Tax Accrual Workpapers May Be Privileged By Robert W. Wood and Alfred K. Leong • Wood & Porter • San Francisco The fine line between tax accounting work History Lesson and tax legal work is often blurry. The Many M&A TAX REPORT readers may not even preparation of a tax return may involve remember Arthur Young, the other Arthur- both number crunching and legal analysis. named accounting firm. Yet, in 1984, the U.S. Most accountants would consider the Supreme Court in Arthur Young, Inc., SCt, 465 preparation of tax accrual workpapers as US 805 (1984), upheld the rights of the IRS to accounting work. obtain tax accrual workpapers prepared by After all, tax accrual workpapers involve the taxpayer’s independent auditors. That the calculation and the recording of a was a big deal at the time. Notably, the journal entry for potential tax liabilities source of that invigorated authority was the on the company’s books. What could be IRS’ broad summons authority. The Supremes more fundamental to accounting than the specifically rejected Arthur Young’s position preparation of a journal entry? that the workpapers were not relevant to the Thus, the preparation of tax accrual IRS audit. workpapers is often left to the tax accountants, Arthur Young was an important case. Yet, on who presumably know more about FAS 109 the heels of that victory, the IRS reaffirmed its and FIN 48 than most tax attorneys. However, policy of restraint in Announcement 84-46. Just a recent District Court case, Textron, Inc., what is “restraint”? That policy contemplated DC-RI, 2007-2 USTC ¶50,605 (Aug. 29, 2007), that the IRS would not seek tax accrual demonstrates the importance of involving workpapers absent unusual circumstances. tax attorneys in a company’s preparation of The main unusual circumstance was simply tax accrual workpapers. The involvement of when the examiner has not been able to obtain tax attorneys in the preparation of tax accrual the necessary facts from the taxpayer. workpapers may protect the workpapers from In such a case, to put an additional control being disclosed to the IRS later during an audit. on the circumstance, the IRS examiner was 3 T H E M & A T A X R E P O R T supposed to obtain written approval from Look-See? the chief of examination. Even then, the In holding that the taxpayer did not have request is to be limited to the portion of to turn over its tax accrual workpapers to the workpapers believed to be material and the IRS, the court ruled that the tax accrual relevant to the examination. Just how all this workpapers were protected under the attorney- worked in practice was debatable, and to client privilege, the tax practitioner privilege some extent, could still be debated today. under Code Sec. 7525, and the work-product In any event, in 2002, the IRS announced privilege. That sounds like a three-pronged that it was modifying its mantra of restraint. victory. In Announcement 2002-63, the IRS said However, the court also held that the that the IRS examiner must request the taxpayer’s disclosure to its independent taxpayer’s tax accrual workpapers for any auditors waived both the attorney-client listed transaction claimed on a return. OK, privilege and the tax practitioner privilege. that suggests there’s a higher standard Ouch. Nonetheless, the court ruled that such when a listed transaction is involved (sound disclosure did not waive the work-product familiar?). Plus, if a taxpayer claimed two privilege (in large part, because the auditors or more of these listed baddies on a return, were not viewed as potential adverse parties, the examiner then could have a field day. In and because the auditors signed confidentiality such a case, the examiner must request the agreements). tax accrual workpapers for all items reported In determining whether the tax accrual on the return. Not exactly restraint, one workpapers were protected as work product, might argue. It is with this background that the court considered the question of whether the Textron case looms large. the tax accrual workpapers were prepared “in anticipation of litigation.” Noting a split Key Papers in the Circuits as to the standard to apply In Textron, the IRS issued summons for in determining whether a document was the taxpayer ’s tax accrual workpapers in prepared “in anticipation of litigation,” connection with its audit of the taxpayer ’s the court applied the “because of” test as 2001 tax return. The taxpayer ’s in-house articulated in M. Adlman, CA-2, 98-1 USTC tax attorneys and CPAs had prepared the ¶50,230, 134 F3d 1194 (1998), and concluded tax accrual workpapers. The workpapers that the tax accrual workpapers were protected consisted solely of a spreadsheet as work product. containing: (a) a list of items on the taxpayer’s tax returns, Caution Ahead? which, in the opinion of the taxpayer’s Textron is a significant victory for taxpayers. in-house tax attorneys, involved issues on Nonetheless, corporations should proceed which the tax laws were unclear; with caution. Other taxpayers may encounter (b) estimates by the taxpayer’s in-house tax different results in attempting to protect tax attorneys expressing, in percentage terms, accrual workpapers (or other documents) their judgments regarding the taxpayer’s from disclosure to the IRS. chances of prevailing in any litigation over Indeed, two standards exist for determining those issues; and whether a document is prepared “in (c) the dollar amounts reserved to reflect the anticipation of litigation.” Some courts have possibility that the taxpayer might not applied the “principal purpose” standard, prevail in such litigation. while other courts may conclude differently The taxpayer’s independent auditors had on the question of whether certain tax accrual examined the tax accrual workpapers for workpapers are work product. purposes of issuing an unqualified opinion Furthermore, the work product privilege is a on the taxpayer ’s financial statements. qualified (rather than an absolute) privilege. If Notably, the tax accrual workpapers did not the IRS can show a “substantial need” for the include any documents pertaining to the protected documents and an inability to otherwise underlying transactions in question. obtain the information contained therein without 4 T H E M & A T A X R E P O R T “undue hardship,” the taxpayer may be required • The tax accrual workpapers should not be to disclose tax accrual workpapers even though disclosed to the corporations’ external tax they are protected under the work product preparers (such disclosure might waive privilege. [See Fed. R. Civ. P. 26(b)(3).] the work product privilege). • The tax accrual workpapers should be Line-Item Advice kept in a separate file from the documents Textron offers some valuable lessons for pertaining to the underlying transactions for corporate tax departments to employ in the which there is questionable tax treatment. preparation of tax accrual workpapers: • Corporations should consider creating a Last Word procedure whereby tax attorneys review Like it or not, companies are implementing questionable tax positions during the process processes for compliance with FIN 48’s new of preparing tax accrual workpapers. recognition, measurement and disclosure • Corporations should consider creating requirements. In this context, the Textron a procedure whereby tax attorneys case gives companies strategies for creating review questionable tax positions during steps in their FIN 48 compliance process to the process of preparing tax accrual protect their FIN 48 workpapers as work workpapers;corporations should take product. steps to ensure that all written tax analysis Plainly, Textron does not guarantee that is prepared by an attorney eligible for such steps will protect the companies’ FIN 48 the work-product privilege. workpapers under the work product privilege. • Corporations should require their independent Equally plainly, taking these steps can help auditors to sign confidentiality agreements. give companies a fighting chance.