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IRS Loses Another Case Involving Auditor Work Papers

Expert Witness: Fulcrum Inquiry
Taxpayers won again in the ongoing dispute over whether tax accrual work papers are privileged. The case arguable applies regardless of which of the split in authority one adopts as the starting point. All of this is important because accounting requirements (FIN 48) would otherwise make accountants’ tax accrual work papers an IRS treasure trove. The case might also have applicability in battles over other types of work papers in which legal contingencies are at issue.

In Regions Financial Corp. v. United States, (N.D. Ala., No. 2:06-CV-00895-RDP, 5/8/08), the IRS lost another battle in its effort to get information from outside accountants’ tax accrual work papers. This case could be particularly damaging to the IRS’s position because the Court’s rationale arguably would apply regardless of which split in authority is adopted as the starting point.

This case, and the similar Textron case described below, are also important because accounting recordkeeping requirements (contained in FIN 48) would otherwise make accountants’ tax accrual work papers an IRS treasure trove. (See the FASB’s Gift to the IRS for details).

The Regions case involves an IRS audit of two transactions that qualify as “listed transactions”. The IRS sought work papers maintained by Ernst & Young (E&Y), the taxpayer’s outside public accounting firm. The taxpayer instructed E&Y to withhold twenty documents totaling 151 pages. E&Y produced approximately 260,000 pages.

Because of positions taken by the parties, the Court only addressed whether the documents were privileged, and whether such privilege was waived by giving E&Y the documents. The Court reviewed the withheld documents in camera before concluding that they deserved protection. The withheld documents consisted of:

1. Three documents created by the taxpayer’s outside legal counsel which the taxpayer provided to E&Y
2. A document created by E&Y tax personnel who are not involved in the taxpayer’s audit, and
3. Documents that discuss the preceding four documents. Of these, some of these documents were withheld entirely, and others were produced in a redacted form.

The Court noted a split authority regarding the test to be applied. The Fifth Circuit articulates a “primary motivating purpose” test which states that litigation creating the privilege need not be imminent so long as the primary motivating purpose behind the creation of the document was to aid in possible future litigation. The Second Circuit articulates the more liberal (i.e., affording greater protection) “because of litigation” standard. The “because of litigation” standard (as provided in U.S. vs. Aldman, 134 F.3d 1194 (2nd Cir. 1998) states”

“In light of the nature of the document and the factual situation in the particular case, the document can fairly be said to have been prepared or obtained because of the prospect of litigation.”

Interestingly, both parties articulated the position that they should prevail regardless of which standard applies. Although the Court discussed at length the origin and application of each of these tests, the Court agreed that a decision regarding which of these tests was correct need not be determined because both tests had been met in the particular circumstances at issue. For this reason, the IRS loss has broader applicability.

In ruling against the IRS, the Court summarized:

“The IRS argues that ‘E&Y’s withheld tax accrual work papers are not entitled to work product protection because they would have been prepared, even in the absence of the prospect of litigation, to comply with Regions’ public reporting requirement’. Regions counters that it would not have contingent liabilities at all if it did not think that it was going to be sued by the Service over the tax consequences of the Transaction.

Regions has the stronger argument. Were it not for anticipated litigation, Regions would not have to worry about contingent liabilities and would not need to elicit opinions regarding the likely results of litigation…

The Service’s argument is that Regions cannot claim work product production of the contested documents had any use other than litigation preparation. The IRS has not cited, nor has the court found, any authority that articulates such a test. Indeed, the court has found no support for the conclusion that a party must show that it was motivated by preparation for litigation and nothing else in order to claim that a document is protected work product. The Service’s argument is unpersuasive.”

This conclusion is consistent with the Textron case that we summarize under Tax Accrual Work Papers are Probably Safe. However, the more recent Regions case goes beyond the Textron conclusion because (i) the discussion of prior case precedent is broader, and (ii) unlike Textron, Regions did not have a similar history of IRS audits and disputes.

The Court also addressed the IRS argument that any privilege was waived because the production to the auditors were either made to an adversary or a third party that could serve as a conduit to an adversary. Reaching a decision similar to Textron, the Court rejected the IRS’s position that a privilege waiver occurred through the taxpayer’s independent public accountants.

The IRS says that the loss will not alter the IRS policy of claiming that tax accrual work papers are not prepared for litigation and hence are subject to IRS subpoena. The IRS is currently appealing the decision in the Textron case to the First Circuit.

Although both the Regions and Textron cases involve accountant work papers in a tax context, the same rationale might also be applicable to work papers and records involving accounting for contingencies such as litigation.

David E. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials - CPA, MBA, CMA and ASA.

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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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