In United States v. Textron Inc., 577 F.3d 21 (1st Cir. 2009), cert. denied, 2010 WL 2025148 (May 24, 2010), the First Circuit held that Textron's tax accrual workpapers—specifically, spreadsheets listing uncertain tax positions, percentage estimates of the hazards of litigation, and tax reserve amounts—were not work product and therefore were not privileged.

When the Supreme Court declined to review Textron, the IRS may have felt that it had finally won the privilege wars. But any declaration of victory was premature.

In a new decision, the D.C. Circuit has revived taxpayers' hopes that they can discuss their tax exposure with counsel, and disclose those discussions to their accountants, without having to produce records of those deliberations to the IRS. See United States v. Deloitte LLP, 2010 WL 2572965 (D.C. Cir. June 29, 2010).

Background of the Textron Case

Textron considered three possible privileges: the attorney-client privilege, the I.R.C. § 7525 privilege, and the work-product privilege. However, because disclosure to the company's accountants waives the first two, the case ultimately focused on the work-product privilege.

The work-product privilege was first recognized by the Supreme Court in Hickman v. Taylor, 329 U.S. 495 (1947), where the Court noted that in order to prepare for litigation, an attorney must "assemble information, sift what he considers to be the relevant from the irrelevant facts, prepare his legal theories and plan his strategy without undue and needless interference." The privilege, which subsequently was partially incorporated into Rule 26(b)(3) of the Federal Rules of Civil Procedure (F.R.Civ.P.), protects "documents and tangible things that are prepared in anticipation of litigation or for trial by or for another party or its representative (including the other party's attorney, consultant, surety, indemnitor, insurer, or agent)." The scope of the privilege largely depends upon how the "anticipation of litigation" standard is interpreted.

First Circuit Applies New Test for Identifying Work Product

The prevailing test for identifying work product is: Was the document created "because of" the possibility of litigation? In Textron, the First Circuit gave lip service to that test, but it actually applied a new test: Was the document created "for use in litigation"? The majority opinion concluded that Textron's tax accrual workpapers were not "created for use in litigation" because they were not the sort of thing that a lawyer would use at trial. Previously, no court had held that work product was limited to documents prepared for use at trial. But the majority in Textron believed the IRS claim that the taxpayer had engaged in an "abusive tax shelter," and that made all the difference to the work product analysis, although it should have been irrelevant.

Supreme Court Denies Textron's Petition

Textron asked the Supreme Court to review the case. It pointed out that what had been a two-way split among the circuit courts—most follow the "because of" test, whereas the Fifth Circuit applies a "principal purpose" test—had now become a three-way split (with the adoption by the First Circuit of a "for use in litigation" test). Unfortunately, the Supreme Court denied Textron's petition.

Although that was bad news for taxpayers in the First Circuit, where Textron is now the law, the Supreme Court's refusal to review the case was not a decision on the merits. It does not mean that the Supreme Court approved of the First Circuit's reasoning.

Some commentators predicted that courts outside the First Circuit would not follow Textron and, instead, would protect most tax accrual workpapers under a more traditional work-product analysis. Now, in the Deloitte case, the D.C. Circuit has done just that.

Background of the Deloitte Case

The dispute in Deloitte involved district court tax litigation concerning two partnerships whose partners included affiliates of Dow Chemical. The government subpoenaed documents from Dow's independent auditor, Deloitte. Deloitte declined to provide the documents and the government sued to compel production. The dispute concerned three documents.

The first document was a 1993 draft memorandum prepared by Deloitte that summarized a meeting between Dow employees, Dow's outside counsel, and Deloitte employees about the possibility of tax litigation regarding the partnership and accounting issues relating thereto (the "Deloitte Memo").

The other two documents were not prepared by Deloitte, but were provided by Dow to Deloitte so that it could review the adequacy of Dow's tax reserves. These documents were: (1) a 1998 memorandum and flow chart prepared by two Dow employees, including an in-house attorney; and (2) a 2005 tax opinion prepared by Dow's outside counsel (together, the "Dow Documents").

