The perfect storm gathers: recent announcements by the IRS coupled with the climate of increased law enforcement call into question continuing vitality of announcement 2002-63 regarding tax accrual workpapers.

Introduction

Although the Internal Revenue Service has long since shifted from the friendly and service-oriented approach to a tough guy persona, (1) taxpayers have still taken some solace that they could generally enjoy protection of their tax accrual workpapers. (2) Internal Revenue Announcement 2002-63 stated generally that such papers would not be sought if taxpayers complied with the listed transaction disclosure rules, and if "unusual circumstances" were found not to exist. In the current government environment, however, the "unusual" of yesterday may be changing. For instance, in October 2005, Deborah Butler, IRS Associate Chief Counsel (Procedure and administration), noted in a public forum that the IRS had undertaken "a limited expansion of the policy set out in Announcement 2002-63." (1A) Although no further detail was provided at the session where she spoke, such pronouncements highlight the fluid situation with regard to tax accrual workpapers. Just days after she spoke, moreover, the IRS announced that it would implement an Issue Management System (IMS) of the Large and Mid-Size Business Division (LMSB) by 2006. The IMS will "require agents and managers to track all significant workpapers" and will allow information sharing about issues under development. (3) In a real sense, tax practitioners should remember the whisper heard by Kevin Costner's character in the film, Field of Dreams: "If you build it, he will come." This IRS move toward the indexing of workpapers creates a structural incentive to weaken the protected status of the workpapers even further. Prior to Announcement 2002-63, the IRS requested tax accrual workpapers a total of five times in 30 years. In 2005 alone, the IRS "submitted about 50 requests for tax accrual workpapers." (4) The resulting thousand-fold increase, even if limited to listed transactions, is most telling.

It is not an overstatement to say that tax accrual workpapers constitute a tool by which the government, and even private litigants, may be able to invade the innermost thoughts of tax analysts should they continue to regard tax accrual workpapers as confidential. Any time that a corporation faces a restatement of earnings and an ensuing Securities and Exchange Commission Investigation (or a private shareholder derivative action), the tax accrual workpapers will be produced to the government (or private litigants). Given the IRS's increased interest in the workpapers, it is difficult to imagine the IRS scrupulously restraining itself from requesting or otherwise obtaining the workpapers when the workpapers have been disseminated already to plaintiffs' attorneys and the SEC.

In old sailor's jargon, a perfect storm is gathering, and tax accrual workpapers are in the eye of the storm. Consider the trends. Over the last three years, the current administration has increased the IRS's yearly budget to ensure compliance with the revenue laws. (5) At the same time, the IRS is transferring large portions of its workforce from service components to enforcement activities. Possibly fueling both of these changes is the slew of corporate scandals. A storm picks up energy as it passes over warm waters. In a sense, there has been a "global warming" of the enforcement environment throughout the many "seas" of government.

For instance, in certain regards the Sarbanes-Oxley Act has turned auditors and accountants into public watchdogs. At the same time, the Department of Justice has created a Corporate Fraud Task Force to deal with the fall-out of Enron. Numerous companies have paid large civil settlements, and even criminal fines, for myriad violations. Adding to the rising cost of settling a major investigation is the increased pressure from the government to waive the attorney-client and work-product privileges.

Importantly, although the tax accrual workpapers usually reveal no criminal exposure, there is nothing in the law that prevents the DOJ or the SEC from turning over tax accrual workpapers to the IRS. With the increased pressure on the IRS to find revenue, staunch abusive tax shelters, and punish bad corporate actors, it may only be a matter of time before the IRS begins to acquire workpapers from other government agencies. Likewise, private litigants have an interest in accessing the tax accrual workpapers. If a shareholder derivative action can be predicated upon accounting and tax irregularities following a restatement of income, then it seems indisputable that the plaintiffs bar will seek access to the tax accrual workpapers. If the privilege has been waived (and the documents have been produced), then the case law indicates that a resourceful and tenacious plaintiffs attorney will ultimately prevail in the attempt.

Owing to the current enforcement environment, it could be naive to draft tax accrual workpapers under the assumption that their contents will remain confidential or of limited circulation. Simply put, the IRS may well be tempted to expand the "unusual circumstances" exception of Notice 2002-63 through direct requests to taxpayers sooner rather than later. Given the astronomical increase in IRS demand for workpapers last year, this expansion may already be happening. Even barring that event, however, a very tempting backdoor exists for the IRS and private litigants to acquire these documents via their earlier production in a DOJ or SEC investigation. In short, taxpayers should listen for the thunder, and prepare for the storm. While there are some practical ways to prepare for landfall and attempt to shield workpapers, nothing may prevent the ultimate disclosure of those materials. Given what appears to be an inevitability, it may be time to consider changes in how workpapers are prepared. (6)

The Perfect Storm

Before 2002, the IRS had a relatively laissez-faire policy in requesting tax accrual workpapers. For the most part, such information was not solicited. (7) Indeed, up until June 2002, the IRS requested tax accrual workpapers a total of 5 times in 30 years. (8) Announcement 2002-63 changed that environment dramatically. Although it promised to limit the request of tax accrual workpapers to listed transactions with the rarest of exceptions, that limitation seems to be expanding with the changing weather. Subsequent pronouncements and decisions, often benign on their face, have increased the possibility of disclosure. Additionally, increased enforcement by the IRS itself, and its cooperation with other agencies, has added to the tempest. With storm clouds approaching, there can no longer be business as usual.

