This week’s National Law Review featured blogger is Matthew D. Lerner of Steptoe & Johnson LLP who provides some great tips on how to manage tax documents to best prepare for legal action. 
A recent appeals court decision provides the latest development in the ongoing battle between taxpayers and the IRS regarding the disclosure of tax workpapers. It also provides hope that work product protections may still be available for litigation analyses that a company’s attest auditors review in preparing financial statements.[i] Typically, taxpayers claim that certain workpapers are protected by the work product doctrine because they contain analysis of potential tax issues raised by transactions in anticipation of future litigation with the IRS over those issues. The IRS asserts that these workpapers are used to prepare financial statements and should not be subject to protection either because they are not prepared in anticipation of litigation or because they are disclosed to third party auditors, thus waiving any protection.
On June 29, 2010, the D.C. Circuit became the latest court to address this controversy in a matter that involved documents prepared by, or in the possession of, the accounting firm Deloitte LLP (then known as Deloitte & Touche LLP) (“Deloitte”). In this case, the United States sought to compel Deloitte to produce two categories of documents related to a civil tax refund case brought by partnerships formed by subsidiaries of the Dow Chemical Company (“Dow”) (the partnerships are referred to as the Chemtech partnerships or “Chemtech”). The first category included three documents Deloitte withheld on the basis of privileges asserted by Dow, including (i) a June 2005 tax opinion related to Chemtech; (ii) a September 1998 legal and tax analysis provided to Deloitte by an in-house attorney at Dow; and (iii) a July 1993 internal Deloitte memorandum recording thoughts and impressions of Dow’s attorneys concerning tax issues related to Chemtech. The second category of documents included all responsive documents maintained at Deloitte’s affiliate in Zurich, Switzerland ( “Deloitte Switzerland”).
At the trial court level, the District Court for the District of Columbia held that the three documents in the first category were protected from disclosure by the work product doctrine because they were prepared in anticipation of future litigation over the tax treatment of Chemtech.[2] The court held that the protection was not waived by disclosure to Deloitte because Deloitte, as Dow’s independent auditor, was not a potential adversary, and no evidence suggested that it was unreasonable for Dow to expect Deloitte to maintain confidentiality.
The trial court also denied the motion to compel with respect to the second category of documents. The court held that Deloitte did not have sufficient control over the documents maintained at Deloitte Switzerland to enable their production. The court stated that the government failed to establish that Deloitte had the “legal right, authority or ability to obtain documents upon demand” from Deloitte Switzerland. The court determined, “Close cooperation on a specific project does not per se, establish an ability, let alone a legal right or authority, on [Deloitte’s] part to acquire documents maintained solely by a legally distinct entity.”
The United States appealed the District Court’s decision with respect to the three documents in the first category withheld by Deloitte: (i) the June 2005 tax opinion related to Chemtech; (ii) the September 1998 legal and tax analysis provided by an in-house attorney at Dow; and (iii) the July 1993 internal Deloitte memorandum recording thoughts and impressions of Dow’s attorneys concerning tax issues related to Chemtech.[3]
The government argued that the 1993 internal Deloitte memorandum was not work product because (i) it was prepared by Deloitte, not Dow or Dow’s counsel; and (ii) it was generated as part of the audit process, not in anticipation of litigation. The D.C. Circuit rejected the government’s categorical arguments with respect to the first document prepared by Deloitte. The court stated that Deloitte’s preparation of the document does not exclude the possibility that it contains Dow’s work product. The court also stated that a document can contain protected work product material even though it serves multiple purposes, so long as the protected material was prepared because of the prospect of litigation. However, the court determined that the District Court did not have a sufficient evidentiary foundation for its holding that the Deloitte memorandum was purely work product. The court therefore remanded so that the District Court could conduct an in camera review of the document and determine whether it was entirely work product, or whether a partial or redacted version of the document could be disclosed.
The government also argued that the other two documents were not protected from disclosure because Dow waived work product protection by disclosing the documents to Deloitte. The D.C. Circuit rejected this argument and concluded that (i) Deloitte was not a potential adversary with respect to the litigation that the documents address and (ii) Deloitte was not a conduit to potential adversaries because Dow had a reasonable expectation of privacy as a result of Deloitte’s obligation to refrain from disclosing confidential information.
