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In a decision praised by tax practitioners and assailed by the IRS, United States v. Textron Inc., a district court has held that the work-product privilege allowed Textron Inc. to resist an IRS summons seeking to obtain memoranda and opinions prepared by Textron’s in-house tax attorneys and outside counsel. The IRS has already indicated that it will likely appeal this decision.

The Textron decision involved a summons issued by the IRS that sought access to Textron’s “tax-accrual work papers” relating to its 2001 tax year. Although the term “tax-accrual work papers” is not defined by statute or regulations, the summons defined such work papers to include all “financial work papers or documents created or assembled by the taxpayer . . . relating to any tax reserve for current, deferred, and potential or contingent tax liabilities . . . [including] any and all analysis, computations, opinions, notes, summaries, discussions, and other documents relating to such reserves and any footnotes.”

Textron particularly objected to turning over to the IRS a spreadsheet prepared by Textron’s counsel expressing, in percentage terms, their judgments regarding Textron’s chances of prevailing in any litigation involving specific tax positions claimed by Textron on its tax return. Textron also objected to disclosing backup work papers consisting of the notes, memoranda and opinions of Textron’s attorneys concerning the tax positions taken by Textron on its tax returns and financial statements. All of the information sought by the IRS in its summons had previously been disclosed by Textron to Ernst & Young, its independent auditor, and was used by Ernst & Young in connection with the preparation of Textron’s tax return and financial statements (which were filed with the SEC).

In resisting the IRS summons, Textron asserted that the information requested was protected by the attorney-client privilege, the tax practitioner-client privilege contained in Section 7525 of the Internal Revenue Code and the work-product privilege. Although the district court did find that the tax accrual work papers in question would otherwise be protected by the attorney-client privilege and the tax practitioner-client privilege, such privileges were deemed waived when the work papers were furnished to Ernst & Young. However, the court also found that the work papers were protected under the work-product privilege, and that such privilege had not been waived by Textron.

In its decision, the court cited Section 7602 of the Internal Revenue Code as providing authorization for the IRS to issue an administrative summons for the production of “any books, papers, records, or other data which may be relevant or material” in “ascertaining the correctness of any return, . . . determining the liability of any person for any internal revenue tax, . . . or collecting any such liability.”

The court further acknowledged that when documents requested in a summons are not produced, the IRS may petition the federal district court for an order compelling compliance and that such an order would be issued if the IRS can demonstrate the following five elements: There is a legitimate purpose for the investigation pursuant to which the summons is being sought; the inquiry or material sought may be relevant to the purpose; the information sought is not already within the possession of the IRS; the administrative steps required by the Internal Revenue Code have been followed; and the information sought is not privileged. The court readily found that the IRS had established the first four of these elements and focused most of its attention on the applicability of a privilege.

After analyzing the nature of the tax accrual work papers sought by the summons, the court concluded that such work papers were prepared by counsel in the course of providing legal advice (even though such advice was in support of certain accounting functions and decisions). Therefore, such advice was, on its face, protected by the attorney-client privilege as well as by Section 7525 of the code, which confers a similar privilege on confidential tax advice rendered to a taxpayer by any federally authorized tax practitioner.

The court rejected the IRS argument that the tax practitioner-client privilege was limited by Section 7525(b) which provides that the privilege does not apply to written communications between a tax practitioner and the taxpayer “in connection with the promotion of the direct or indirect participation of such corporation in any tax shelter (as defined in Code Section 6662(d)(2)(C)(iii)).”

This argument was advanced by the IRS, since one of the transactions reported on Textron’s 2001 tax return was a so-called “SILO” transaction, which has been identified by the IRS as a tax shelter transaction. In rejecting this IRS argument, the court indicated that the limitation contained in Section 7525(b) did not apply to the legal advice rendered by Textron’s attorneys since such advice was not rendered “in connection with the promotion” of Textron’s participation in the alleged tax shelter. Rather, such advice was rendered after the transaction had been completed and only in connection with the reporting of the transaction.

Notwithstanding its finding that the tax accrual work papers sought by the IRS otherwise constitute information protected by the attorney-client privilege as well as the tax practitioner-client privilege, the court concluded that both privileges were waived as a result of Textron’s disclosure of the work papers to Ernst & Young. In this regard, the court cited well-established authority that a voluntary disclosure to a third-party waives the attorney-client privilege and the tax practitioner-client privilege. The fact that Ernst & Young was also rendering tax advice to Textron, similar in nature to the advice that was the subject of the summons, did not alter the court’s conclusion that the privilege had been waived.

The court next focused on the applicability of the work-product privilege that applies to materials prepared or gathered by an attorney in anticipation of litigation or preparation for trial. As the court in Textron noted, the U.S. Supreme Court had previously ruled that the purpose of the privilege is “to protect a zone of privacy in which a lawyer can prepare and develop legal theories and strategy with an eye toward litigation free from unnecessary intrusion by his adversaries.” Although originally articulated by court decisions, the work-product privilege has been codified in Federal Rule of Civil Procedure 26(b)(3).

In the context of tax controversies, the work-product privilege has been extended to protect opinions and memoranda prepared by counsel in anticipation of litigation. In Textron, the court specifically focused on the requirement that material be prepared “in anticipation of litigation” in order to be protected by the privilege. In concluding that this privilege was applicable, the court rejected the “primary purpose” test asserted by the IRS that would have extended the privilege only to documents created for the primary purpose of aiding in possible future litigation.

Rather, the court adopted the more inclusive “because of” test pursuant to which the relevant inquiry is whether the document was prepared or obtained “because of” the prospect of litigation. In the case of Textron, the court noted the contentious relationship between the IRS and the taxpayer that had resulted in multiple audits in prior years and the taxpayer’s reasonable expectation of an IRS challenge to the positions claimed on its 2001 tax return.

Finally, in examining whether the work-product privilege had been waived, the court indicated that a different standard would be followed than the standard that applied to the waiver of the attorney-client and the tax practitioner-client privileges. In the case of the work-product privilege, the court cited authority that only third-party disclosures that are inconsistent with keeping the protected information from an adversary constitutes a waiver of the privilege (unlike the attorney-client and tax practitioner-client privileges which are waived by any third-party disclosure).

In this regard, the court also cited judicial authority that disclosure of information to a taxpayer’s independent auditor does not waive the work-product privilege because it does not substantially increase the opportunity for potential adversaries to obtain the information. In essence, because independent auditors and accountants have a professional duty of confidentiality and loyalty to their clients, they are not considered a conduit of information to a potential adversary. Furthermore, in Textron, it was demonstrated that Ernst & Young had contractually agreed not to provide any other party with the information disclosed by Textron.

The Textron decision is important in several respects. First, it demonstrates the limitations of both the attorney-client and the tax practitioner-client privileges because of the likelihood that those privileges will be deemed waived by disclosure to auditors, accountants and other professionals. Second, it highlights the importance of the work-product privilege and the limited scope of how that privilege can be waived.

Although the decision in Textron provides a degree of comfort to taxpayers and professional tax advisers, it should be noted that the chief counsel of the IRS has indicated that the IRS is likely to appeal this decision.

MARK L. SILOW is the administrative partner and chief operating officer of Fox Rothschild. Silow formerly was chairman of the firm’s tax and estates department. Silow’s work involves a broad range of commercial and tax matters including business and tax planning, corporate acquisitions and dispositions, real estate transactions, estate planningand employee benefits.

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