The IRS issued Announcement 2002-63 as part of its efforts to shut down abusive tax shelter transactions. Generally, the announcement provided that the IRS would seek tax accrual workpapers in two situations. First, a request would be made when a return claimed a tax benefit from a listed transaction. Second, a request would also be made under "unusual circumstances." (9) Although not defined at the time, the IRS indicated that unusual circumstances would exist if three conditions were met: first, if an examiner identified a specific issue for which additional facts were needed; second if the examiner sought all facts relating to the specific issue from the taxpayer and any available third parties; and finally, if the examiner performed a reconciliation of the taxpayer's Schedule M-1 or M-3 pertaining to the specific issue in addition to seeking a supplementary analysis. (10)

Notwithstanding the seemingly taxpayer protective approach in Announcement 2002-63, the first condition begged the question. When would additional facts be needed? Would an investigation by another administrative agency trigger the need for additional facts?

Rather than answering those questions directly, the IRS has chosen to rely on two supposed safeguards. First, in response to concerns that the request of tax accrual workpapers would become routine, Donald L. Korb, IRS Chief Counsel, explained that procedural safeguards existed to prevent a flash flood of requests. Specifically, in order to obtain an applicable summons, the agent has to secure the approval of a chain of upper IRS officials. (11) Second, the IRS highlighted that Announcement 2002-63 contains an incentive to taxpayers not to engage in listed transactions: If taxpayers avoid listed transactions, the IRS will not request their tax accrual workpapers. (12) To reverse course now and increase requests for workpapers, the thinking goes, could backfire on the IRS. In short, those who decided to avoid risky tax shelters because they wanted to keep their workpapers confidential might conclude that there is no longer a real confidentiality incentive and, all other things being equal, simply decide to engage in listed transactions.

Notwithstanding the safeguards, there remains cause for concern. Continuing focus on corporate fraud and financial accounting irregularities may have seeded the clouds of suspicion and caused the IRS to rethink its previous policy. To be sure, the climate changed just one year after Announcement 2002-63 was issued, when the IRS posted frequently asked questions regarding tax accrual workpapers. Although it affirmed that the "unusual circumstances" language meant the IRS would seek workpapers in rare instances only, the FAQs confirmed that the standard still required careful factual and legal analysis on a case-by-case basis. The FAQs also contained examples indicating where "unusual circumstances" could exist. The second situation illustrated that where the IRS developed a reasonable suspicion--through third-party information--that a taxpayer was destroying factual information relating to an audited transaction, it would then be appropriate to seek the tax accrual workpapers relating to that transaction. (13) This has left the door ajar. At this point, all that appears to be keeping the door swinging open is IRS self-restraint and the initial promise made in IRS Announcement 2002-63. As much as the IRS may claim to respect the confidentiality of tax accrual workpapers, and as much as tax practitioners wish them to be privileged, tax accrual workpapers are something of an illegitimate stepchild in the family of privileged communications whose status will always be in question.

The Not-So-Confidential Status of Tax Accrual Workpapers

Tax accrual workpapers start from a disadvantaged position in the realm of privileged and confidential documents. IRS Announcement 2002-63 stated that because "Tax Accrual Workpapers are not generated in connection with seeking legal or tax advice, but are developed to evaluate a taxpayer's deferred or contingent tax liabilities in connection with a taxpayer's disclosure to third parties of the taxpayer's financial condition, Tax Accrual Workpapers are not privileged communications." (14) According to one commentator, "[t]his general rule is derived from the well-established principle that the preparation of tax return information is typically not privileged." (15) Another commentator cited the position of one IRS official: "[a]ccording to [former IRS Chief Counsel B. John] Williams, the attorney-client privilege won't protect any of the workpaper documents because it is likely to have been waived when disclosed to the corporation's auditor." (16)

This position, based on the 1984 Supreme Court decision of United States v. Arthur Young & Co., (17) is rather extreme. True, the Supreme Court unanimously decided that there was no "accountant-client" privilege and no "accountant work-product protection," and accordingly enforced an IRS summons of tax accrual workpapers provided to an independent auditor. It did not, however, hold as an absolute that tax accrual workpapers could never be protected. Indeed, there is some authority that portions of tax accrual workpapers, or certain related analytical memoranda, could be protected under the work-product doctrine, as long as they were first prepared in anticipation of litigation and only subsequently provided to an auditor with whom the company had a common interest and was not adverse or a potential conduit of confidential information to an adversary. (18) As the district court reasoned in a 2004 case:

   [T]he critical inquiry--to me--must be whether
   Deloitte & Touche should be conceived of as an
   adversary or a conduit to a potential adversary. As
   ... other courts have observed, an independent auditor
   could be conceived of as an adversary because
   of its important public function to independently
   ensure the accuracy of a company's financial reports
   ... I conclude, however, that a waiver is not
   supported by the circumstances of this case or applicable
   case law and that such a holding will not
   impair auditor independence. As I read them, the
   work product cases require a tangible adversarial
   relationship. (19)

In short, there are courts that, in certain situations, will shield documents created by, or shared with, tax executives and external auditors.