Accountant's Memo Incorporating Comments by Counsel Qualified as Work Product

The government argued that the Deloitte Memo was not work product because it was prepared by a Deloitte auditor, not by Dow or its "representative." The D.C. Circuit rejected that argument because regardless of who authored the document, it contained the opinions of Dow's lawyer, who clearly was a "representative." The lawyer's opinions were work product, even though they were intangible (i.e., spoken) and only became tangible when the auditor wrote them down. (The court noted that the definition in F.R.Civ.P. 26(b)(3), which refers to "documents and tangible things," is not exclusive.)

The government next argued that the Deloitte Memo was not work product because it was prepared as part of a routine audit rather than for litigation. This was essentially the argument that prevailed in Textron because the First Circuit failed to understand that a document might have a dual purpose: It could be (1) prepared to facilitate the preparation of financial statements; and also (2) prepared in anticipation of litigation. Indeed, it is the potential for loss as a result of litigation that causes a reserve to be established in the first place.

The D.C. Circuit rejected the government's assertion that the function of a document (preparing audited financial statements) was determinative. The court held that the contents of the document are critical to determining whether it is work product.

The D.C. Circuit followed the majority of courts in applying the "because of" test, which classifies as work product documents that can fairly be said to have been prepared or obtained because of the prospect of litigation. The court distinguished United States v. El Paso Co., 682 F.2d 530 (5^th Cir. 1982), because that case was decided by the Fifth Circuit, the only circuit to reject the "because of" test in favor of the "primary purpose" test. The court then cited with approval the Second Circuit's decision in U.S. v. Adlman, 134 F.3d 1194, 1195 (2^nd Cir. 1998), where the court said that "a document created because of anticipated litigation, which tends to reveal mental impressions ... does not lose work-product protection merely because it is intended to assist in the making of a business decision influenced by the likely outcome of the anticipated litigation." The D.C. Circuit agreed with Adlman that a document can have a dual purpose and still qualify as work product.

The court then considered Textron and distinguished it as turning on the "particular documents at issue." It also noted that the dissent made "a strong argument that while the court said it was applying the ‘because of' test, it actually asked whether the documents were ‘prepared for use in possible litigation,' a much more exacting standard."

In conclusion, the D.C. Circuit rejected the IRS position that the Deloitte Memo was not privileged, either because it was prepared by Deloitte or because it was created in connection with a financial accounting audit. The court remanded the case to the district court so that the court could examine the document. To the extent that it contained thoughts and analyses by legal counsel, the document would be privileged, but the document might also contain nonprivileged material. If so, it would have to be produced with the privileged material redacted.

Disclosure to an Accountant Does Not Necessarily Waive the Work-Product Privilege

The work-product privilege can be waived through disclosure, but only if the disclosure is inconsistent with the adversary system, such as disclosure to an adversary or to someone who could be a "conduit" to an adversary.

In Deloitte, the government claimed that Dow waived the privilege for the Dow Documents because it showed them to Deloitte. It reasoned that Deloitte was a potential adversary of Dow "because disputes sometimes arise between independent auditors and their clients and because independent auditors have the power to issue opinions that adversely affect their clients." The D.C. Circuit rejected these arguments. The power to issue an adverse opinion did not make Deloitte "the sort of litigation adversary contemplated by the waiver standard." Moreover, the speculative possibility of a future dispute did not make Deloitte a potential adversary.

Further, "the question is not whether Deloitte could be Dow's adversary in any conceivable future litigation, but whether Deloitte could be Dow's adversary in the sort of litigation the Dow Documents address." The court found that "Dow anticipated a dispute with the IRS, not a dispute with Deloitte." Thus, disclosure to Deloitte was not a waiver.

The government also argued that Deloitte was a "conduit to Dow's adversaries." This could arise if Dow had "engaged in self-interested selective disclosure by revealing its work product to some adversaries but not to others." Or it could arise if Dow did not have "a reasonable basis for believing that the recipient would keep the disclosed material confidential."

