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In U.S. v. Textron Inc.¹ the First Circuit, en banc, considered whether the attorney work product doctrine shielded from an IRS summons “tax accrual work papers” prepared by lawyers and others in Textron's tax department to support Textron's calculation of tax reserves in its audited financial statements. The narrow legal issue was the application of Federal Rule of Civil Procedure 26(b)(3)(A), which provides in relevant part, “Ordinarily, a party may not discover documents and tangible things that are prepared in anticipation of litigation or for trial by or for another party …. .” (Emphasis added.)

At trial, the district court held that the attorney-client privilege was waived when Textron provided the work papers to its outside accountant, Ernst & Young. However, the court still denied the Service access to the papers because it found that, although the papers were used for a business purpose, they “would not have been prepared at all 'but for’ the fact that Textron anticipated the possibility of litigation with the IRS.”²

On the initial appeal, the First Circuit's three-judge panel affirmed the lower court, rejecting the Service's contention that the “mere presence of a business or regulatory purpose defeats work-product protection.”³ However, in March 2009 the First Circuit vacated the panel's decision, and on August 13, in a 3-2 decision, the full court reversed the district ruling, holding that Textron's tax accrual work papers were not protected by the work product doctrine.

In sum, the “final” Textron decision limits the scope of protected attorney work product to materials “prepared for use in” or “done for” possible litigation. The court wrote:

To sum up, the work product privilege is aimed at protecting work done for litigation, not in preparing financial statements. Textron's work papers were prepared to support financial filings and gain auditor approval; the compulsion of the securities laws and auditing requirements assure that they will be carefully prepared, in their present form, even though not protected; and IRS access serves the legitimate, and important, function of detecting and disallowing abusive tax shelters.

The decision thus adopts yet one more formulation of the work product doctrine, and it is strikingly different from the rules applicable in several other circuits. The Fifth Circuit follows a test that focuses on whether “the primary purpose” of documents was to prepare for potential litigation, while the Second, Sixth, Ninth, and D.C. Circuits adopt a “because of” or “but for” potential litigation test.⁴

In a vigorous dissent, two judges characterized the impact of the decision this way: “In straining to craft a rule favorable to the IRS as a matter of tax law, the majority has thrown the law of work-product protection into disarray. … The time is ripe for the Supreme Court to intervene and set the circuits straight on this issue which is essential to the daily practice of litigators across the country.”⁵

This commentary will not consider whether the new Textron rule is “right” as a matter of law or “policy,” whether it is consistent with prior precedents, or whether the decision should or will be adopted in other circuits, or reviewed, reversed, or sustained by the Supreme Court. I will instead offer a few ideas for tax directors and their counsel to consider in evaluating how they will do business after Textron, which is today the law in Maine, Massachusetts, New Hampshire, Puerto Rico and Rhode Island.⁶

Some further background. Textron's tax work papers listed items in its return that, if identified and challenged by the Service, could result in additional tax claims. The tax accrual spreadsheets listed each debatable item, including the dollar amount of the possible dispute and a percentage estimate of the Service's chances of success. The spreadsheets reflecting these calculations were in some instances supported by “backup emails or notes.” Textron's tax lawyers were “centrally involved” in preparing these materials, and Textron “also used an outside counsel to advise it on tax reserve requirements.” As described by the district court, the backup materials included “notes and memoranda written by Textron's in-house tax attorneys reflecting their opinions as to which items should be included on the spreadsheet and the hazard of litigation percentage that should apply to each item.”⁷ Unfortunately, there is no further specific description in the opinions as to the content of the backup emails, notes, and memoranda.

The majority emphasized that the trial judge did not find that the papers were “prepared for use in possible litigation,” but only that the reserves would cover liabilities that might be determined in litigation. The majority concluded that even if the judge had made a “for use” finding, “that finding would have been clearly erroneous.”