Work-product protection, however, applies only to materials originally prepared in "anticipation of litigation," (20) and not "in the ordinary course of business, or pursuant to public requirements unrelated to litigation." (21) Hence, tax accrual workpapers, in their broadest sense, may not usually qualify for protection "because it could not be fairly said that they were created 'because of actual or impending litigation." (22) Only where the workpapers, or portions of them, could be couched in terms of an anticipated lawsuit or investigation, would there be possible work-product protection. (23)

The Second Circuit Court of Appeals held in United States v. Adlman (24) that where a memorandum analyzing 58 potential IRS claims was prepared by a taxpayer's outside accounting firm at the request of a taxpayer's tax attorney, then the document was work-product protected. The court reasoned that the analysis of the tax consequences of a proposed corporate reorganization was work product because it was prepared in expectation of litigation with the IRS. The court's holding is instructive:

   We hold that a document created because of anticipated
   litigation, which tends to reveal mental
   impressions, conclusions, opinions or theories concerning
   the litigation, 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. Where
   a document was created because of anticipated
   litigation, and would not have been prepared in
   substantially similar form but for the prospect of
   that litigation, it falls within [Federal Rule of Civil
   Procedure] Rule 26(b)(3). (25)

In distinguishing the more restrictive standard, the court in Adlman explained that it favored the broader standard of preparation in anticipation of litigation:

   The formulation applied by some courts in determining
   whether documents are protected by workproduct
   privilege is whether they are prepared
   "primarily or exclusively to assist in litigation"--a
   formulation that would potentially exclude documents
   containing analysis of expected litigation, if
   their primary, ultimate, or exclusive purpose is to
   assist in making the business decision. Others ask
   whether the documents were prepared "because
   of' existing or expected litigation--a formulation
   that would include such documents, despite the fact
   that their purpose is not to "assist in" litigation.
   Because we believe that protection of documents
   of this type is more consistent with both the literal
   terms and the purposes of the Rule, we adopt the
   latter formulation. (26)

Taxpayers who aggressively push for the broader standard should, of course, understand that it is but one tool to shield workpapers--or, rather, the separate analytical memoranda that support the raw numbers. (27)

The different holdings in Arthur Young & Co. and Adlman do not reflect judicial confusion, but rather illustrate that whether work-product protection attaches to documents like tax accrual workpapers depends on a fact-specific inquiry of when and how such documents (or, more accurately, the analyses within them that are prompted by litigation concerns) are created and then disseminated. In short, where tax accrual workpapers are simply prepared in the ordinary course of business, and then later shared with external auditors in the normal course of vetting a company's financial statements, they will not be privileged. To the extent that portions of the workpapers can be traced to specific litigation concerns, were drafted at the direction of attorneys, and whose confidentiality, even vis-a-vis company auditors, were zealously guarded later on, then those portions may receive work-product protection. Of course, even work-product protection may not be enough to deter the IRS, when one considers not only the increased enforcement efforts of the IRS, but other parallel developments in the government.

Increased Enforcement--The Downpour Begins

The IRS may not long forebear in seeking review of tax accrual workpapers in more than listed situations. The Bush Administration's FY 2005 Budget, for example, includes an additional $300 million for IRS efforts to ensure compliance with the tax laws, and increases the total IRS budget by 4.8 percent--significantly above the average for non-defense, non-homeland security discretionary spending. (28) This increase is even more significant when one considers that the budget continues a three-year trend of increasing resources for the IRS to improve taxpayer compliance and to target abusive transactions. (29)

Amplifying the effect of all of those numbers is the push to shift IRS employees from customer service to tax law enforcement. In 2003, IRS Commissioner Mark W. Everson envisioned that improvements in technology would allow the IRS to "realign approximately 10,000 positions over the next two years, impacting nearly 10 percent of its workforce." (30) Although the past two years only show an increase of two percent, change is occurring. (31)

Notwithstanding the modest increase in enforcement employees, the IRS had plenty to show in return. During 2004, the IRS posted an impressive gain in enforcement revenue, up $5.5 billion from 2003. (32) During that same time period, the IRS "[i]ncreased audits of high-income taxpayers by 40 percent, ... and audits of large corporations te 16.7 percent, up from 12.1 percent last year, reversing eight years of decline." (33)

Additional Requests--The Hurricane Approaches

Without a doubt, the IRS initiative to increase enforcement has affected the agency's approach to requesting tax accrual workpapers. While it appears that the bulk of those requests may relate to listed transactions, other dangers abound. On October 26, 2005, Deborah Butler, IRS associate chief counsel of procedure and administration "discussed a limited expansion of the policy set out in Announcement 2002-63." (33A) Although no details were provided, any change in policy would be room for concern.

Agency Partnerships--The Eye of the Storm

Indubitably, taxpayers must be concerned not only with the changing approach of the IRS, but also with the coordination with, and investigation by, other federal and state agencies. For instance, the IRS has "developed a strong working relationship with the Department of Justice." (34) Indeed, in 2003, Commissioner Everson lauded the efforts of former Deputy Attorney General Larry Thompson and current Assistant Attorney General of the Justice Department's Tax Division Eileen J. O'Connor for their efforts to combat abusive transactions. (35) In 2004, the Treasury Department noted that the IRS had "been working closely with the Department of Justice in criminal and civil cases against taxpayers who [participated] in tax scams and the individuals and firms" who promoted those scams. (36) Subsequently, in 2005, "[w]orking in conjunction with the Department of Justice, the IRS won some important victories in high-profile abusive tax shelter cases." (37)

Additionally, the IRS may begin to work more closely with the Securities and Exchange Commission. (38) While current laws prohibit the IRS from sharing tax return information with other government agencies, (39) the locks on that door may be loosened. "Information sharing between the IRS and SEC became an issue [in 2002]" when Commissioner Everson "said it was an idea 'worthy of some discussion.'" (40) Such a combination would be a fitting piece for the IRS and its aggressive enforcement approach.

