicly traded conglomerate with approximately 190 subsidiaries. Like other large corporations, Textron’s federal tax returns are audited periodically. During the audits, the Service examines the returns for the tax years that are part of the audit cycle. In seven of its past eight audit cycles before the cycle at issue (which covered the years 1998–2001), Textron appealed disputed matters to the IRS Appeals Board; three of these disputes resulted in litigation.

On an annual basis, Textron and its subsidiaries prepare tax accrual workpapers. The subsidiaries’ workpapers were used in the preparation of Textron’s workpapers. The workpapers consisted of:

(1) A spreadsheet containing:

(a) Lists of items on Textron’s tax returns, which, in the opinion of Textron’s counsel, involved issues on which the tax laws were unclear and therefore might be challenged by the IRS;

(b) Estimates by Textron’s counsel expressing, in percentage terms, their judgments regarding Textron’s chances of prevailing in any litigation over those issues (hazards of litigation percentages); and

(c) The dollar amounts reserved to reflect the possibility that Textron might not prevail in such litigation (tax reserve amounts).

(2) Backup workpapers consisting of the previous year’s spreadsheet and earlier drafts of the spreadsheet together with notes and memoranda written by Textron’s in-house tax attorneys reflecting their opinions as to which items should be included on the spreadsheet and the hazard of litigation percentage that should apply to each item.

The tax accrual workpapers for Textron were prepared by attorneys and CPAs working for Textron. Textron’s subsidiary companies prepared their workpapers with some input from private law firms and outside accounting firms. According to Textron officials, Textron’s ultimate purpose in preparing the tax accrual workpapers was to ensure that Textron was “adequately reserved with respect to any potential disputes or litigation that would happen in the future.”

IRS Document Requests

In conducting its audit of Textron for the 1998–2001 audit cycle, the IRS followed its standard procedure for gathering relevant information by issuing information document requests (IDRs) to Textron. During the audit cycle, the Service issued more than 500 IDRs, and Textron complied with all of them, except for the ones seeking the tax accrual workpapers of Textron and one of its subsidiaries, Textron Financial Corporation (TFC). The IRS was interested in these workpapers because it believed they contained information on certain sales and leasing transactions by TFC that the IRS believed were tax shelter transactions. Under its general policy of restraint, the Service does not usually request tax accrual workpapers as part of an examination. However, this policy does not apply in an examination that involves listed transactions.

Because Textron did not provide the workpapers in response to the IDRs, the IRS issued an administrative summons for “all of the Tax Accrual Workpapers” for Textron’s tax year ending on December 29, 2001. Textron again refused to produce the workpapers, asserting that they were protected by attorney-client, tax practitioner–client, and work-product privileges. The IRS petitioned a district court to enforce the summons against Textron. As described below, the district court, after considering whether the privileges applied and whether Textron had waived the privileges, held that work-product privilege applied and had not been waived, so Textron did not have to give its tax accrual workpapers to the IRS.

Attorney-Client Privilege

The attorney-client privilege protects confidential communications between an attorney and a client relating to legal advice sought from the attorney. If the communications are not related to legal representation or to the provision of legal advice by an attorney, the communications are not covered by the attorney-client privilege.Therefore, communications between an attorney and a client in the course of an attorney’s providing accounting services are not privileged.

Textron argued that its tax accrual workpapers were privileged because they were prepared by attorneys and reflected their legal conclusions in identifying items on Textron’s return that might be challenged and assessing Textron’s prospects of prevailing in any ensuing litigation. The IRS argued that Textron’s tax accrual workpapers were not protected by the attorney-client privilege because, in preparing them, Textron’s attorneys were performing an accounting function by reconciling the company’s tax records and financial statements.

The court noted that the mere preparation of a tax return is viewed as accounting work and that a taxpayer could not change this simply by having an attorney perform the work. However, the court stated that it is equally true that communications containing legal advice provided by an attorney may be privileged even though they are made in connection with the preparation of a return. According to the court, in the context of an IRS audit, where representation by an attorney during an audit consists of verifying the accuracy of a return, the work is accounting work, but if an attorney participates in an audit to deal with issues of statutory interpretation or case law that may have been raised in connection with examination of the taxpayer’s return, the attorney is doing “lawyer’s work” and the attorney-client privilege may attach to that work.

The court found that Textron’s tax accrual workpapers essentially consisted of nothing more than its attorneys’ opinions regarding items that might be challenged due to uncertainty in the law and their assessments regarding Textron’s chances of prevailing in any ensuing litigation. Therefore, it held that the preparation of the workpapers was lawyer’s work that was protected by the attorney-client privilege.

Tax Practitioner–Client Privilege

The tax practitioner–client privilege is a statutorily created extension of the attorney-client privilege. Sec. 7525(a)(1) states that:

With respect to tax advice, the same common law protections of confidentiality which apply to a communication between a taxpayer and an attorney shall also apply to a communication between a taxpayer and any federally authorized tax practitioner to the extent the communication would be considered a privileged communication if it were between a taxpayer and an attorney.

Because the attorney-client privilege does not apply when an attorney performs accounting work (such as preparing a tax return), the tax practitioner–client privilege does not apply when a tax practitioner prepares a tax return. It also does not apply to written communications between the tax practitioner and a client “in connection with the promotion of the direct or indirect participation of the person in any tax shelter” (Sec. 7525(b)(2)).