The Appeals court decision makes clear that some documents that become part of the tax audit workpapers do retain work product protection, even if disclosed to financial auditors to assist in the preparation of financial statements. However, it is also evident from this decision that such work product claims will likely continue to be challenged by the IRS and heavily scrutinized by the courts. Accordingly, it is imperative that taxpayers take as many precautions as possible to preserve work product protection, as well as attorney-client privilege, with respect to sensitive analysis contained in tax workpapers.
Taxpayers must understand that proving work product generally involves common sense. One trying to prove that a document was prepared in anticipation of litigation should ask herself what steps would indicate to a court that litigation truly was expected and this document was prepared for that purpose. What follows is a series of suggestions to help preserve such protection to the extent possible.
1. Get Counsel Involved.
To preserve privilege, be certain to include counsel meaningfully in communications regarding legal issues, and document counsel’s substantive role in these communications. While an attorney’s involvement is not legally required to make something work product in most jurisdictions, as an evidentiary matter, it helps to establish an anticipation of litigation and indicates that an issue is being treated as more than just an item for audit. Coordinate with the company’s General Counsel with respect to sensitive tax documents to avoid waiver of work product with respect to those documents through disclosure in other litigation. At the same time, be careful to avoid asserting inappropriate claims of protection on documents. An inappropriate claim of privilege risks waiver of privilege with respect to documents that otherwise would be privileged with respect to the same issue. Inappropriate privilege claims can also damage your credibility and result in higher tensions and increased controversy over what should be “routine” privilege claims.
2. Formalize a Tax Litigation Group.
Creating a formal tax litigation group within the company can help to identify tax controversy matters more clearly and separate issues that are anticipated to result in litigation. Such a group should advise the company on the conduct of tax controversies and litigation. In this primary role, the group should give advice to the company regarding whether and how to proceed in litigation, whether to settle, and what settlement terms to propose or accept. Secondarily, the company may use the group’s hazards-of-litigation advice in establishing financial statement tax reserves.
It is preferable that the group’s leader be an attorney responsible for managing tax litigation and have at least a dotted line reporting relationship to the law department (to enjoy a presumption that the attorney-client privilege applies as well). The group should exclude the persons whose responsibilities are solely the preparation of financial statements.
This does not require hiring new personnel or re-assigning people to a new tax controversy position. The group may be composed of people with other job responsibilities. It is really a “part-time” committee of people with related roles. The key is that decisions about which matters litigation may be expected for come in the setting of this separate group’s meetings or consideration, that the group members separately perform this function, and that they document their conclusions and clearly identify issues for which more than a mere audit is expected. In the group’s analyses, it must be careful not to suggest that the company believes its position is wrong and that is why litigation is expected. Document only that the IRS, given its policies and positions, is expected to challenge the company on the issue and the company intends to fight.[4]
3. Control Who Creates Documents.
If the company has a tax litigation group, sensitive analysis of tax issues should be confined to documents created at the direction of, and under the control and supervision of, the group’s leader. If not, they should be prepared by someone with a key role and responsibilities regarding tax controversy decisions. Such documents should indicate that they are prepared by attorneys or tax practitioners and that they are prepared at the request of the group leader for litigation purposes. Take care not to attach these labels to other documents or that label will cease to have meaning and potentially be used to argue that a waiver of privilege or work product protection has occurred with respect to other documents. Do not combine these work product analyses with non-work product discussions.