The combination of efforts has occurred at the state level as well. In 2003, the IRS "entered into a nationwide partnership agreement with 40 state tax agencies," and "the District of Columbia to combat abusive tax avoidance." (41) Under those agreements, the IRS exchanged information about abusive transaction leads. The partnership continued in 2004, and was expanded to cover 45 states, with leads being shared on more than 20,000 taxpayers. (42) Being able to receive such information provides a great boon to the IRS in that it may be one less hurdle to seeking taxpayer information.

These partnerships and agreements may be the final elements of the perfect storm.

While evidence exists that the IRS may be increasing its requests for tax accrual workpapers, a larger challenge looms in the information's being revealed in other contexts.

The Overall Governmental Transparency Campaign

Not only is the IRS beefing up enforcement, but so are other government departments and agencies. The slew of corporate accounting scandals that rocked the United States in 2001 and 2002 resulted in what can be accurately described as a multi-tiered "transparency campaign" aimed at American business. This transparency campaign is encapsulated in President Bush's "ten point plan" of March 7, 2002, in which he stressed goals such as prompt reporting of financial data, independence of auditors and audit committees, and more accountability of corporate officers in the vetting of financial documents. (43)

In response to the scandals, Congress passed the Sarbanes-Oxley Act of 2002, the most far-reaching reform of the securities laws since the 1934 Securities Exchange Act. Among other initiatives, the legislation:

* Created a new accounting oversight board to police the accounting profession.

* Strengthened auditor independence rules.

* Required that audit papers be retained for five years.

A key piece of the 2002 legislation was its focus on the role of auditors. While the reporting and certification requirements received much of the headlines, the real story is the virtual transformation of company auditors and attorneys into independent watchdogs. (44)

Furthermore, an immediate reaction inside the executive branch to the Enron and WorldCom scandals was the creation of the Corporate Fraud Task Force in July 2002, (45) chaired by the Deputy Attorney General of the Department of Justice and including the Assistant Attorney General of the Tax Division. By its second year, the Task Force boasted more than 500 corporate fraud convictions or guilty pleas, with charges against 900 defendants and more than 60 CEOs. (46) Multi-departmental in approach, the Corporate Fraud Task Force, and its Enron Task Force component, have focused on the role of auditors and financial institutions.

The Deferred Prosecution a/k/a "Cooperation" Agreement

A cooperation (or deferred prosecution) agreement is increasingly a weapon of choice in the Department of Justice's enforcement arsenal. Because any major DOJ investigation is staffed by both civil and criminal DOJ attorneys, the result is that companies subject to major investigations can expect to face not only a large demand to settle civil liability but also the possibility of indictment. Often, the only way to settle an investigation short of trial is to pay a large civil settlement and enter into a deferred prosecution agreement with a cooperation component that may include waiving the attorney-client privilege and providing documents against former officers and employees against whom criminal charges may be brought. Such a solution can ruin a company. Where defendants have refused to cooperate, the government has demonstrated that it is willing to prosecute vigorously, such as in the Adelphia, Craig Consumer Electronics, Dynegy, Unify, Graham-Field Health Products, HealthSouth, and U.S. Technologies cases. (47)

The importance of the deferred prosecution agreement cannot be overemphasized. Notwithstanding its bringing the obstruction case against the accounting firm of Arthur Andersen (which caused the firm to implode), the Enron Task Force entered into deferred prosecution agreements with, among others, Merrill Lynch & Co. Inc. and Canadian Imperial Bank of Commerce, which allegedly aided and abetted the fraud at Enron. In a more striking example, Tommy Hilfiger USA, Inc. not only agreed to pay $18.1 million in back taxes, but also entered into a deferred prosecution agreement to supply documents to federal prosecutors and provided confidential documents to the Hong Kong Inland Revenue Department. (48)

A more devastating example of the waiver of privilege and wholesale production of documents, however, occurred in the KPMG case. In October 2005, the Justice Department announced a superseding indictment against 19 individuals at KPMG for alleged conspiracy to defraud the IRS, tax evasion, and obstruction of the internal revenue laws arising out of tax shelters in effect from 1996 through 2004. (49) Undoubtedly, what allowed the government to proceed against so many individuals in that case is the exceptionally broad cooperation agreement entered into by KPMG. Among other things, KPMG agreed:

* To cooperate fully with DOJ, the IRS, and any designated agency regarding any matter under investigation to which KPMG has information;

* To disclose all information under inquiry, including but not limited to activities of KPMG, and its present and former partners, employees, and agents; and

* To forgo asserting any claim of privilege or work-product doctrine, with limited exceptions. (50)

In return for KPMG's cooperation and waiver of the privilege, the government agreed to defer prosecution of KPMG. (51)

Waiver of Privilege

The government increasingly expects some form of waiver as a measure of cooperation in settlement negotiations. The "completeness" of the disclosure and of the cooperation are the ultimate driving factors:

   [In] assessing the adequacy of a corporation's cooperation
   [factors to consider are] the completeness of
   its disclosure, including, if necessary a waiver of the
   attorney client and work product protections....(52)

There is little doubt that a primary interest of DOJ is getting a corporation to turn on its former employees who may have been engaged in wrongdoing:

   In gauging the extent of the corporation's cooperation,
   the prosecutor may consider the corporation's
   willingness to ... waive the attorney client and
   work product privileges....(53)

The SEC has taken similar steps as well. (54) In sum, the trend is toward requesting a waiver of the privilege.

