First, work product analysis is an inquiry into why documents are created. The question for the court, with respect to each and every document and on a document-by-document basis, is, “Why did the applicant create this document?” By its very nature, such an inquiry requires a temporal analysis, with the court revisiting the moment the document was created. If a document was originally created for non-litigation purposes (that is, prepared irrespective of the prospect of litigation or prepared with an unreasonable prospect for litigation), traditional work product doctrine does not immunize the document and instead compels discovery.
In its opinion, the First Circuit, like the district court before it, demonstrated confusion over the purpose of tax accrual workpapers. It found that the prospect for litigation motivated taxpayers to create these tax documents. In particular, the court stated that any business purposes for workpapers “derives from and is inextricably related to anticipating litigation.” The anticipation of these disputes, the court continued, “triggered” business and accounting obligations.
But the court got it exactly backwards. Rather than litigation “triggering” reporting obligations, the reporting obligations for corporate taxpayers trigger considerations of litigation. Tax accrual workpapers are created according to federal securities law and GAAP principles, not in anticipation of litigation. Workpapers may contain determinations with respect to levels of certainty pertaining to likelihood of success on the merits, but those determinations are not in and of themselves reasonably prepared in anticipation of litigation. More importantly, without the antecedent reporting obligations, it is safe to say that many companies would not create workpapers at all, and certainly not for litigation reasons.
Second, the court revealed a significant lack of understanding with respect to dispute resolution procedures in the tax context. In particular, it effectively found that all disputes over taxes between taxpayers and the taxing agency are inherently adversarial and qualify as litigation for purposes of determining “reasonable” anticipation of litigation. The court ignored the vast majority of tax disputes for business taxpayers, including negotiations over proposed adjustments to return positions, conferences with the IRS audit-team manager, accelerated issue resolution procedures, and even appearances before the IRS Office of Appeals. Moreover, it subsequently characterized all remaining disputes--without identifying a single such dispute except those before the IRS “Appeals Board”--as “adversary administrative proceedings.”
Even if one concedes that tax disputes reaching a certain level of administrative review are adversarial in nature (as defined under the Federal Rules and contained in the Restatement), it does not necessarily follow that anticipating litigation with respect to negotiations at that stage is reasonable. For Textron’s last eight audit cycles dating back to 1959, for example, involving thousands of proposed adjustments to Textron’s reporting positions, the taxpayer and the IRS resorted to litigation over disputed issues just three times. In other words, less than one percent of all adjustments were litigated. Those are bad odds, even for the eternal, litigious optimist.
Third, the Federal Rules mandate that an applicant “expressly make the claim” of privilege, and “describe the nature of the documents, communications, or tangible things not produced or disclosed” such that other parties, including the court, can appropriately evaluate the claim. Courts also prefer explicit claims, because application of the work-product doctrine “must be supported by district court findings on the circumstances of preparation and purpose of the documents.” Such findings, in turn, require courts to examine the documents as well as the circumstances surrounding their creation and subsequent handling, a responsibility that obligates courts to request detailed document indexes and privilege logs, to conduct in camera inspections, to order production of carefully redacted documents, and to craft detailed protective orders.
With respect to the dispute between the IRS and Textron over its tax accrual workpapers, no federal court has yet examined the documents at issue, let alone “determine with specificity” Textron’s asserted reasons for creating the documents. It is true that Textron produced a privilege log listing the withheld documents, but the log never became part of the record, and both the district and circuit court failed to review a single listed document.
Fourth, the First Circuit did not explore adequately how Textron and E&Y might be potential adversaries. With the recent proliferation of tax shelter malpractice cases--with clients suing law firms, accounting firms, and banks and with law firms, accounting firms, and banks suing each other--an independent auditor reviewing a public company’s financial statements is, more than ever, a potential adversary or conduit to an adversary. For recent treatment of the tax shelter malpractice phenomenon, see Jay Soled, Tax Shelter Malpractice Cases and Their Implications for Compliance.
At the heart of dispute between the IRS and Textron were nine Sale-In, Lease-Out (SILO) transactions entered into by one of Textron’s subsidiaries. Not only can E&Y issue an adverse opinion with respect to Textron’s financial statements; it might very well be an adverse party in a later proceeding involving the legality of the SILO transactions it advised.
In addition, E&Y’s ultimate allegiance is complicated. Its duty may run to the corporate client under the common interest doctrine. But it may also run to the corporation’s creditors and stockholders as well as the investing public, third parties that may possess adverse interests to the corporate client and that, in any event, are owed independent obligations from E&Y. In this context, the possibility for a later unforeseen dispute between Textron and E&Y is considerably more likely than the court acknowledges, particularly given the prohibited tax shelters at issue.
Finally, the decision creates a perverse standard whereby more aggressive, abusive behavior receives a greater degree of protection than less aggressive, compliant behavior. Such a standard blows a hole in the Treasury. It undermines the government’s summons power. It prevents the taxing agency from adequately performing its regulatory function of verifying a taxpayer’s self-assessed tax liability. And it immunizes nearly every document analyzing the potential tax benefits of a transaction. Tax professionals will no longer need to rely on the attorney-client or tax practitioner-client privileges, because the work-product doctrine now swallows them both. And since it is harder to waive work-product protection than the two other privileges, tax advice will receive greater protection than other forms of legal advice.
In the end, the First Circuit’s decision protects precisely the kind of abusive tax avoidance that Congress and the Treasury Department have fought for the last decade to root out and punish.
Indeed, in every respect, the decision makes the government’s anti-shelter job a whole lot harder.