FIN 48, Tax Accrual Workpapers, and the Law of Privilege

By: STEVEN Z. KAPLAN

March 2008

Pursuant to Financial Interpretation No. 48 (“FIN 48”) to FAS 109, every entity applying generally-accepted accounting principles must create reserves for any “uncertain” income tax position, unless the entity concludes that it is “more likely than not” to prevail if the tax position were challenged.

This standard poses not only enormous administrative problems for the reporting entity, but also the question whether the workpapers and related files documenting that “more likely than not” reserve analysis are, and can remain, privileged and confidential. If not,these FIN 48 reserve analyses that the entity and its auditors generate may provide the IRS with a well-marked road map to potential soft spots on a tax return?

I. The IRS Audits the Taxpayer’s Returns.

To understand the privilege problems that FIN 48 reserve analysis presents, we can consider the following hypothetical:

A corporate taxpayer claims various research tax credits on its returns for three years. Before filing its returns, the taxpayer retained experts to help it determine whether the expenditures qualified for the credits, and, if so, in what amounts. Based on those expert reports and its own study, the taxpayer claimed $25 million of research credits on its returns. The IRS then commences an audit of those credits.

The company retains outside tax and litigation counsel to advise it. Those lawyers, in turn, provide the taxpayer with their analyses of the strengths and weaknesses of the case, including assessments of the experts’ work, an application of the law to the known facts, and consideration of various factors that may impact the court’s or jury’s findings. Counsel’s analyses do not express a percentage likelihood of success on the merits, but conclude that the position has significant merit.

II. The Taxpayer’s Reserve Decision and Its Auditor’s Information Requests.

Based upon its assessment of the case, including its counsel’s work, the company determines that its position satisfies the “more likely than not” standard. It therefore creates no FIN 48 reserve for any of the claimed tax credits.

Because the company’s auditors are charged with determining whether the financial statements are accurate and the amounts of the claimed credits are indisputably “material,” they must review the company’s conclusion that it is “more likely than not” to win the dispute. The auditors begin by requesting access to the company’s and outside counsel’s respective analyses. Those analyses contain, after all, the most detailed assessment of the strengths and weaknesses of the dispute, along with discussions of how the law may be applied to the facts believed to exist. Any auditing firm would want them.

III. The Corporation’s Dilemma.

The auditor’s request, however, raises the following critical questions: (1) are the reserve analyses, expert reports, and related documents privileged; and, if so, (2) will they lose that status if they are provided to the auditors? If they are not privileged or if providing them to the auditors waives any privilege they may have, these analyses will become fair game for the government if it demand access to them in attacking the credits. Moreover, the files that the auditors themselves generate as part of their FIN 48 review may also, unless privileged, become the subject of an IRS summons or a government litigation subpoena.

Though cognizant of the IRS’s previously expressed “policy of restraint” in seeking “tax accrual workpapers,” the company is also keenly aware of the government’s more recent statements signaling its intention to seek FIN 48 files without any self-imposed limitations. Consequently, the company and its counsel consider the following questions:

1. If the company produces the requested files to the auditors, will it lose any privileges that protect their highly-sensitive contents?
2. If the company refuses to produce all of the files that the auditors request, will the auditors respond by requiring a reserve for all or some part of the potential tax liability?
3. Other than providing the auditors with direct access to the company’s and lawyer’s reserve analysis files, are there other ways to satisfy their information needs?

After weighing all of these concerns, the company declines to give its auditors access to its FIN 48 files or those of its counsel, except for the expert reports (which it realizes it will have to give the IRS anyway). It does, however, conduct meetings at which the auditors ask questions of company personnel and its counsel regarding the relevant facts (as then known), the applicable legal standards, and the perceived strengths and weaknesses of the tax position.

The auditors take extensive notes of these meetings for their files, conduct their own review of the relevant business records, and have their own tax lawyers analyze the applicable law and the merits of the case. Essentially, the company leaves it to its auditors to make their own findings and conduct their own legal analysis, albeit with the active assistance of the company and its counsel.

The auditors eventually conclude that the corporation has the better of the argument. They concur that the corporation’s position satisfies the “more likely than not” standard, but also recognize that the outcome is, by definition, “uncertain.” The auditors decide (albeit reluctantly) that no reserve is required.

IV. The Government’s Demand and the Textron Decision.

The IRS, after audit and appeal, disallows the credits. The company then commences litigation with the government to establish its right to them. The government serves demands upon the company and its auditors for the contents of their respective FIN 48 files, along with deposition subpoenas seeking testimony from the personnel who performed these FIN 48 reviews. The company and the auditors respond by seeking protection from the court on the grounds of the attorney-client, Code Section 7525 tax advice, and work-product privileges.

