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Internal documents prepared by a corporation, which analyze the potential success of IRS challenges to its tax returns, is protected work product and not discoverable by the IRS as part of a subsequent investigative subpoena, according to the U.S. First Circuit Court of Appeals.
In this case, Textron, Inc. and its various subsidiaries had prepared internal tax accrual workpapers, which listed positions the company was taking on its 2001 IRS returns, and which might require the company to set aside a reserve. These positions were then analyzed by Textron attorneys who estimated a percentage likelihood that the position would not prevail if challenged by the IRS. Textron had also produced these workpapers to its independent auditor, Ernst & Young.
The IRS had issued an administrative summons to obtain the documents, which Textron refused to produce, claiming various legal defenses. The IRS sued to enforce the subpoena. After an evidentiary hearing, the district court for the District of Rhode Island ruled that the documents were protected as work-product, and also found that Textron’s disclosure to Ernst & Young did not constitute a waiver (although it did rule that the disclosure constituted a waiver of any attorney-client privilege claimed).
The IRS appealed. The First Circuit agreed with the District Court, finding that the documents were produced “because of” potential litigation. While not all dealings with the IRS during an audit could be construed as comercial litigation, “the resolution of disputes through adversary administrative processes, including proceedings before the IRS Appeals Board” fell under the definition of litigation.
The IRS had argued that preparation of tax returns was not meant to be an adversary process, but a self-reporting exercise, which relied on the good faith of taxpayers, and that it was entitled to verify such self-assessment by reviewing any relevant information.
The First Circuit did not disagree, but found that good-faith disputes regarding the proper application of tax law also arose during the audit process, that the disputes were in essence adversarial and would inevitably be the subject of litigation if not resolved.
The Court determined that the function of the documents was to analyze litigation for the purpose of creating and auditing a reserve fund, and therefore, the driving force behind the preparation of the documents was the need to reserve money in anticipation of disputes with the IRS.
Finally, as to whether Textron had waived its privilege by disclosing the information to Ernst & Young, its auditors, the Court recited that work product protection was provided against adversaries, and therefore, only disclosing material in a way which was inconsistent with keeping it from an adversary, would act to waive the work product protection.
With this in mind, the First Circuit remanded the case to the District Court to determine whether their disclosure would substantially increase the risk that the contents of Textron’s workpapers would be disclosed to the IRS, its adversary.
USA v. Textron, Inc. No. 07-2631
January 21, 2009