September 2007

To maintain accounting records under generally accepted accounting principles, companies need to assess the likelihood of judgmental positions being sustained. The recent tax case United States vs. Textron, No. 06-198T (Aug. 29, 2007), is important in establishing a taxpayer’s right to prevent disclosure of (i) its internal analyses of these controversial tax positions, and (ii) how those positions are reflected in the company’s financial statements prepared under generally accepted accounting principles.

For lots of obvious reasons, the IRS would love to get these records. The Textron Court summarized the issue as follows

““Textron’s affidavits state that its tax accrual workpapers are privileged because they were prepared by counsel and reflect counsel’s legal conclusions in identifying items on Textron’s return that may be challenged and assessing Textron’s prospects of prevailing in any ensuing litigation. The IRS argues that the workpapers are not privileged because, in preparing them, Textron’s attorneys were not providing legal advice but, rather, were performing an accounting function by reconciling the company’s tax records and financial statements.”The Court concluded that the taxpayer had potential protection from discovery by the IRS because of (i) attorney-client privilege, (ii) the work-product privilege arising because of litigation (or the anticipation of litigation) and (iii) IRC Section 7525(a). Any one of these three privileges would prevent production.

However, citing a long line of cases that independent auditors do not have privilege, and that sharing information with outside auditors waives the privilege, the Court ruled that Textron waived both the attorney-client privilege, and privileges under IRC Section 7525(a). Then, the Court distinguished the work-product privilege from the other two waived privileges, and ruled that the taxpayer had not waived the work-product privilege. This different result occurred based on prior cases that indicated a lack of such waiver because the outside auditor was not an “adversary” or conduit to an adversary.

The case has increased importance because tax professionals are anticipating significant problems because of the implementation of FIN 48. This accounting pronouncement requires disclosure of tax reserves (See the FASB’s Gift to the IRS for details). Although the Textron case predates the new reporting requirements under FIN 48, the same rationale would appear to apply.

IRS Chief Counsel, Donald Korb, already proclaimed, “We’re not going to change anything as a result of this case. Nothing in the decision undermines the IRS policy of seeking tax accrual work papers when appropriate.” Despite the IRS protests, this decision is a significant defeat to the IRS regarding them obtaining tax accrual work papers prepared by tax counsel.

The IRS faced bad facts with Textron, because the company had a long history of disputes with the IRS. Accordingly, it was believable that Textron’s tax-accrual work papers were the result of a litigation assessment. However, companies without this tax-litigation history may have difficulty showing that they are anticipating litigation when preparing the analysis. To overcome this potential challenge, taxpayers should involve legal counsel and memorialize the bone fide belief that litigation with the IRS is a genuine possibility. Based on this, the taxpayer should invoke the work-product privilege when preparing tax analysis, including those required under FIN 48.

Fulcrum Inquiry is a licensed CPA firm. We perform valuation and economic analysis involving tax issues.