4. Create Only Defined Types of Documents.
Categorizing your documents and establishing guidelines for what types of analysis should be included in each category can help confine sensitive legal analysis to litigation-oriented documents that are most entitled to privilege and work product protection. When creating documents, separate legal analysis from non-privileged information, including: (i) business advice; (ii) tax reserve numbers and calculations; and (iii) other advice not intended to remain confidential. Create specific documents for disclosure outside the group that are limited to only hazards-of-litigation percentages and only aggregate reserve information.[5]
5. Control How Documents Are Labeled
Documents should be labeled, as appropriate, to state that they contain confidential legal advice, subject to privilege and protected by the work product doctrine. While not legally required, attaching a work product label to a document intended as such provides evidence of the company’s intent with respect to that document. Likewise, be careful not to label business advice, tax return advice, or other advice not intended to be confidential, as privileged or protected. If one overuses labels, the labels lose credibility even when properly attached, and may be ignored by a court in its analysis. At the same time, also take care not to label documents containing legal analysis and advice as documents that relate to tax reserve analysis or tax contingency analysis.
6. Control Access to Documents Inside the Company
The wider the distribution of a document, the more likely it is that a court will find there has been a waiver with respect to attorney-client privilege or work product protection. Because one of the indicia of privilege or work product is the care with which a document is handled, common sense dictates that a court will look askance at claims for protection of documents that were made widely available within the company to people whose jobs did not require their access to those materials. Accordingly, only disclose legal documents with respect to an issue to other employees/officers on a need-to-know basis. Also, to the extent possible, try to avoid “broadcast” emails and limit email “chains” related to documents. Each e-mail and response to an e-mail generates a copy of the document and increases the risk of waiver. When storing documents, separate and clearly mark legal documents. This not only protects against waiver, but can demonstrate intent to keep the information confidential. Keep in mind that no protections attach to business advice documents, so store business documents in a separate location from the legal documents.
7. Enact and Follow Policies to Identify Anticipated Litigation
It is critical to prove that litigation was anticipated with respect to an issue in order to establish work product protection for documents that contain analysis of that issue. General litigation policies can be used effectively as “designation” tools to identify issues for which litigation is anticipated clearly. For example, make use of document hold requests to communicate that litigation is anticipated. Consider formal guidelines that certain counsel must be involved in issues expected to result in litigation, and then include such counsel only when litigation is expected. When enacting such general policies, be cognizant of the fact that the presence of a general policy and the absence of its application in a specific case can create a negative inference. Thus, if a company has a general policy that documents related to issues for which litigation is anticipated are made subject to a litigation hold, then the absence of a litigation hold with respect to documents related to another issue may be used to demonstrate that litigation was not anticipated with respect to that issue.[6] As a result, the tax department must apply a litigation hold to those documents relating to any issue for which the company is claiming to anticipate litigation Likewise, if company policy dictates that the General Counsel must approve litigation-related decisions (e.g. budget, choice of counsel), be sure those policies are followed for potential tax litigation.
8. Work With Your Auditors and Other Third Parties to Protect Work Product
Interactions with auditors and other third parties create significant risks that material that would otherwise be subject to privilege or work product protection will lose that protection as a result of waiver. Accordingly, take steps to work with your auditors and other third parties to develop a good relationship and preserve protection where possible.
For example, many times accountants are hired not as auditors but to provide specific support in connection with a tax issue. In those instances, enter into written agreements through counsel with third-party consultants to whom you wish to disclose privileged information (e.g., so-called Kovel arrangements), so that their work is performed under the direction and control of counsel. Such a step makes the assertion of attorney-client privilege possible for communications with the consultant, and provides strong evidence of the anticipation of litigation. Be aware of the potential limitations of the accountant-client privilege, particularly when considering whether to disclose sensitive documents in the context of the preparation of an opinion letter. Request that your attest auditors’ engagement letter include a specific confirmation that those accountants must and will maintain confidentiality of your documents to the fullest extent allowed by law. It may also be helpful to have the engagement letter acknowledge that the relationship between company and auditor is non-adversarial and the two expect to work together cooperatively. Where possible, have auditors review key documents but not take copies. While that has no direct, legal effect on whether a protection is actually waived, it can bolster a claim that you took all possible steps to avoid wider dissemination by keeping control of the actual document, which is a key element of proving work product protection should apply. Ask that your auditors specifically note when a conclusion in their workpapers was derived from documents prepared by the company as litigation analyses. Finally, do not prepare separate documents directly for the auditors that discuss litigation analysis. While a decision regarding work product should be based on the purpose for which the underlying analysis was prepared, not the specific documents, the recent decisions suggest that it is easier to preserve work product protection when the document itself was prepared for the purpose of litigation.