The Service argued that to the extent that the workpapers reflected the advice of the CPAs working in Textron’s tax department, the tax practitioner–client privilege did not apply because the work the accountants performed did not qualify for attorney-client privilege or because the work involved the promotion of a tax shelter. Because, with respect to the workpapers, Textron’s tax accountants—like its attorneys—advised Textron regarding its tax liability on matters on which the law is uncertain and/or estimated the hazards of litigation percentages, the court ruled that they were performing work that would qualify for the attorney-client privilege. It rejected the IRS’s contention that the privilege did not apply under the promotion of a tax shelter exception because, looking at the legislative background of Sec. 7525, it determined that Sec. 7525(b) was meant to apply to outside accountants who were involved in the sale of tax shelters. Therefore, even though the workpapers discussed certain transactions that qualified as tax shelters, this exception to the privilege did not apply because they were prepared by Textron’s inside CPAs.

Work-Product Privilege

The work-product privilege (or work-product doctrine, as it is frequently called) is related to the attorney-client privilege. It applies to materials prepared or gathered by an attorney in anticipation of litigation. Under this privilege (codified in Federal Rule of Civil Procedure 26(b)(3)), a party seeking an attorney’s work product covered by the privilege is entitled to it only on a showing of a substantial need for it. The privilege can be invoked in response to an IRS summons.

Anticipation of litigation: Courts have applied two different tests to determine whether a document was prepared in anticipation of litigation, the “primary purpose” test and the “because of” test. For a document to be privileged under the primary purpose test, anticipation of litigation must be the primary purpose of the document’s creation. The Fifth Circuit, in El Paso Co., 682 F2d 530 (5th Cir. 1982), held that a taxpayer’s tax accrual workpapers (which contained information similar to Textron’s workpapers) were not work product because they were created primarily for use in its outside financial audit.

Under the because of test, documents are held to be prepared in anticipation of litigation if they were prepared or obtained because of the prospect of litigation. The practical difference between this test and the primary purpose test in the context of tax litigation is that, under this test, documents that include assessments of the potential and estimated cost of litigation can be considered to have been created in anticipation of litigation even if they were primarily created or used for purposes other than litigation. However, the party claiming the privilege must show that they subjectively believed that litigation was possible, and that belief must be objectively reasonable. (See Adlman, 134 F3d 1194 (2dCir. 1998).)

With respect to the work-product privilege, the Service tried to convince the court to adopt the primary purpose test. It asserted that Textron prepared the workpapers in the ordinary course of business in order to satisfy the securities laws’ requirements that financial statements filed by publicly traded companies comply with GAAP (which mandate the creation of reserves to meet contingent liabilities). The IRS contended that Textron had to provide its independent auditor with the kind of information contained in the workpapers in order to obtain a “clean” audit opinion. Because the documents were prepared in the ordinary course of business, the IRS argued that the anticipation of litigation requirement of the work-product privilege was not met.

Textron argued that the court should use the because of test. It asserted that its tax accrual workpapers were prepared because it anticipated the possibility of litigation with the IRS regarding various items on its return, pointing to the hazards of litigation percentages contained in the workpapers as evidence that the possibility of such litigation was the reason they were prepared. It pointed to the unsettled nature of the law surrounding the issues discussed in the workpapers and its history of controversy and litigation with the IRS as evidence that it actually believed litigation was possible and that this belief was reasonable.

The district court, which lies in the First Circuit, applied the because of test because the First Circuit had adopted that standard in an earlier nontax case (Maine v. Dept. of the Interior, 298 F3d 60 (1st Cir. 2002)). Applying the test, the court reasoned that while it might be accurate to say that the workpapers helped Textron determine what amount should be reserved to cover any potential tax liabilities and that the workpapers were useful in obtaining a clean opinion from its outside auditors, there would have been no need to create a reserve if Textron had not anticipated a dispute with the IRS that was likely to result in litigation or some other adversarial proceeding. Therefore, the reserve for liabilities and, by extension, the tax accrual workpapers were created because of anticipated litigation with the IRS. The court also agreed with Textron that due to the unsettled state of the law and Textron’s previous history with the IRS, Textron’s anticipation of litigation in this case was well founded.

Substantial need: In addition to arguing that the work-product privilege did not apply, the Service argued that if it did apply, it should be disregarded because the IRS had a substantial need for the information in the tax accrual workpapers. The district court stated that although the workpapers were relevant to the IRS’s audit, they provided only the opinions and conclusions of Textron’s attorneys and accountants and did not provide any factual information that would assist the Service in determining Textron’s tax liability. Because the information in the workpapers had little bearing on the determination of Textron’s tax liability, the court held that the IRS had no substantial need for the information that would override the privilege.

Waiver of the Privileges

The Service further argued that by sharing the workpapers with its independent auditors, Textron had waived all three privileges. The court agreed with the IRS about the attorney-client and tax practitioner–client privileges but disagreed about the work-product privilege. According to the court, the purpose of the attorney-client and tax practitioner–client privileges is to insure that confidential communications between a client and an adviser remain confidential, while the work-product privilege’s purpose is to prevent an adversary from obtaining an unfair advantage in litigation by obtaining documents prepared in anticipation of litigation. Because any dissemination of documents to a third party necessarily destroys confidentiality, the court held that Textron had waived the attorney-client and tax practitioner–client privilege by giving the documents to its auditors. However, because giving the workpapers to the independent auditors was not inconsistent with the purpose of the work-product privilege (i.e., in this case, keeping the documents from the IRS), the court held that Textron had not waived the work-product privilege by doing so.

Textron, Inc., D. R.I. (8/28/07)

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