The court rejected these arguments because Dow had not made selective disclosures to adversaries and because it did have a reasonable expectation of confidentiality. Its expectation was reasonable because Deloitte, as an independent auditor, had an obligation to refrain from disclosing confidential client information" under its professional ethics rules. See Rule 301 of the AICPA Code of Professional Conduct.

The court noted that no other circuit court had addressed whether disclosing work product to an independent auditor constitutes waiver. The Textron court did not reach the question of waiver because it held there was no privilege.

Which Is Correct: Textron or Deloitte?

Textron held that in-house tax accrual workpapers were not work product. Deloitte holds that similar documents are work product and that disclosing them to the company's auditors is not a waiver. Indeed, even a document prepared by a company's auditor can be work product to the extent it reflects the thoughts of the company's lawyers.

We reiterate that Textron is an anomalous, outcome-driven decision. It is inconsistent with the Second Circuit's Adlman case, noted above, and with the Sixth Circuit's Roxworthy case. U.S. v. Roxworthy, 457 F.3d 590 (6th Cir. 2006). In Roxworthy, the court held that tax memoranda prepared by KPMG were work product. The "anticipation of litigation" requirement was met because the taxpayer (Yum Brands) had an objectively reasonable belief there could be litigation, based on the following facts: it was audited annually; the dollars at issue were significant; and there was a large discrepancy between a tax loss and a book loss. See also Regions Financial Corp. v. United States, 2008 WL 2139008 (N.D. Ala. 2008) (tax accrual workpapers held to be protected by the work-product privilege).

There is no tax case on point in the Eighth Circuit, which covers a number of Midwestern states including Minnesota. However, a non-tax case strongly suggests that the Eighth Circuit would agree with Deloitte on what qualifies as work product (although the case did not involve waiver). See Simon v. G.D. Searle & Co., 816 F.2d 397 (8^th Cir. 1987).

In G.D. Searle, a corporation's in-house lawyers established individual loss reserves (including settlement value) after notice of a claim or suit. Its risk management department then aggregated those reserves for a variety of business purposes relating to budgeting, profit projections, and insurance.

The Eighth Circuit held that the aggregate numbers were not protected because they were not prepared in anticipation of litigation and did not reveal an attorney's thoughts about individual cases. However, it held that any such documents that did reflect the individual case reserves calculated by an in-house attorney were protected work product because they revealed "the mental impressions, thoughts, and conclusions of an attorney in evaluating a legal claim." This holding is similar to the holding by the D.C. Circuit that the Deloitte Memo, even though prepared by an accounting firm, was work product to the extent it reflected the thoughts of Dow's lawyers.

What's Next?

Deloitte is a major taxpayer win, but the case may not be over. It is worth recalling that Textron initially won at the First Circuit, but the government asked for and obtained a rehearing. Although rehearings are not commonly granted, given its success in Textron, one would expect the government to ask the full D.C. Circuit to rehear the case.

Assuming the government fails to get a rehearing (or loses after a rehearing), it will be interesting to see if it asks the Supreme Court to review Deloitte. When the shoe was on the other foot in Textron, the government argued to the Supreme Court that the First Circuit's approach was fully consistent with decisions in other courts. It may not feel that way regarding Deloitte.

Given that there is a clear circuit split, this is an issue that the Supreme Court should review. However, it had a golden opportunity to do so in Textron. Numerous amicus briefs were filed by major business and professional organizations urging the Court to take the case. That it decided not to take the case suggests that it similarly would have no interest in taking Deloitte. Still, by the time a petition would be filed in Deloitte, there would be a new justice on the Court. Most likely, that justice will be Elena Kagan.

Interestingly, it was Ms. Kagan who signed the government's brief asking the Court not to take Textron. Perhaps she will change her mind—only time will tell. In the meantime, the privilege wars will continue unabated.