May 25, 2010
The Supreme Court Will Not Reconsider the Textron Case
On May 24th, the Supreme Court announced that it will not reconsider the 1st Circuit Court of Appeals controversial ruling in Textron Inc. v. United States (2009-2 U.S.T.C. ¶50,574 (August 13, 2009). As a result, the work product privilege, which has been used in the past to protect taxpayer accrual workpapers from discovery by the Internal Revenue Service, will no longer be available to taxpayers in the 1st Circuit (Maine, Massachusetts, New Hampshire, Rhode Island and Puerto Rico). The decision could lead to further challenges to the work product privilege if other circuits adopt the 1st Circuit’s position. The decision also could have ramifications beyond the tax arena for documents prepared in anticipation of litigation: e.g. documents which are used in GAAP financial statements to support other contingent liabilities.
In concluding that the work product privilege did not apply, the Court found that the taxpayer accrual workpapers were not prepared in anticipation of litigation. (Normally, the work product privilege applies to documents prepared in anticipation of litigation but does not protect documents created in the ordinary course of business and which are created to meet accounting standards.) In Textron, the Court contrasted the tax accrual workpapers with documents typically prepared for litigation and concluded that the workpapers were prepared for calculating reserves rather than for use in litigation.
Currently, there is a split amongst the circuits with regard to the applicability of the work product privilege to "dual purpose" documents. These types of documents are prepared in the ordinary course of business to support a business decision (i.e. the amount of reserves to set aside), but arguably are also created in support of potential litigation. This split in the circuit courts could lead to some interesting questions with regard to where a company’s principle office is and where its audits will be performed in order to avail itself of the work product privilege.
Facts of the Case:
Textron, Inc. is a major aerospace and defense conglomerate with approximately 190 subsidiaries. One of its subsidiaries, Textron Financial Corp., was audited for engaging in nine "listed transactions" known as Sale In Lease Out transactions (SILO’s). The IRS requested all financial workpapers created by the taxpayer, the taxpayer’s accountant and the independent auditor relating to any tax reserve accounts for potential or contingent tax liabilities. The Textron tax accrual workpapers included a spreadsheet that listed Textron’s uncertain tax positions that if challenged could result in additional taxes being assessed; the chances of prevailing at litigation with the IRS if the issues were litigated (given as a percentage); and the amount set aside as a reserve. Textron refused to furnish this information to the IRS asserting work product privilege. The IRS petitioned the United States District Court to have the documents turned over pursuant to Internal Revenue Code §7604.
Background on IRS Summons Process
Internal Revenue Code Section §7602 gives the IRS authority to summons a taxpayer’s books and records for purposes of ascertaining the correctness of any return, creating a return where none has been filed or determining and collecting any Internal Revenue Tax. Internal Revenue Code §7604 states that when the requested documents are not produced, the IRS can petition United States District Court to compel compliance. One argument against enforcement is privilege and that this privilege has not been waived.
In its defense, Textron asserted three types of privileges: attorney client privilege, tax practitioner-client privilege (under Internal Revenue Code § 7525) and the work product privilege (codified in Federal Rules of Civil Procedure 26(e)). Both the attorney client privilege and the tax practitioner-client privilege are waived when information is disclosed to a third party. In the Textron case, disclosure to the independent auditors waived those privileges. Thus, the focus of the Textron case was on the applicability of the work product privilege.
Work product privilege protects documents or materials prepared or gathered by an attorney in anticipation of litigation or in preparation for trial. The privilege is waived when there is a disclosure to a third party of information in a matter that substantially increases the opportunity for the adversary to obtain that information. Waiver for work product privilege was not addressed in Textron because the Court denied the privilege outright.
The Court of Appeals rejected that the work product privilege protected Textron’s tax accrual workpapers. In doing so, the Court found that the tax accrual workpapers were not created for use in future litigation. The Court reasoned that the tax accrual workpapers were created for the purpose of meeting GAAP accounting standards with respect to the Company’s tax reserves. As a result, the tax accrual work papers were produced irrespective of litigation and not for use in litigation. In fact, the Court found that the tax accrual workpapers were such that they would not be useful in any future litigation. As a result, the 1st Circuit Court of Appeals found that the work product privilege did not apply and enforced the IRS’s summons.
A Supreme Court review of the Court of Appeals Decision might have resolved the split in the Circuits and clarified the meaning of work product privilege. However, this is not an option after the Supreme Court determined it would not reconsider the Court of Appeals decision. What happens next remains to be seen. With the implications of Announcements 2010-9, 2010-17 and 2010-30 regarding disclosures of uncertain tax positions and the potential for further erosion of taxpayer privilege, the roadmap to transparency for the IRS is becoming clearer every day.