INTRODUCTION
In a highly controversial split decision, the U.S. Court of Appeals for the First Circuit ruled that the work product privilege does not protect a company’s tax accrual work papers from IRS discovery. In U.S. v. Textron Inc., ____ F.3d ____, 2009 WL 2476475, No. 07-2631 (1st Cir. Aug. 13, 2009), the First Circuit held that the tax accrual work papers are not protected work product because they were prepared to support financial filings and gain auditor approval, rather than for use in possible litigation. American in-house attorneys denounce the opinion, claiming that it eviscerates their ability to work with company auditors to ensure accurate and well-informed financials and accounting disclosures. The decision creates a split among circuits, making the issue ripe for Supreme Court review.
BACKGROUND
The IRS defines tax accrual work papers as “audit workpapers, whether prepared by the taxpayer, the taxpayer’s accountant, or the independent auditor, that relate to the tax reserve for current, deferred and potential or contingent tax liabilities, however classified or reported on current audited financial statements, and to footnotes disclosing those tax reserves on audited financial statements.” Internal Revenue Manual, Section 4.10.20.2(2).
A company’s tax and legal personnel generally create the tax accrual work papers in order to calculate the appropriate amount of total tax reserves. Textron’s tax accrual work papers included a spreadsheet listing each questionable item that might be the subject of possible dispute by the IRS, the dollar amount subject to dispute, and the estimated chance of success by the IRS on that item. The papers also included numerous backup materials, including documents written by Textron’s in-house counsel reflecting their opinion as to which items should go on the spreadsheet and risk of litigation percentage that should apply to each item.
During an IRS examination of Textron, IRS agents found that a Textron subsidiary had invested in transactions that the IRS determined to be tax shelters, and subsequently issued an administrative summons seeking all of the company’s relevant tax accrual work papers. Textron refused to comply, claiming that the tax accrual work papers were protected by the work product privilege.
The IRS filed suit in Rhode Island federal district court to force Textron to produce the tax accrual work papers. The district court determined that the work papers were protected by the work product privilege because Textron would not have prepared them “but for” the fact that Textron anticipated the possibility of litigation with the IRS. U.S. v. Textron Inc., 507 F. Supp. 2d 138, 150 (D.R.I. 2007).
A panel of the U.S. Court of Appeals for the First Circuit agreed with the district court in full, but at the IRS’ request, the First Circuit vacated its panel opinion and reheard the case en banc. After the rehearing, the First Circuit issued a 3-2 decision reversing the district court and concluding that the work product privilege did not protect Textron’s tax accrual work papers. U.S. v. Textron Inc., ____ F.3d ____, 2009 WL 2476475, No. 07-2631 (1st Cir. Aug. 13, 2009).
Work papers are not protected if not prepared for use in litigationThe majority in the First Circuit’s en banc decision did not inquire as to whether the tax accrual work papers were prepared “because of” the prospect of future litigation, as the district court and First Circuit panel had done. Rather, the en banc majority considered the actual intended use of the work papers, noting that even though the documents may have included legal thinking and analysis, Textron did not prepare the work papers “for use” in possible litigation. Instead, Textron had prepared the documents to quantify its tax reserves, support its financial statement, and obtain a clean audit. 2009 WL 2476475, *5. The majority concluded: “Any experienced litigator would describe the tax accrual work papers as tax documents and not as case preparation materials.” 2009 WL 2476475, *7.
The majority noted that Textron would have had to prepare the tax accrual work papers in order to comply with statutory and audit requirements, even if there was only a remote chance of litigation. 2009 WL 2476475, *6.
Accordingly, the majority determined that the work papers were not protected by the work product privilege because “[t]here is no evidence in this case that the work papers were prepared [in anticipation of litigation] or would in fact serve any useful purpose for Textron in conducting litigation if it arose.” 2009 WL 2476475, *9.
The two judges representing the minority view – two judges who rendered the original panel decision – issued a strongly worded dissent. They wrote: “The majority’s analysis ignores a tome of precedents from the circuit courts and contravenes much of the principles underlying the work-product doctrine.” 2009 WL 2476475, *10. The dissent adds: “Textron’s litigation hazard percentages contain exactly the sort of mental impressions” that the work product privilege is designed to protect. 2009 WL 2476475, *14.
The dissent pointed out that the majority opinion contradicts its own First Circuit precedent of Maine v. United States Dep’t of Interior, 298 F.3d 60 (1st Cir. 2002), which had previously adopted the standard set forth by the Second Circuit in United States v. Adlman, 134 F.3d 1194 (2nd Cir. 2002). In that case, the Second Circuit protected similar work papers and held that the work product privilege does not only extend to materials prepared to assist in the actual trial, but to any document prepared in anticipation of litigation. 2009 WL 2476475, *18.
CONCLUSION
Shortly after the Textron en banc opinion was published, the Association of Corporate Counsel released a response “decrying” the decision, claiming that it “eviscerates practical protection of attorney work product for in-house counsel.” The ACC voices its concern that Textron actually encourages in-house counsel to avoid documenting or sharing information with accountants and auditors if that information could be used against the company’s interest later.
Indeed, many commentators are concerned that Textron could have far-reaching implications, particularly for publicly traded companies that are required to have their financial statements audited and certified. Though the IRS has an announced policy of self-restraint in requesting tax accrual work papers, this opinion may result in more such requests, leaving taxpayers without a viable means to protect their work product.
The implications could reach even further to the extent that the First Circuit has arguably changed the definition of work product originally set forth in Hickman v. Taylor, 329 U.S. 495 (1947). The Textron decision might open the door for litigants to request an opposing party’s analysis of the business risks of the litigation, including the estimated cost of the litigation, since those documents would not have been created for literal “use in” the litigation.
It may be more likely, however, that the Textron decision will be interpreted very narrowly. A future court could easily look at the focus by both the IRS and the majority on Textron’s alleged use of tax shelters, and find that the Textron opinion should only apply in cases where the work papers sought relate only to tax shelters and are only those papers prepared in compliance with securities laws and auditing requirements.
In any event, the Circuit split created by Textron makes the issue of work product protection for tax accrual work papers ripe for Supreme Court review. As of the publication of this commentary, Textron had not yet filed a petition for writ of certiorari, which is due in mid-October 2009, absent extension.
Mr. Lager is a partner of Zuber & Taillieu LLP, where he specializes in tax law. He earned a J.D. from the University of Pennsylvania Law School, and a B.A. from the University of California, Berkeley, graduating with distinction.
