Tax Accrual Workpapers Not Protected by Work-Product Privilege

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

Sitting en banc, the First Circuit reversed the ruling of a panel of the court and held that a corporation’s tax accrual workpapers were not protected from an IRS summons by the work-product privilege.


In the course of an audit of the 1998–2001 tax returns of Textron, Inc., a major aerospace and defense conglomerate, the IRS issued an administrative summons for Textron’s tax accrual workpapers. These workpapers are spreadsheets prepared by persons (some of whom were lawyers) in Textron’s tax department to support Textron’s calculation of its tax reserves for its audited financial statements. The IRS sought the workpapers because it had identified from Textron’s 2001 return nine sale-in, lease-out (SILO) transactions that Textron Financial Corp., a Textron subsidiary, had engaged in that the IRS believed were listed transactions. Textron refused to produce the workpapers, and the IRS sought an order in district court to enforce the summons.

The Work-Product Doctrine

The work-product doctrine, which was originally articulated by the Supreme Court in Hickman v. Taylor, 329 U.S. 495 (1947), was codified for the federal courts in the Federal Rules of Civil Procedure. Fed. R. Civ. P. 26(b)(3) provides that

a party may obtain discovery of documents and tangible things otherwise discoverable . . . and prepared in anticipation of litigation or for trial by or for another party or by or for that other party’s representative (including the other party’s attorney, consultant, surety, indemnitor, insurer, or agent) only upon a showing that the party seeking discovery has substantial need of the materials in the preparation of the party’s case and that the party is unable without undue hardship to obtain the substantial equivalent of the materials by other means.
The question of when the doctrine is applicable (i.e., when documents have been “prepared in anticipation of litigation or for trial”) has been the source of considerable litigation. Two competing tests for determining when a document was prepared in anticipation of litigation have arisen. Under the “primary purpose” test, a document is privileged only if the primary purpose for producing the document was to aid in possible future litigation. Under the “because of” test, a document is privileged if it is produced because of the prospect of litigation. The tests can produce different results in the case of documents that were created partially for business purposes and partially for litigation purposes (dual-purpose documents). Under the primary-purpose test, a document produced primarily for nonlitigation business purposes but also in part for use in possible litigation will not be protected, whereas under the because-of test it will be protected.

The because-of test, which is followed in five circuits, was set out in Adlman, 134 F.3d 1194 (2d Cir. 1998). Although the because-of test as expressed in Adlman extended the work-product privilege to dual-purpose documents, it specifically excluded certain documents from the privilege, stating:

Conversely, it should be emphasized that the “because of” formulation that we adopt here withholds protection from documents that are prepared in the ordinary course of business or that would have been created in essentially similar form irrespective of the litigation. It is well established that workproduct privilege does not apply to such documents.

The court derived this “ordinary course of business” exception from a note by the Advisory Committee on the 1970 amendments to the Federal Rules of Civil Procedure. The First Circuit adopted the becauseof test in Maine v. Department of the Interior, 298 F.3d 60, 68 (1st Cir. 2002) (“we therefore agree with the formulation of the work-product rule as adopted in Adlman”). It also specifically noted that it adopted the ordinary-course-of-business exception.

The District Court and First Circuit Panel Decisions

In the district court, Textron argued that its tax accrual workpapers were protected by either the attorney-client privilege, the tax practitioner privilege, or the work-product privilege. The district court rejected Textron’s attorney-client and tax practitioner privilege claims because Textron had shown the spreadsheets to its outside financial auditors, Ernst & Young, thereby waiving the privileges. However, it held that Textron had not waived the work-product privilege and therefore it considered whether the privilege applied. Among other issues, it addressed whether Textron created the workpapers “in anticipation of litigation.”

Following the precedent of the Maine decision, the district court applied the because-of test to make this determination. Because the Textron workpapers analyzed the prospects for and the likely results of litigation over its tax positions, the district court concluded that although Textron undeniably created the workpapers to satisfy its financial audit requirements, “but for” the prospect of litigation the documents would not have been created at all. Consequently, the documents were created in anticipation of litigation under the because-of test despite the fact that they were created for use in Textron’s audit and financial statement preparation. In response to the IRS’s contention that the ordinary-course-of-business exception to the because-of test applied, the court found that because the workpapers had a litigation purpose, the fact that they were created to satisfy a business or regulatory requirement did not mean that they were not created because of the anticipation of litigation.