Anecdotal evidence suggests that SEC and Justice Department attorneys have been so aggressive and consistent in asking for waivers, that there is some backlash from the organized defense bar. (55) Part of that backlash may have prompted the very recent memorandum regarding "Waiver of the Attorney-Client and Work Product Protection" of October 21, 2005, from Deputy Attorney General Robert D. McCallum. (56) It mandates that each U.S. Attorney and head of departmental components are to establish a "written waiver review process" that preserves prosecutorial discretion yet memorializes and somewhat rationalizes the waiver request process.

This does not necessarily mean that the government will seek fewer waivers. Rather, it suggests that what was once an extraordinary request is becoming an increasingly routine, bureaucratic exercise. One reason for the Justice Department's new approach is that it offers great efficiencies for the government: the ability to have the corporation conduct the investigative work and provide the "smoking gun" documents. Recent cases bear out this very trend. (57)

Limited Waiver (Protecting Workpapers)

In the KPMG deferred prosecution agreement, the waiver of the privilege was a "limited waiver." This concept is not new. The hope for companies that enter into "limited waiver" agreements with the Justice Department or SEC is that only the agencies will see the privileged documents, and that very few of those documents will ever see the light of day in a criminal prosecution against a former employee.

"Limited waiver" actually encompasses two different doctrines: partial waiver and selective waiver. As the Third Circuit Court of Appeals explained:

   Selective waiver permits the client who has disclosed
   privileged communications to one party
   to continue asserting the privilege against other
   parties. Partial waiver permits a client who has
   disclosed a portion of privileged communications to
   continue asserting the privilege as to the remaining
   portions of the same communications. (58)

Both waivers have "limits." With partial waiver, absent an agreement or stipulation, courts usually find a broad subject matter waiver whenever the receiving party argues it is prejudiced by only a partial release. Additionally, most courts reject selective waiver (59) for two reasons. First, they view it as illogical to benefit from selectively combing through files for exonerating documents, while shielding anything incriminating. Second, they see an inconsistency in client confidentiality to reveal privileged information to one group while shielding it from another. (60) In short, the bottom line is that when privileged communications are waived, there may be little to stop a determined third party from obtaining those communications in a subsequent litigation.

That said, there are steps that defendants can take to strengthen the "limited" aspect of the waiver to make it more difficult for private litigants (and even the IRS) to obtain privileged or confidential materials that are turned over to Justice Department or the SEC. These include:

* Requiring the government to issue a grand jury subpoena for work-product privileged materials, such as workpapers;

* Labeling all privileged materials "grand jury materials";

* Marking all privileged materials "exempt from FOIA" in order to allow the government to resist Freedom of Information Act requests;

* Making the government agree in writing that the documents produced do not constitute a general waiver of any privilege;

* Trying to have the government agree in writing that it shares a "common interest" with the company in resolving matters;

* Having the government promise to limit circulation to the investigative team;

* Requiring the return of all privileged materials after the investigation ends;

* Obtaining a government promise to resist third-party subpoenas; and

* Obtaining a government promise to inform the company of other agency requests for the materials.

It is important to understand that even with such protections, the waiver of the privilege may not be nearly as "limited' as a company may wish. The following example illustrates the typical route by which waived materials are acquired by third parties, including potentially the IRS.

The Perfect Storm Swirls

Fast forward a year from today to the following hypothetical. The SEC is investigating Conglomerate Corp. for a major restatement of income owing to suppression of negative information regarding its profit margins for a computer chip. The chip goes into many communications devices of third-party vendors. The SEC investigation shows that two years earlier margins had been much lower than originally forecasted. This was so because the error rate in the chips spiked following a systemic flaw in the manufacturing devices. Expensive redesigns, re-supply of chips to vendors, warranty issues, and, ultimately, reduced sales had hit Conglomerate Corp. very hard. Its CFO, fearful not only for his own job, but also of layoffs of many innocent employees at the production plant, falsified profit margins, cash flow statements, and earnings reports. The CFO had also lobbied hard with the legal department to downplay the litigation exposure of several lawsuits brought from smaller vendors. The company's tax accrual workpapers reflect some of these decisions, as well as many other perfectly legitimate ones. Some company vice-presidents quietly dumped their stock after they saw the company's last 10K, before the restatement of income.

Justice Department criminal attorneys become involved as the case unfolds. Multiple counts of criminal indictment are threatened against the company, as well as a concomitant suspension of all of the company's contracts with the government. The only way to avoid these dire results, the government attorneys say, is for the company to waive the privilege in respect of all communications regarding the chip technology. The company agrees and crafts a very careful deferred prosecution agreement, pursuant to which it turns over all documents requested: e-mail correspondence, legal memoranda, and tax accrual workpapers.

Following the conviction of the CFO and several vice-presidents, multiple civil lawsuit are filed against Conglomerate Corp. The private litigants move to discover all evidence provided to the government. Despite the company's best efforts, the district court refuses to recognize the selective waiver. Accordingly, the private litigants now have full access to company's privileged information it produced to the government, including the tax accrual workpapers. Given that both the Justice Department and private litigants have obtained those documents, it would certainly be naive to believe the IRS would not be sorely tempted to request them as well--notwithstanding Announcement 2002-63.

