Tax Workpapers and Work Product Privilege

CPA Journal, The, Apr 2008 by Gabbin, Alexander L, Wells, Jean T

Textron and the Auditor-Attorney Relationship

The recent decision in United States v. Textron Inc. and Subsidiaries [507 F. Supp. 2d 138 (D.R.I. Aug. 28, 2007)] will have far-reaching implications for the treatment and discoverability of tax accrual workpapers prepared in reliance on advice provided by attorneys. While the court held that disclosure of risk of liability by a client's attorneys to an independent auditor for the purpose of developing tax accruals waived the attorney-client privilege, it did not waive the "work product privilege," which exists to serve a different public policy than the attorney-client privilege. In January 2008, the IRS appealed the district court's decision to the First Circuit Court of Appeals.

Textron involved the government's attempt to enforce an IRS summons for all of Textron's tax accrual workpapers. The ultimate outcome of Textron will have implications for the delicate 30-year balance forged between independent auditors and external attorneys, two parties who work together to maintain confidence in financial statements without intruding upon the confidentiality of the attorney-client and the work product privileges.

In Textron, the court affirmed the principle that tax workpapers fall within the protection of work product privilege. Generally, the work product privilege serves as a barrier to prevent a potential adversary from gaining an unfair advantage over a party by obtaining documents prepared by the party or its counsel in anticipation of litigation. Such documents could benefit the adversary by revealing the party's strategy or the party's own assessment of the strengths and weaknesses of its case. In Textron, the court ruled that only disclosures by Textron that were inconsistent with keeping the information from an adversary would constitute a waiver of work product privilege. Textron had disclosed the tax workpapers only to its independent auditors, who gave Textron a pledge of confidentiality.

The Textron Facts

The case began when the IRS sought to enforce a 2005 IRS summons issued to Textron to produce all of its tax accrual workpapers for the tax year ending December 29, 2001, and the workpapers in connection with the IRS's examination of tax liabilities for 1998-2001. The IRS was particularly concerned about nine salein, lease-out (SILO) transactions that a Textron subsidiary had engaged in. SILO transactions were classified as "listed transactions" by the IRS in February 2005 (Notice 2005-13).

Textron highlights the IRS's increased focus on seeking tax accrual workpapers. The IRS has had the right to obtain tax accrual workpapers for more than 30 years, but it seldom exercised this authority prior to 2002. Before Enron's collapse and the plethora of concurrent corporate scandals, the IRS had requested tax accrual workpapers only five times in 30 years. After 2002, the IRS's policy of voluntary restraint dramatically changed. In 2005 alone, the IRS requested tax accrual workpapers a total of 50 times ("Reed Smith Bulletin 06-26," September 2006), including Textron's. This surge suggests that such behavior may be the start of increased vigilance from other governmental agencies and regulators.

Textron refused to produce its tax accrual workpapers on the basis that they were protected by attorney-client privilege, tax practitioner-client privilege, and work product privilege. Textron claimed that its ultimate purpose in preparing the tax accrual workpapers was to ensure that it was adequately reserved for any future litigation. Textron also asserted that the summons was issued so that the IRS could use the documents related to the SILO transactions as a bargaining lever in settlement negotiations.

The IRS argued that Textron's tax accrual workpapers should not receive work product privilege protection, because they were prepared in the ordinary course of business. The IRS maintained that Textron would have created the workpapers in essentially similar form irrespective of litigation. The IRS further asserted that Textron's primary purpose for preparing the workpapers was to demonstrate that its contingent liability reserves were in accordance with GAAP and thereby deserved a clean audit opinion from the independent auditor.

The Textron Decision

The court was not persuaded by the IRS's "ordinary course of business" argument. Focusing instead on the contingent liability reserves reported in Textron's audited financial statements, the court reasoned there would have been no need to create a reserve in the first place if Textron had not anticipated a dispute with the IRS that was likely to result in litigation or another adversarial proceeding.

The court found that Textron had waived the attorney-client privilege and the tax practitioner-client privilege when it provided the workpapers to its independent auditors. Nevertheless, the court found that Textron did not waive the work product privilege, because the independent auditors had confidentially agreed not to disclose the information in the workpapers. Furthermore, the court relied on AICPA Code of Professional Conduct Rule 301, which expressly states that the independent auditor has a professional obligation to not "disclose any confidential client information without the specific consent of the client." The court concluded that the IRS failed to demonstrate a "substantial need" for the workpapers, because the determination of any tax owed by Textron must be based on factual information readily available by other means.