On August 13, 2009, the United States Court of Appeals for the First Circuit issued a long-awaited decision which raises questions about the continued ability of businesses and other entities to protect confidential documents prepared by their lawyers. While the decision, United States v. Textron, Inc., involved the Internal Revenue Service’s effort to obtain a set of internal tax documents known as tax accrual workpapers, the decision has potential implications for a far broader scope of documents prepared by an entity’s in-house and outside lawyers.
Textron, like every publicly traded corporation, is required by federal securities law to have its financial statements certified by an independent auditor. Such financial statements must include reserves for contingent tax liabilities, which are estimates of how much the company may owe if certain positions taken on the company’s tax returns are challenged by the IRS. To compute the reserve for a particular item, a company will generally estimate the percentage likelihood that the IRS would prevail and multiply that by the dollar amount in issue. To support the reserve computations and satisfy its auditors of the reasonableness of those computations, the company’s lawyers may prepare detailed, candid assessments of the strengths and weaknesses of the positions taken on the return.
In the recent case, the IRS served an administrative summons for these supporting (i.e., tax accrual) workpapers during an audit of Textron, which involved alleged tax shelter transactions. Textron resisted disclosing the workpapers on the ground that they were protected by the attorney work product doctrine. This doctrine provides a privilege (separate from the attorney-client privilege) for documents prepared by a party’s lawyers “in anticipation of litigation or for trial.” The purpose of this doctrine is to permit a party’s lawyer to honestly assess the client’s position on an issue that may be contested, without fear that the client’s adversary may later obtain that evaluation and use the lawyer’s candid, detailed assessments of the client’s position against the client.
This was precisely the basis of Textron’s argument: While published financial statements generally only disclose the aggregate amount set aside for tax reserves, the backup workpapers could provide a roadmap to the IRS of the thought processes of Textron’s lawyers, as to which issues were the “soft spots” on the return and what percentage chance the lawyers believed the IRS had to succeed on each issue if the IRS challenged Textron’s position.
The District Court held that the workpapers were protected work product documents, and a three-judge panel of the First Circuit Court of Appeals agreed. The IRS asked for a rehearing before all five judges of the Court of Appeals, and that request was granted. In the recent decision issued by the full Court of Appeals, a sharply divided 3-2 majority reached the opposite conclusion, holding that the workpapers were not protected by the work product doctrine and had to be disclosed to the IRS. (The attorney-client privilege was not a factor since it had previously been determined that Textron had waived that privilege by disclosing the workpapers to its outside accountants.)
The critical issue in the decision, which makes it so potentially important, was the court’s determination that the workpapers did not qualify as work product since they did not meet the necessary threshold of having been prepared “in anticipation of litigation.” As background, before Textron, most federal courts, including the First Circuit, had broadly interpreted the term “in anticipation of litigation” to include documents prepared “because of” the prospect of litigation, including documents prepared for dual purposes. That is, if there were a business purpose or regulatory requirement for preparing a document, but it was also prepared because of the possibility of later litigation, the privilege could still apply. In contrast, one federal circuit, the Fifth Circuit, permitted the privilege to be invoked only when the “primary motivating purpose” for creating the document was to aid in possible future litigation.
Based on the broader standard which the First Circuit had adopted before Textron, Textron argued that even though its tax accrual workpapers were prepared to support its financial statements and thus to comply with federal securities law, they were also necessarily prepared “in anticipation of litigation” against the IRS since, by definition, the only reason a tax reserve was needed at all was the possibility that the IRS would challenge its tax reporting position and Textron would be required to defend its position against the IRS.
In the recent decision, the three majority judges held that the workpapers were prepared to comply with securities law requirements and had not been prepared in anticipation of litigation. While the majority stated that it was leaving in place the broader “because of” test which the court had previously adopted, the majority appeared to adopt a new and much different test which requires documents to have been “prepared for use in possible litigation” to qualify for work product protection. In a strongly worded dissenting opinion, the two minority judges stated that the majority judges had in fact discarded the “because of” test, and had wrongly replaced it with a far narrower “prepared for use” test which eliminates the protection for documents prepared for dual purposes.
The new First Circuit decision is binding only in four New England states (Massachusetts, Maine, New Hampshire and Rhode Island) and Puerto Rico, and it strictly decides only the issue of whether the IRS can obtain tax accrual workpapers. Nonetheless, the decision raises questions for every entity about the future sanctity of documents prepared by its lawyers which assess the entity’s position on any issue which may later be contested.
The first question raised by the decision is how courts which have not yet addressed the question of tax accrual workpapers will rule on that issue following Textron. This includes the Seventh Circuit, which encompasses Wisconsin, Illinois and Indiana. The Court of Appeals for the Seventh Circuit has previously adopted the broader “because of” test for work product documents (just as the First Circuit did before Textron), and has specifically ruled that documents prepared to comply with a specific regulatory obligation can nonetheless be considered work product if they were also prepared because of the possibility of later litigation. However, the Seventh Circuit has not yet considered the specific issue of tax accrual workpapers.
Until that occurs, business entities and their tax counsel need to be especially careful, and not only for return positions involving tax shelters. The majority opinion in Textron emphasized that the IRS’ policy is to only seek tax accrual workpapers where, as in the Textron audit, specifically listed tax avoidance transactions are involved (and this may well have been a factor in the court’s ultimate decision). However, the published IRS policy statement which the court cited states that the IRS can seek tax accrual workpapers in any situation (i.e., even where listed avoidance transactions are not involved) where there are “unusual circumstances,” and the Internal Revenue Manual defines “unusual circumstances” expansively and further provides that the policy limitations will not apply to any case being investigated by the IRS Criminal Investigation Division. Businesses and their tax counsel thus cannot assume based on the discussion of IRS policy in Textron that the IRS will only seek tax accrual workpapers in shelter situations.
A second, broader question following Textron is whether the decision will be limited to the specific issue of tax accrual workpapers, or will be expanded to cover more general types of work product documents. As noted, the IRS audit in Textron involved alleged tax shelters, and the majority judges stressed that in such situations the IRS should not be precluded from “discovering under-reporting of corporate taxes, which is likely endemic.” This suggests the possibility that in future cases not analogous to enforcement of the tax laws in potential tax-avoidance situations, courts perhaps may not be as willing as the First Circuit was in Textron to restrict earlier decisions which have protected dual purpose documents as work product.
Until such future cases are decided, in-house and outside lawyers for business entities should be especially cautious in generating documents laying out strategies or assessing the strengths and weaknesses of their client’s positions, particularly where it could be claimed that the documents were prepared for an independent business purpose (i.e., to assist in a business decision) or to satisfy a specific regulatory requirement. As the dissenting judges noted in Textron, the majority decision places especially at risk of disclosure documents which analyze the business risk of a dispute, or reveal the amount of money set aside in a litigation reserve fund.
For further information on this issue, please contact the author of this alert or your Michael Best attorney.