Courts Limit IRS Access to Tax Accrual Work Papers

Courts Limit IRS Access to Tax Accrual Work Papers

By Paul Claytor, CPA

The Internal Revenue Service (IRS) remains intent on securing its access to corporate taxpayers’ tax accrual work papers. Author Paul Claytor describes how events may confound the IRS’s ability to access these work papers.

The IRS closely guards its right of access to internal corporate documents, including tax accrual work papers that might indicate overly aggressive tax positions. With the 2006 release of Financial Accounting Standards Board Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, corporate taxpayers must document uncertain tax positions, perhaps leaving public companies at even greater risk to IRS access. Recent legal developments, however, raise questions about the IRS’s unrestricted right to access these documents.

Past IRS Practice
Relying on a 1984 U.S. Supreme Court decision, the IRS has long maintained that a company’s tax accrual work papers fall within the scope of documents it may review as part of its tax audit and examination procedures.

Tax accrual work papers comprise documentation that describes and assesses the risk a taxpayer assumes regarding uncertain tax positions. The documentation can provide the IRS with information about a taxpayer’s aggressive tax positions and assessment of its own risk.

Despite its claimed authority, the IRS has nonetheless followed a “policy of restraint” as far as actually demanding tax accrual work papers in a routine tax audit. The IRS typically will request the documents only if it has exhausted all other sources of information. Until about five years ago, the IRS rarely demanded tax accrual work papers.

Recent Events
In the past several years, the IRS has ratcheted up its enforcement activity regarding abusive tax shelter transactions. As a result, it now requires analysis of the taxpayer’s tax accrual work papers in certain tax shelter audits.

At the same time, FIN 48 now requires companies with audited generally accepted accounting principles financial statements to analyze and document their uncertain or controversial tax positions. Thus, corporate taxpayers may possess documents that literally describe their uncertain or aggressive tax positions.

The IRS has declared that FIN 48 documentation constitutes tax accrual work papers, meaning it can demand access. A recent court case, however, suggests that courts may impose some limits on the IRS position.

In United States v. Textron Inc., a federal district court examined the IRS’s ability to access and examine internal documents that the taxpayer argued were privileged. The court held that while the IRS summons for the production of tax accrual work papers satisfied rules requiring a legitimate purpose for enforcement of the summons, the work papers were protected by the work-product doctrine.

The work-product doctrine generally protects materials prepared in anticipation of litigation from discovery. The court implied that the attorney-client privilege and tax practitioner-client privilege could also apply in certain circumstances. Here, though, the taxpayer waived those privileges by sharing the work papers with an independent auditor.

The IRS Responds
The IRS has announced that it is reconsidering its policy of restraint in response to Textron, FIN 48, and other litigation. It also issued a so-called “action on decision” following the 2006 decision in United States v. Roxworthy. In Roxworthy, the Sixth Circuit Court of Appeals held that two tax opinions analyzing the tax consequences of certain transactions, prepared in anticipation of litigation, were protected from an IRS administrative summons.

In its “action on decision,” posted on the IRS Web site in September 2007, the IRS took a position of nonacquiescence to the decision. It explained that it will continue to aggressively challenge “unjustified assertions of work-product doctrine (and other privileges) in all appropriate cases,” including those appealable to the Sixth Circuit.

Forewarned is Forearmed
Banks can protect internal documents prepared for financial accounting purposes from IRS scrutiny by adhering to the technical requirements for privilege. The court’s opinion in Textron provides a road map that banks can follow to manage critical and “confidential” tax accrual work papers.

Paul Claytor is an executive specializing in tax controversy services with Crowe Chizek and Company LLC in Oak Brook, Ill. He can be reached at 630.574.1629 or pclaytor@crowechizek.com.

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