Conclusion: Practical Steps to Take

In the current enforcement environment, companies should be more careful than ever about what they put in communications believed to be privileged. Careless statements in tax accrual workpapers, in e-mails, or in other communications can easily end up disclosed.

To the extent that tax accrual workpapers are arguably made in anticipation of litigation and are subsequently shared with auditors, steps can be taken to build in work-product protection. They should be clearly marked as "Work Product" and "Confidential--Not to be Circulated," as appropriate. There should be a common interest agreement with the auditors that spells out the litigation risks to be avoided and prohibits the auditors from disclosing those workpapers.

Other steps to take to keep tax accrual workpapers confidential are the obvious ones: avoid listed transactions and any other behavior that might lead to an investigation by the IRS, Justice Department, SEC, or other government agency. Where investigations do occur, the taxpayer should strive to limit the scope of documents it provides to the government, and build in as many confidentiality protections as possible. In terms of audits, absent a true common interest in avoiding specific litigation or dealing with a government investigation, "the independent auditor [should] perform its own tax analysis of [any] items in question rather than having the taxpayer turn over the tax accrual workpapers. This additional work is, of course, at the taxpayer's expense, and there is a risk that the auditor will not agree with the taxpayer's position." (61) Also, while acknowledging likely push-back from independent auditors, some commentators have incisively advised that "tax executives should strive to limit the documentation that is actually created for the purpose of being turned over to the corporation's independent auditors. For example, a page or two of numbers constituting the corporation's aggregate tax reserve would be ideal. Thus, corporations could effectively maintain confidentiality concerning back-up legal memoranda." (62)

In sum, the ultimate conclusion must be that as much as a taxpayer can and should seek to maintain confidentiality of tax accrual workpapers, they must be drafted as though they could appear on the front page of The Wall Street Journal. Like boarding up a beach house when the gathering storm darkens, the protections will not hold if the perfect storm strikes.

(1) See generally Mark W. Everson, Commissioner of Internal Revenue, Prepared Testimony of Commissioner of Internal Revenue Mark W. Everson Before the Senate Finance Committee Hearing on Corporate Tax Shelters October 21, 2003 (Oct. 21, 2003), discussed in Everson Testifies on Tax Shelters at Finance Committee Hearing, 2003 TNT 204-28 (Oct. 22, 2003) [hereinafter "2003 Everson Testimony"].

(1A) Robert T. Zubg, "IRS Expanding Circumstances Under Which Agency Will Seek Workpapers, Official Says," BNA Daily Tax Report (Oct. 26, 2005).

(2) See Burgess J.W. Raby & William L. Raby, Work-Product Privilege and the Nonlawyer Tax Practitioner, 2004 TNT 136-30 (July 15, 2004). Tax accrual workpapers are audit workpapers, prepared by the taxpayer, the taxpayer's accountant, or the independent auditor relating to the tax reserve for current, deferred, and potential or contingent liabilities, however classified or reported on audited financial statements, and to footnotes disclosing those tax reserves on audited financial statements. I.R.M. 4.10.20.2(2) (July 2004).

(3) See Sirena J. Scales, IRS Issue Management System to Track Tax Accrual Workpapers, 2005 TNT 212-5 (Nov. 3, 2005) (quoting LMSB Deputy Commissioner Bruce Ungar).

(4) Warren Rojas, IRS, SEC Officials Hail Reporting Gains, Downplay Disclosure Pains, 2005 TNT 206-4 (Oct. 26, 2005) [hereinafter "Warren Rojas, IRS, SEC Officials"].

(5) Press Release, U.S. Department of the Treasury, Bush Administration's Aggressive Actions to Combat Abusive Tax Shelters (Feb. 20, 2004) [hereinafter "Bush Administration's Aggressive Actions"].

(6) See, e.g., Thomas J. Callahan, Jeffry J. Erney & Gregory J. Gawlik, Tax Accrual Workpapers: IRS Efforts to Obtain Them, Corporate Strategies to Protect Them, 55 The Tax Executive 364 (Sept.-Oct. 2003) (sounding the klaxon, this article remains relevant and useful despite intervening events).

(7) See generally Announcement 84-46, 1984-18 I.R.B. 18. Interestingly enough, the IRS issued Announcement 84-46 despite its contemporaneous victory in United States v. Arthur Young & Co., 465 U.S. 805 (1984). In that case, a unanimous Supreme Court held that tax accrual workpapers prepared by a corporation's independent certified public accountant were not protected by an accountant-client privilege or an accountant work-product privilege. Nevertheless, Announcement 84-46 soothed the fears of taxpayers by reasserting that it would generally not request tax accrual workpapers.

(8) Tax Analysts, Transcript of Tax Analysts Tax Accrual Workpaper Conference Available, 2004 TNT 142-44 (July 23, 2004) [hereinafter "2004 Tax Analysts' Transcript"] (comments of B. John Williams, former IRS Chief Counsel).

(9) See Announcement 2002-63, 2002-27 I.R.B. 72.

(10) I.R.M. 4.10.20.3.1 (July 2004).

(11) See 2004 Tax Analysts' Transcript, supra note 8 (question and answer between Jim Joseph and IRS Chief Counsel Donald L. Korb); see also I.R.M. 4.10.20.4 (July 2004); Chief Counsel Notice CC-2003-012.

