Judge denies IRS request for tax accrual work papers

Companies with audited GAAP financial statements should take note that the U.S. District Court in Rhode Island, in a case that has attracted national attention, ruled that certain sensitive "tax accrual work papers" are protected from disclosure by the work-product privilege and, accordingly, are not subject to discovery requests from the IRS. Several important lessons can be learned from Textron:

  • Companies should take steps to make sure that all written tax analyses of troubling tax positions are prepared internally or by an attorney to be eligible for the work-product privilege.

  • Tax accrual work papers should not be prepared by or made available to the tax return preparers. (In Textron, the work papers were not prepared until after the returns were filed.)

  • Files for the tax accrual work papers should be maintained separate from the underlying transaction documents.

  • Companies should consider developing a procedure to have particularly troubling tax positions analyzed by tax counsel, as opposed to normal internal review under FIN 48. (The documents in Textron were ultimately protected under the attorney work-product privilege and not by the tax practitioner-client privilege.)

  • Confidentiality agreements should always be utilized to cover any limited disclosures to financial auditors to maintain the viability of the work-product privilege.

    In the case, Textron, headquartered in Rhode Island, allegedly engaged in transactions that the IRS had identified as abusive tax shelters. The question before the Court was whether tax accrual work papers had to be disclosed to the IRS in response to an IRS summons.

    While there is no recognized definition of what constitutes "tax accrual work papers," this case involved spreadsheets listing transactions and positions that could be challenged by the IRS. These work papers were prepared by Textron's tax counsel after the company's tax returns were filed and were examined by Ernst & Young during the course of a confidential financial audit. The work papers included estimates by Textron's tax counsel expressing, in percentage terms, Textron's chances of prevailing in potential tax litigation with the government on these issues. There were also calculations of the reserves needed to cover the possibility that Textron might not prevail. The tax accrual work papers did not include the underlying transaction documents.

    The District Court ruled that Textron did not have to hand over the tax accrual work papers, concluding that the documents were prepared in anticipation of litigation and were protected by the work-product privilege. In analyzing the issues, the District Court utilized the "because of" standard for determining whether the work papers were prepared in anticipation of litigation--the same standard adopted by the Sixth Circuit in U.S. v. Roxworthy, 457 F.3d 590 (6th Cir. 2006). Not all Circuits apply this standard, which could be the basis for a different outcome in another Circuit.

    Although Textron's disclosure to Ernst & Young effectively waived its claim to both the attorney-client and tax practitioner-client privileges, the Court found that the disclosure did not result in a waiver of the work-product privilege because Ernst & Young agreed to treat the work papers as confidential and was not a potential adverse party.

    IRS Chief Counsel, Donald Korb, has already stated "We're not going to change anything as a result of this case. Nothing in the decision undermines the IRS policy of seeking tax accrual work papers when appropriate." Despite the Chief Counsel's protestations to the contrary, however, this decision is a significant set-back to the IRS with respect to compelling the production of corporate taxpayer tax accrual work papers prepared by tax counsel evaluating the risk of transactions and positions setting forth percentages of likelihood of IRS success.

    This decision also highlights the ongoing quandary faced by internal tax and legal departments trying to determine how to satisfy the disclosure requirements of FIN 48 while not developing an audit roadmap for the IRS setting forth the analysis and evaluation of tax positions. Although the audit in Textron predated FIN 48, Textron's methodology of reviewing tax positions is consistent with the methodology required by FIN 48. Thus, the holding in this case should equally apply to FIN 48 analyses.

    Companies should revisit their FIN 48 analyses with the holding in Textron in mind and implement privilege protocols that give them the best opportunity to safeguard their FIN 48 analyses. While under current policy, the IRS exercises "discretion" in requesting tax accrual work papers, it is likely that the frequency with which the IRS requests these types of documents will increase. In the interim, Waller Lansden Dortch & Davis, LLP will continue to monitor the Textron decision as it will likely be appealed and it is expected that other cases in other Circuits will also be initiated by the IRS.

    AccountingWEB would like to thank Mike Yopp, Leigh Griffith, Don Stuart, and Brett Carter of Waller Lansden Dortch & Davis, LLP for allowing us to reprint this story. The authors can be reached at 800-487-6380.

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