Appeals Court Finds Protection for Tax Accrual Work Papers Produced for Dual Purpose of Possible IRS Litigation and SEC-Filed Financial Statements

A split First Circuit panel ruled that the work-product doctrine protects tax accrual work papers prepared by a company for the purpose of calculating tax reserve liability from an IRS subpoena even though the work papers were also prepared in conjunction with the independent audit of the company’s SEC-filed financial statements. The question of whether showing these tax accrual workpapers to the company’s independent auditor was remanded for consideration by the trial court. In a ringing dissent, Judge Boudin found that the IRS offered compelling evidence that the sole reason for creating the estimates of risks with respect to the tax positions was to prepare the reserve figures for the company’s financial statements and satisfy the outside auditor that the reserves were adequate. (US v. Textron, CA-1, No. 07-2631, January 21, 2009)

The federal securities laws require public companies to have their financial statements certified by an independent auditor, noted the dissent, and a key element of the audit is evaluating the adequacy and reasonableness of the company’s reserve account for contingent tax liabilities. Judge Boudin interpreted the Supreme Court’s Arthur Young opinion as rejecting privilege for the preparation of tax accrual work papers since companies have to comply with SEC financial statement obligations and accounting rules and would do so with or without a privilege.

In finding that the tax accrual work papers were protected from the IRS, the appeals panel first found that, while not all dealing with the IRS during an audit is litigation, the resolution of disputes through adversary administrative processes, including proceedings before the IRS Appeals Board, meets the definition of litigation.

The panel then found that one of the purposes behind the creation of the documents was anticipation of litigation by analyzing litigation for the purpose of creating and auditing a reserve fund. Even more, it could fairly be said that the driving force behind the preparation of the documents was the need to reserve money in anticipation of disputes with the IRS. The mere concurrent presence of complying with SEC regulations as a purpose for producing the tax accrual papers did not defeat the work product protection, said the panel. Protection of dual purpose documents is consistent with the purpose of the work product doctrine.