(12) See 2004 Tax Analysts' Transcript, supra note 8 (comments of former IRS Chief Counsel B. John Williams); see also Emily A. Parker, IRS Deputy Chief Counsel for Operations, Speech before the Texas Federal Tax Institute (known as the "Return to the Alamo" speech) (June 6, 2003), in IRS Official Lists Actions Taken to Curb Corporate Tax Abuses, 2003 TNT 114-6 (June 13, 2003).

(13) See Q&A 11 of the "Frequently Asked Questions" publication issued on July 28, 2005; see also 2003 Everson Testimony, supra note 1 (IRS Commissioner Mark W. Everson noting that one of the ways the IRS finds out about questionable transactions is through anonymous tips).

(14) Announcement 2002-63, 2002-27 I.R.B. 72.

(15) Philip R. West, Obtaining and Providing Outside International (and Other) Tax Advice in the Current Tax Enforcement and Compliance Environment, Tax Management International Journal (2005).

(16) Kenneth A. Gary & Sheryl Stratton, IRS Balancing Workpaper Request Restraint with Deterrence, Korb Says, 2004 TNT 138-1 (July 19, 2004).

(17) 465 U.S. 805 (1984).

(18) Merrill Lynch & Co. v. Allegheny Energy Co., 229 F.R.D. 441, 449 (S.D.N.Y. 2004).

(19) Id. at 447.

(20) The work-product rule was originally laid down by the Supreme Court in Hickman v. Taylor, 329 U.S. 495 (1947), and was subsequently codified in Fed. R. Civ. P. 26(b)(3).

(21) United States v. El Paso Co., 682 F.2d 530, 542 (5th Cir. 1982) (internal citations omitted).

(22) United States v. Adlman, 134 F.3d 1194, 1202 (2d Cir. 1998) (quoting Charles Alan Wright, Arthur R. Miller & Richard L. Marcus, 8 Federal Practice & Procedure, [section] 2024, at 346 ("even though litigation is already in prospect, there is no work-product immunity for documents prepared in the regular course of business rather than for purposes of the litigation.")).

(23) Interestingly, Chief Counsel Notice CC-2003-22 (July 1, 2003) states "the IRS Chief Counsel concluded that some Chief Counsel Advice could be completely withheld from public disclosure under section 6110 of the code (i.e., fully redacted) if, for example, it consisted entirely of attorney work product." This statement acknowledges that tax advice, if prepared in anticipation of litigation and at the direction of attorneys, stands some prospect of being protected, as will be explained further below.

(24) 134 F.3d 1194 (2d Cir. 1994).

(25) Id. at 1195 (the IRS failed to make a highly persuasive showing necessary to overcome work-product protection; the memorandum did not address or reflect the taxpayer's business reason for the proposed restructuring, but only revealed technical and legal analysis of the outside accountants, and the IRS had made no showing, beyond bare assertion, that relevant information in the memorandum was unavailable by other means).

(26) Id. at 1198.

(27) Some commentators have argued that splitting the data from the analytical explanations, which would be contained in separate "back up legal memoranda" would be advisable. See Thomas J. Callahan, Jeffry J. Erney & Gregory J. Gawlik, supra note 6, at 367.

(28) Press Release, U.S. Department of the Treasury, April 15th Tax Day Reminder: Treasury & IRS Continue to Crackdown on Abusive Tax Shelters (April 9, 2004) [hereinafter "2004 Tax Day Reminder"].

(29) Bush Administration's Aggressive Actions, supra note 5.

(30) Mark W. Everson, Memorandum for Teresa Mullett Ressel, Assistant Treasury Secretary for Management and Chief Financial Officer (Nov. 25, 2003) in IRS Commissioner Everson Memo on Service's Need for Voluntary Separation Inventive Payments (VSIP) and Voluntary Early Retirement Authority (VERA) for FY 2004-2005 to Modernize, Reorganize Agency, BNA Daily Tax Report (Sept. 1, 2005). Additionally, improvements in technology are more than shallow promises. Recently, the IRS announced that it would implement the Issue Management System (IMS) of the Large and Midsize Business Division (LMSB) by 2006. The IMS will "require agents and managers to track all significant workpapers," and will allow information sharing about issues under development. See Sirena J. Scales, supra note 3.

(31) Stephen Joyce, IRS Working to Reshape Workforce in Effort to Boost "Front Line" Enforcement Personnel, BNA Daily Tax Report (Sept. 1, 2005) ("In fiscal year 2003 a total of 48.11 percent of the IRS workforce was dedicated to enforcement actions; that percentage is projected to be 50.16 percent for FY 2005, according to IRS data.").

(32) IRS Oversight Board Annual Report 2005, at 16 [hereinafter "2005 Oversight Board Annual Report"]. Unfortunately, "during the same period, Gross Accounts Receivable, all unpaid tax, penalties, and interest on taxpayers' delinquent accounts, increased from $278 billion to $285 billion, an increase of $7 billion. Id.

(33) Id. at 15.

(33A) Robert T. Zung, supra note 1A.

(34) 2003 Everson Testimony, supra note 1.

(35) Id.

(36) 2004 Tax Day Reminder, supra note 28.

(37) 2005 Oversight Board Annual Report, supra note 32, at 16.

(38) Warren Rojas, IRS, SEC Officials, supra note 4.

(39) See I.R.C. [section] 6103.

(40) Warren Rojas, IRS, SEC Officials, supra note 4.

