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...
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