What did Textron's executives and tax lawyers do wrong, and what might other professionals do to increase the chances - by no means certain - of work product protection for a tax lawyer's backup emails, notes, and memoranda (assuming, without conceding, that there is no reasonable hope in the First Circuit for tax accrual spreadsheets and percentage estimates)? The majority opinion provides a number of potential guideposts, albeit vague and uncertain, as follows:

Any experienced litigator would describe the [Textron] tax accrual work papers as tax documents and not as case preparation materials. … Every lawyer who tries cases knows the touch and feel of materials prepared for a current or possible (i.e., “in anticipation of”) law suit. … No one with experience of law suits would talk about tax accrual work papers in those terms. A set of tax reserve figures, calculated for purposes of accurately stating a company's financial figures, has in ordinary parlance only that purpose: to support a financial statement and the independent audit of it. … [M]any of the debatable cases affording work product protection involve documents unquestionably prepared for potential use in litigation if and when it should arise. There is no evidence in this case that the work papers were prepared for such a use or would in fact serve any useful purpose for Textron in conducting litigation if it arose.

So, here are a few ideas to consider when a client seeks tax advice (whether or not in connection with preparing tax accrual work papers):

• Clearly indicate in writing (if true) that the material is intended to constitute “attorney work product” and that it has been requested by the client and prepared by the attorneys “for use in” and has been “done for” possible litigation. Identify the possible nature of and parties to the litigation, and the “useful purpose” that the work is intended to serve in conducting litigation if it should arise.

• Keep all such material in a separate file, preferably in the office of a lawyer (either an in-house or outside lawyer).

• The lawyers preparing the material preferably should be tax attorneys who themselves have litigation experience (trial and appeals) or, if they do not, litigation attorneys should be involved along with the “substantive” tax lawyers.

• If in-house lawyers are involved, preferably they should be persons who function in the company only as lawyers, i.e., they do not wear two hats and function both as lawyers and as tax directors or in other non-legal roles. Outside lawyers presumably function only as lawyers.

• The materials preferably should have the “touch and feel” of materials that “every lawyer who tries cases knows … [were] prepared for a current or possible (i.e., 'in anticipation of’) law suit.” What does this mean? Presumably, items such as: (1) notes of interviews of potential witnesses; (2) marked-up copies of critical company documents (e.g., board resolutions, contracts, invoices, books of account, emails), reflecting the attorney's evaluations as relevant to trial and appeal of litigation; (3) possible trial scenarios and strategies, such as the order of presentation of witnesses and documents, questions for cross-examining opposing witnesses and experts, draft trial summation statements, etc.; (4) possible appeal scenarios and strategies, such as grounds for appeal, identifying reversal error by the trier of fact, etc.; (5) evaluation of differences in litigating the case in the Tax Court, the Claims Court or a district court, including differences in law or practice in different circuits; and (6) evaluation of possible settlement strategies, not only with the Service's Appeals Office, but more particularly the Service's relevant District Counsel who could be involved in litigation.

All of these seem fairly obvious. How many tax executives and tax counsel have considered these points and gone to these potentially costly efforts in obtaining and providing tax advice in the past? Usually (not always) tax controversies present primarily questions of law, not fact, so that witness interviews, affidavits, and similar materials that have the touch and feel of trial preparation have, in the past, been thought to be less important, if not irrelevant. Is the cost of such efforts worth the potential benefit with regard to the particular issue in the particular context?

The Textron majority appears to have been so hostile to the case before it that one wonders whether any “work product” claim, at least in the context of preparing public company financial statements, would pass muster with it. Nevertheless, one must take the Court of Appeals at its word, and hope that if the lawyer's product genuinely has the right touch and feel, it will be respected as protected work product. Prudence suggests that these questions should be addressed and current business practices re-evaluated promptly.

This commentary also will appear in the November 2009 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Schmehl and Fox, 633 T.M., Compelled Production of Documents and Testimony in Tax Examinations, and in Tax Practice Series, see ¶3850, Examination: Audits, Assessments, Appeals.