Tax accrual workpapers are generally prepared by a company’s outside accountants (or attorneys) during the company’s financial audit. The workpapers generally include a listing of tax positions which, in the opinion of the producing accountant or attorney, involve areas of legal uncertainty and therefore may be challenged by the IRS or other agencies. Within the workpapers, the company’s accountant or legal counsel will express their judgments regarding the company’s chances of prevailing on those issues. The workpapers further note the amounts which the company has reserved on its financial statements to reflect the possibility that the company may not prevail in such litigation.
For these reasons, tax accrual workpapers could be very valuable to the IRS. These workpapers would serve as a roadmap for the IRS to assess the company with additional tax.
The IRS Has Broad Power To Subpoena Most Taxpayer Records
Congress has generally given the IRS broad investigatory powers, including the power to subpoena taxpayer records, to uncover material which may be relevant for “ascertaining the correctness of any return, determining the liability of any person for any Internal Revenue tax, or collecting any such liability.” Courts have interpreted this to mean that the IRS may obtain any material which “might put a light upon” a taxpayer’s financial situation and which has “more than idle hope” of providing the IRS with valuable information – a very low threshold.
However, the IRS’ summons power is subject to traditional evidentiary privileges and limitations. The IRS cannot compel a taxpayer to disclose communications which are otherwise protected by the Attorney-Client Privilege or Attorney Work Product doctrine.
The U.S. Supreme Court Has Allowed The IRS To Subpoena Tax Accrual Workpapers, But The IRS Has Limited The Circumstances In Which It Would Make Requests
In 1984, U.S. Supreme Court ruled that an accounting firm could not resist an IRS summons for tax accrual workpapers that the accounting firm prepared for its examination of a company’s tax reserves and tax policies. The Court ruled that there was no traditional privilege applicable to the workpapers prepared by accountants and the Court decided not to establish such an accountant-client privilege in that case.
Despite the IRS’ broad subpoena authority, the IRS has generally declined to utilize its authority to subpoena tax accrual workpapers. Potentially fearing the loss of its power by Congressional action if the power was abused, the IRS has voluntarily imposed limits on its request of tax accrual workpapers. For returns filed after July 1, 2002, the IRS has stated that it will generally only use its subpoena power to request tax accrual workpapers if: 1) the taxpayer participated in a “listed transaction”; or 2) the IRS determines that the company had financial accounting irregularities, such as those requiring a restatement of earnings.
Two Recent Cases Have Held That The IRS May Not Request Tax Accrual Workpapers Prepared By Attorneys
In a recent blow to the IRS’ authority to request tax accrual workpapers, two recent federal district court cases established that tax accrual workpapers prepared by attorneys were protected under the Attorney Work Product Doctrine.
The Attorney Work Product Doctrine generally protects documents prepared in anticipation of litigation. The doctrine is intended to promote fairness in litigation by preventing an adversary from using discovery to pry into the legal analysis and strategy of an opposing party.
In both decisions, the courts were satisfied that the taxpayer’s tax accrual workpapers were protected by the Attorney Work Product Doctrine — although the workpapers were used for the non-litigation purpose of substantiating the accounting treatment of an uncertain tax position. In addition, both courts determined that the taxpayer’s disclosure of those workpapers to their independent auditors did not waive the Work Product protection. (Generally, a privilege is forfeited if the document is otherwise disclosed to a third party.)
The IRS has appealed both decisions to the Federal Circuit Courts of Appeals.
If upheld, these decisions could mean that some tax accrual workpapers will be confidential, although it is unclear how the decisions would apply to most taxpayers. Tax accrual workpapers are generally prepared by accountants – not attorneys. If the tax accrual workpapers are only privileged when prepared by an attorney, most tax accrual workpapers may still not be privileged.