Textron Decision Deems Tax Accrual Workpapers Protected Work-Product

The First Circuit's decision to uphold the district

court's ruling that the taxpayer's tax accrual workpapers

are protected work product should be viewed as a significant

taxpayer victory, but the decision raises as many questions as it

answers.

On January 21, 2009, the U.S. Court of Appeals for the First

Circuit issued the much-anticipated decision in Textron Inc. v.

United States. In a majority decision drafted by Judge Juan

Torruella, the First Circuit upheld the U.S. District Court for the

District of Rhode Island's decision that tax-accrual workpapers

prepared by a taxpayer are protected by the work product doctrine.

However, the majority held that waiver of the protection afforded

by the work product doctrine may occur if the taxpayer's

analysis is reflected in its auditor's workpapers, which are

not protected by the work product doctrine. The court remanded the

case to the district court for further proceedings to determine

whether the auditor's workpapers would reveal the information

contained in Textron's own workpapers, and whether the

auditor's workpapers are discoverable on the grounds that the

taxpayer has the legal right or ability to obtain these documents.

A dissenting opinion by Judge Michael Boudin argues that

tax-accrual work papers are not protected because they are

prepared for reasons independent of the need to prepare for or

conduct litigation.

The First Circuit's decision should be viewed as a

significant taxpayer victory with respect to the principal issue of

whether tax-accrual workpapers are protected by the work product

doctrine. However, the Court's holding regarding waiver is

troubling and arguably incorrect.

IRS History of Restraint in Requesting Tax Accrual

Workpapers

Tax accrual workpapers provide support for a taxpayer's

financial statement tax reserves. They are sensitive documents

because they identify the taxpayer's judgment about the issues

for which the results under the tax laws are unclear (so-called

"soft spots" on the return). Tax accrual workpapers

generally reflect the evaluation of the taxpayer's counsel or

in-house accountants as to the likelihood of success if the issues

were litigated. In other words, in any dispute with the Internal

Revenue Service (IRS), tax accrual workpapers provide the

taxpayer's evaluation of its hazards of litigation. Because of

their sensitive nature, access to these workpapers has been an area

of long-standing controversy between the IRS and taxpayers.

In United States v. Arthur Young Inc., 465 U.S. 805

(1984) the Supreme Court of the United States upheld the right of

the IRS, under its broad summons authority, to obtain tax accrual

workpapers prepared by the taxpayer's independent auditors, and

rejected the taxpayer's position that the workpapers were not

relevant to an IRS audit. In 1981, the IRS adopted a policy of

restraint under which it would not seek tax accrual workpapers

absent "unusual circumstances," such as if the examiner

has not been able to obtain the necessary facts from the taxpayer.

The IRS adopted this policy in response to serious concerns that

unlimited access by the IRS to tax accrual workpapers would have an

adverse effect on the preparation of accurate financial statements.

Under unusual circumstances, the IRS examiner must obtain written

approval from the chief of examination, and the request is limited

to only the portion of the workpapers believed to be material and

relevant to the examination.

In 2002, the IRS announced that it was modifying its historic

policy of restraint with respect to asking for a company's tax

accrual workpapers. Under the modified policy, the IRS examiner

must request the taxpayer's tax accrual workpapers if the

taxpayer claimed a tax benefit from a "listed"

transaction on the return under review. Moreover, if a taxpayer

claimed tax benefits from two or more listed transactions on a

return under review, the IRS examiner must request the tax accrual

workpapers for all items reported on the return.

The Relevant Facts of

Textron

The IRS issued an administrative summons to Textron pursuant to

I.R.C. § 7602 seeking tax accrual workpapers in the actual or

constructive possession, custody or control of Textron or its

accountants for Textron's 2001 tax returns. Textron refused to

comply and asserted, among other defenses, that the tax-accrual

workpapers sought were protected by the work product doctrine

because the documents were prepared in anticipation of litigation,

i.e., in preparation for a tax dispute with the IRS. The

IRS sued to enforce the subpoena.

Historically, IRS audits of Textron had been contentious. The

IRS audits every Textron return, in multi-year cycles. In seven of

the last eight audit cycles, Textron and the IRS have brought at

least one issue to the IRS...