9. Negotiate Disclosures with the IRS
After taking some or all of the above steps above to preserve protection of documents, take steps to prevent inadvertent disclosure to the IRS of protected documents. Require approval of the group’s leader before documents are disclosed to the Service or establish some other formal screening process to prevent disclosures that could result in a waiver of privilege. When withholding documents subject to protection, prepare a detailed privilege log, stating the specific grounds that support the claim for privilege and protection of each document withheld.
It is inevitable that there will be disagreements about the scope of protection afforded specific documents. Try to manage the disclosure process to minimize the scope and intensity of these disagreements. Be candid with the IRS about your concerns, try to get overbroad demands for protected materials scaled back, work quickly to provide responsive, non-protected materials, and be reasonable about the scope of your privilege claims. Doing this can help establish a cooperative relationship with the IRS and focus the controversy, if any, on the most protected documents. Likewise, consider disclosing the least confidential documents to the Service. For example, disclose to the Service those documents that contain no legal analysis or advice. Where there is protected material the IRS really wants that the company is willing to disclose, attempt to negotiate a written agreement that the disclosure of that document will not waive privilege or work product protection more broadly. If, after all this, controversy about a protection still arises, the fact of your cooperation and efforts to comply as much as possible may influence either the IRS’s decision to seek the documents through judicial proceedings, or the judge’s view of the matter. Force the IRS to determine whether it wishes to press the issue against a taxpayer that has cooperated, but that has taken careful steps to create and maintain confidential documents.
The confines of the work product doctrine in the tax context are still being defined. These suggested steps will help you best position your company to obtain the maximum protection. As you consider the creation of materials, ask yourself “does this step help show that we really did anticipate litigation and that this document was created for that purpose.” That is what a court may be called on to determine, and you want the record to demonstrate that the answer is yes.
[1] This is important because the review of such documents by third party auditors waives attorney-client privilege, the other common protection for sensitive materials.
[2] United States v. Deloitte, Case No. 08-411 (D. D.C. June 8, 2009).
[3] United States v. Deloitte, No. 09-5171, (D.C. Cir. June 29, 2010)
[4] Although not free from doubt, it is generally believed that the expectation of having an issue be unagreed and go to IRS Appeals is sufficient to show “an expectation of litigation.”
[5] Understand that there is a tension between protecting the attorney-client privilege and the work product protection. Providing your accountant with a privileged document prepared in anticipation of litigation may result in a broad attorney-client privilege waiver, but it is more likely the document will be viewed as work product than a document drafted especially for the auditor. Given the broad scope of auditors’ need for information and the fact that the document prepared for an auditor likely reveals privileged communications anyway and thus waives attorney-client privilege, many companies are placing more of their eggs in the work product basket.
[6] A litigation hold consists of formal notification of the likelihood of litigation to personnel whose files may contain relevant information, and the implementation of document preservation steps to make certain those materials are not discarded.
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About the Author:
Matthew D. Lerner is a partner in the Washington-based law firm of Steptoe & Johnson LLP, where he is a member of the Litigation and Business Solutions Departments. He represents both corporations and high net worth individuals involved in tax controversies, from pre-audit advice about transaction documentation, file organization and privilege protection, to representation during IRS audits and appeals, through litigation in the Federal Courts. His experience is broad and includes cases involving repair and rehabilitation expenses, asset classification for depreciation purposes, losses from trading in securities and derivatives, corporate restructuring, domestic production activities, international intercorporate transactions, foreign tax credits, tax accounting method questions, and valuation issues. Matt also advises clients facing legal and public relations crises, coordinating responses to congressional inquiries, criminal investigations, civil litigation, public relations scrutiny, and agency review.
Matt received his J.D. from Harvard Law School, magna cum laude, and was editor of Harvard Law Review. He received his A.B. from Amherst College, Phi Beta Kappa. 202-429-8024 / www.Steptoe.com