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October 07, 2008

IRS Fails to Obtain Tax Accrual Workpapers - Work Product Privilege Applies

In Regions Financial Corp. & Subs. v. United States, 101 AFTR 2d 2008-2179, the Internal Revenue Service attempted to obtain the taxpayers tax accrual work papers regarding a contested transaction that the taxpayer had entered into.  At the time, the Service was reviewing the taxpayer's tax liability for 2002 and 2003.  During those years, the taxpayer entered into "listed transactions" or, for simplicity, tax shelters.  The Service served a summons on Ernst & Young LLP, the accounting firm that audited the taxpayer's accounting information.  The taxpayer instructed E&Y to withhold certain documents and to not turn over those documents to the Service.  The litigation then ensued.

The area of dispute dealt with whether a taxpayer must produce its tax accrual work papers in responseto an IRS summons?  To answer that question, the court stated it must address: (i) whether the summons is proper under the four-part test laid out by the United States Supreme Court in United States v. Powell, 379 US 48 (1964), (ii) whether any of the documents are privileged, (iii) if certain documents are privileged, whether the privilege has been waived, and (iv) can the IRS overcome the privilege by showing substantial hardship?  The Regions court found that it did not need to address Steps 1 and 4 because the taxpayer was not arguing that the summons was improper and the Service was not arguing a hardship.  Thus, the case came down to Steps 2 and 3, which are discussed below.

In determining whether a privilege applied, the court recognized that the work-product privilege applies to IRS summonses.  The primary element within the work-product privilege is whether the documents were prepared in anticipation of litigation.  The taxpayer and the Service, however, disagreed on the test to determine whether the documents at issue were prepared in anticipation of litigation in the context of an IRS Summons.  The Service argued that the proper test was the “primary motive purpose” test, which states that litigation need not be imminent as long as the primary motivating purpose behind the creation of the document was to aid in possible future litigation.  The taxpayer argued that the “because of litigation” test applied, which states that in light of the nature of the document and the factual situation in the particular case, the document can be fairly be said to have been prepared or obtained because of the prospect of litigation.  According to many courts, the “because of litigation” test affords the taxpayers a broader protection.  Ultimately, the court agreed with the taxpayer that the proper test was the “because of litigation” standard.

In determining whether the documents were prepared in anticipation of litigation under the "because of litigation" standard, the court went onto say that were it not for anticipated litigation, the taxpayer would not have had to worry about contingent liabilities and would not have needed to elicit opinions regarding the likely results of litigation.  The court also cited United States v. Textron, 507 F. Supp. 2d 138 for support of its analysis.  In Textron, the court applied the “because of litigation” test and held that tax accrual work papers were protected under the work product privilege stating that 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 some other adversarial proceeding.  Ultimately, the Regions court determined that the contested documents contained precisely the kind of legal analysis that the work product doctrine exits to protect.  It is important to note that the court did not protect the underlying facts of the transaction from being disclosed.  Rather, it was the mental impressions and opinions of the taxpayer’s lawyers that were protected.

The court also found that the taxpayer did not waive its privilege when it turned over the documents to its auditors.  The court stated that the auditor, although independent, was not an adversary of the taxpayer and the parties had entered into a confidentiality agreement to protect the disclosure of the information.

See the case for further discussion.

Download case_tax_accrual_work_papers.pdf

 

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October 07, 2008

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