A. The Textron Decision.

Whether the government can obtain these files likely rests on whether the federal district court in United States v. Textron, Inc., 507 F. Supp. 2d 138 (D. R.I. 2007), currently on appeal to the First Circuit Court of Appeals, correctly applied the rules of privilege and waiver. In Textron, the taxpayer had been frequently audited and, on a number of occasions, had appealed adverse examining agent determinations to the IRS appeals office. On three occasions, the disputes carried over into litigation.

During the audit, the IRS served a summons for Textron’s “tax accrual workpapers,” defined in the summons as:

all financial workpapers or documents created or assembled by the Taxpayer, an accountant for the Taxpayer, or the Taxpayer’s independent auditor relating to any tax reserve for current, deferred, and potential or contingent tax liabilities, however classified or reported on audited financial statements, and to any footnotes disclosing reserves or contingent liabilities on audited financial statements.

They include, but are not limited to, any and all analyses, computations, opinions, notes, summaries, discussions, and other documents relating to such reserves and any footnotes….

Those “tax accrual workpapers” included opinions of Textron’s outside counsel regarding uncertainties in the tax law, possible challenges by the IRS, estimates of the likelihood of Textron prevailing in any litigation, and the dollar amount of the reserve reflecting Textron’s possibility of losing in the litigation. In addition, the files also included the opinions of Textron’s in-house counsel. The files did not, however, include any transactional documents or business records relating to the disputed tax positions.

The district court found that Textron’s purpose in maintaining these “tax accrual workpaper” files was to ensure that it had adequately reserved for “any potential disputes or litigation that would happen in the future” and to satisfy its auditors that it had properly reported its contingent liabilities. Textron, 507 F. Supp. 2d at 143. Textron had also permitted its auditors to review those files with “the understanding that the information was to be treated as confidential.” Id.

1. Attorney-Client Privilege.

The files contained documents that, as a threshold matter, were protected by the attorney-client privilege because they contained legal advice regarding the application of the tax laws to specific transactions. The court concluded, however, that Textron had waived any attorney-client privilege claim by permitting a third-party, here the auditors, to gain access to the opinions of its outside and in-house lawyers. The court observed that the attorney-client privilege must be strictly construed and that any disclosure to the auditors of a communication protected under that privilege destroyed the claim of confidentiality.

2. Section 7525 Tax Advice Privilege.

Section 7525 of the Internal Revenue Code creates a privilege for tax advice rendered by a non-lawyer tax professional to a taxpayer under circumstances in which the same advice, if given by a lawyer, would be privileged. U.S. v. Frederick, 182 F. 3d 496 (7th Cir, 1999). Because Textron’s auditors had participated in advising it regarding its tax liabilities and resulting reserve obligations, including the hazards of litigation, the court found that they had performed “lawyers’ work” of the type that Section 7525 protects.

3. Work-Product Privilege.

The work-product privilege preserves “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’” and precludes an adversary from “free-riding” on the lawyer’s thinking and research. U.S. v. Adlman, 134 F. 3d 1194, 1196 (2d Cir. 1998); Frederick, supra, at 500 (7th Cir. 1999). The court concluded that the tax accrual files were work-product because the taxpayer had prepared them in anticipation of future litigation with the government. Maine v. Dept. of the Interior, 298 F. 3d. 60, 68 (1st Cir. 2002). Absent the anticipated IRS challenge to Textron’s uncertain tax positions, Textron would not have generated the files.

The court rejected the IRS’s contention that the reason for the creation of the files had not been to prepare for litigation, but only to permit the auditors to review Textron’s liability reserves and financial statements, a purpose that was purportedly not “in anticipation of litigation.” The court rejected that contention, finding that Textron had created the documents “because” of anticipated litigation. In short, the “uncertainty” of the tax position gave rise to the anticipation of litigation, thereby triggering application of the work-product privilege.

The court also perceived the inherent unfairness of granting the government access to files that would disclose the company’s, its lawyers’, and its auditors’ perceptions of the strengths and weaknesses of the case, the very reason for application of the work-product privilege. Because the auditors had received access to the files solely for liability reserve and tax advice purposes and they had agreed to keep the files confidential, the court affirmed the privilege.

V. Conclusion.

There is no assurance, of course, that the First Circuit will affirm Textron. Even if it does so, the IRS’s public (and surprisingly defiant) comments regarding the decision evidences its commitment to continued litigation with taxpayers in other courts on this issue. Because FIN 48 mandates far more refined tax liability analysis than was ever necessary under FAS 5’s loss contingency rules, its adoption has inspired the IRS’s reconsideration of its “policy of restraint” and heightened its determination to obtain these reserve files. For that reason, the company should take the steps necessary to demonstrate the privileged nature of its and the auditors’ reserve analyses and guard against any waiver of the privilege resulting from disclosure of legal analyses to the auditors.