The IRS appealed the district court’s decision to the First Circuit. A three-judge panel of the court affirmed the district court. Like the district court, it reasoned that there would be no need for workpapers analyzing potential litigation if there was no potential of litigation, so the workpapers were prepared because of litigation. However, the court included an expanded explanation of the reasons for rejecting the application of the ordinary-course-of-business exception. According to the court, the writers of the note to Fed. R. Civ. P. 26(b)(3) from which the Adlman court derived the exception were considering the problem of dual-purpose documents when writing the note and only meant to convey that documents created entirely for nonlitigation business purposes were not covered by the workproduct privilege. Therefore, the exception would not apply to dual-purpose documents.

The Decision of the Full Court

Following the court’s first decision, the IRS petitioned the First Circuit to hear the case en banc. In March 2009 the court granted the IRS’s petition, and the case was reheard by the full court in June. The full court reversed the district court and held that the work-product privilege did not apply to Textron’s tax accrual workpapers. Like the original panel decision, the full court purported to be following the First Circuit’s decision in Maine (and, by extension, the Second Circuit’s decision in Adlman) and to be applying the because-of test for the work-product privilege.

Reviewing the facts of the case, the full court found that Textron created the workpapers “to make book entries, prepare financial statements and obtain a clean audit.” The court pointedly rejected Textron’s contention that the workpapers would be of practical use if litigation did occur, stating that the record contained no proof of this save the bare assertion of a Textron executive. The full court also stated that the district court had not made a finding that the workpapers were prepared for use in litigation.

The full court then analyzed Fed. R. Civ. P. 26(b)(3) and the precedent on the privilege, from the original English common law formulation of the workproduct privilege through the Supreme Court decisions in Hickman v. Taylor and subsequent cases. It found that all these sources indicated that the privilege applied only when the party invoking it created the documents in question at least in part for use in litigation that was underway or anticipated. Consistent with this principle, the court found that the ordinary-course-of-business exception to the work-product privilege contained in the notes to Fed. R. Civ. P. 26(b)(3) (and incorporated into the because-of test by the courts in Maine and Adlman) should be interpreted to mean that a document created in the ordinary course of business was unprotected even if the subject matter of the document was anticipated litigation. Having found that the tax accrual workpapers (1) were prepared for financial statement and audit purposes and not for litigation, (2) would not have been of use in litigation, and (3) were required to be prepared by law and financial accounting rules, the court held that the workpapers were not prepared in anticipation of litigation or for trial and were thus not protected by the workproduct privilege.


The Textron decision contains a vigorous dissent from the judge who wrote the decision of the panel court. The dissent accuses the majority of not following the precedent of Maine and abandoning the because-of test in favor of a new “prepared for any litigation or trial” test. However, although its opinion is not a model of clarity, the majority did not adopt a new standard; rather, it adopted the because-of test with a literal interpretation of the ordinary-course-of-business exception.

The dissent argues that Adlman (and by extension Maine) requires the use of a because-of test with a subjective version of the ordinary-course-of-business exception that is nothing more than a reaffirmation of the main test. The dissent claims that its interpretation of the exception is necessary to keep the exception from swallowing the rule. However, its interpretation would essentially eliminate the exception. It would seem odd that the Adlman court (and the writers of the notes to Federal Rules of Civil Procedure) very specifically included an exception to the because-of test that only reinforced the meaning of the main test and was not intended to have any practical application.

Furthermore, if the Second Circuit intended anything other than a literal interpretation of the ordinary-course-of-business exception, it did not say so directly in the Adlman decision. Despite the dissent’s arguments to the contrary, the Adlman decision as written is at best ambiguous on the issue. The dissent, however, does correctly point out that only the Supreme Court can definitively resolve it.

Textron, No. 07-2631 (1st Cir. 8/13/09) (en banc)

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