Appeals Court Affirms Textron (or not)

In what some characterized as a significant taxpayer victory, the First Circuit Court of Appeals initially upheld a lower court ruling that Textron Inc.’s tax accrual work papers are subject to protection under the work product doctrine. Under that doctrine, documents that are prepared in anticipation of litigation are protected from disclosure unless the party seeking the documents can demonstrate a compelling need for the materials and cannot obtain the information any other way. The doctrine is designed to enhance an attorney’s ability to represent clients without fear that an opponent in current or anticipated litigation will use the work product to the disadvantage of the attorney’s client. Typically, the important sticking points for parties claiming work product protection are whether the documents were prepared in anticipation of litigation and whether the client has waived the protection by disclosing the work product to a potentially adverse third party.

On March 25, 2009, the First Circuit vacated the ruling and scheduled an en banc hearing for June 2, 2009.

On appeal, the IRS argues that the tax accrual workpapers were not prepared in anticipation of litigation because tax disputes with the IRS are not “litigation,” and because Textron had a business purpose related to financial reporting that was not related to litigation. In its vacated opinion, the Appeals Court panel rejected both of these arguments, holding that not all “dealing with the IRS during an audit is ‘litigation’,” but that resolutions of disputes through the adversary administrative process, including administrative appeals, meets the definition of litigation. The panel’s reference to the IRS Appeals process as an adversarial process is not how IRS Appeals Officers typically view their role. Most Appeals Officers attempt to provide an independent review of the IRS’s proposed adjustments seeking what they perceive to be a fair resolution based on an evaluation of the litigating hazards. Nevertheless, the Appeals process can be viewed as adversarial because the IRS Exam team is provided an opportunity to make its case prior to the commencement of the taxpayer/Appeals settlement negotiation.

Regarding the second IRS argument, the panel held that Textron prepared the tax accrual workpapers “because of” litigation, in spite of the fact that the taxpayer had other business reasons (e.g., financial reporting) for preparing the documents. According to the panel, there would be no reason for the financial reporting “but for” the prospect of litigation. The panel held that the documents, because they were designed to assist the taxpayer to establish financial reporting reserves taking into account the risk of tax litigation with the IRS, would not have been prepared “but for” the prospect of litigation.