(41) 2003 Everson Testimony, supra note 1.

(42) 2004 Tax Day Reminder, supra note 28.

(43) See White House Press Release, President Outlines Plan to Improve Corporate Responsibility (Mar. 7, 2002), available at http:// www.whitehouse.gov/news/releases/2002/03/20020307-3.html.

(44) For instance, section 201 of the Sarbanes-Oxley Act lays down prohibitions on non-audit services. Section 301 mandates audit committee independence from the board of directors and gives a company's audit committee the power to hire and fire external auditors. See also 17 C.F.R. [section] 240.10A-3.

(45) Executive Order 13271 (July 9, 2002).

(46) U.S. Justice Department, Corporate Fraud Task Force, Second Year Report to the President (2004), available at http://www.usdoj. gov/dag/cftff2nd_yr_fraud_report.pdf.

(47) DOJ Press Releases available at http://www.usdoj.gov/ 03press/03_1_1.html.

(48) Press Release, Tommy Hilfiger Corporation Announces Resolution of U.S. Attorney's Office Investigation, available at http://www. tommy.com (Aug. 10, 2005).

(49) DOJ Press Release, Oct. 17, 2005, available at http://www. usdoj.gov/opa/pr/2005/October/05_tax_547.html.

(50) Letter from David N. Kelley, U.S. Attorney, S.D.N.Y., to Robert Bennett re: KPMG--Deferred Prosecution Agreement, filed in United States v. KPMG LLP, Case No. 05 CRIM. 903 (S.D.N.Y., Aug. 26, 2005) at [paragraphs] 7-8.

(51) United States v. KPMG LLP, Information, Deferred Prosecution Agreement, Case No. 05 CRIM 903 (S.D.N.Y. Aug. 29. 2005).

(52) Memorandum from Deputy Attorney General Eric Holder, Jr., Bringing Criminal Charges Against Corporations, June 16 1999, at VI.B (emphasis added) available at http://www.usdoj. gov/criminal/fraud/policy/Chargingcorps.html.

(53) Id. at VI.A; see also Memorandum by Deputy Attorney General Larry Thompson, Principles of Federal Prosecutions of Business Organizations, U.S. Attorney's Manual, Title 9, [section] 162, sec. II (A) (4) and VI (A) (emphasis added), available at http://www. usdoj.gov/dag/cftf/corporate_guidelines.htm.

(54) SEC Release No. 44969, Oct. 23, 2001.

(55) See Gabe Friedman, Justice Officials Limit Power to Lift Privilege, San Francisco Daily Journal, October 27, 2005, at 1 ("The move was intended to address concerns raised by white collar criminal defenders who complain that prosecutors are forcing corporations to act against the interests of executives under investigation.... In August the American Bar Association passed a resolution critical of the practice as laid out in Thompson's memo.").

(56) Acting Deputy Attorney General Robert D. McCallum, Jr., Memorandum Regarding "Waiver of Corporate Attorney-Client and Work Product Protection" (October 21, 2005).

(57) For example, Computer Associates International, Inc. entered into a joint settlement agreement with the SEC and the Justice Department on September 22, 2004, to make a $225 million civil restitution payment. In addition, the company agreed to waive its attorney-client privilege with respect to documents related to the investigation. The U.S. Attorney's Office then indicted seven individuals in relation to this matter, including the former CEO of Computer Associates. See SEC Litigation Release No. 18891, available at http://www.sec.gov/litigation/litreleases/lr18891.htm (Sept. 22, 2004).

(58) Westinghouse Electric Corp. v. Republic of Philippines, 951 F.2d 1414, 1423 n.7 (3d Cir. 1991) (internal citations omitted).

(59) See generally United States v. Massachusetts Institute of Technology, 129 F.3d 681 (1st Cir. 1997); Ratliff v. Davis Polk & Wardell, 354 F.3d 165 (2d Cir. 2003); Westinghouse Electric Corp. v. Republic of Philippines, 951 F.2d 1414 (3d Cir. 1991); In re Martin Marietta Corp., 856 F.2d 619, 623 (4th Cir. 1988); In re Columbia / HCA Healthcare Corp. Billing Practices Litigation, 293 F.3d 289 (6th Cir. 2002); McMorgan & Co. v. First Cal. Mortgage Co., 931 F. Supp. 703 (9th Cir. 1996); In re Sealed Case, 676 F.2d 793 (D.C. Cir. 1982); Genentech, Inc. v. U.S. International Trade Commission, 122 F.3d 1409 (Fed. Cir. 1997).

(60) Not all courts are reluctant to enforce limited waiver. See United States v. Shyres, 898 F.2d 647 (8th Cir. 1990); Diversified Industries v. Meredith, 572 F.2d 596 (8th Cir. 1977) (stating in dicta that the court would be reluctant to find a waiver in respect of third parties where a corporation was merely responding obediently to a government subpoena by providing privileged information to the SEC); In re LTV Securities Litigation, 89 F.R.D. 595 (N. D. Tex. 1981) (holding that disclosure to the SEC was protected under the limited waiver doctrine and shielding documents from discovery by a third party).

(61) Philip R. West, supra note 15.

(62) Thomas J. Callahan, Jeffry J. Erney & Gregory J. Gawlik, supra note 6.

THOMAS F. CARLUCCI, ISAAC J. MORRIS, and RUSSELL L. CARLBERG are members of Foley & Lardner LLP's White Collar Defense and/or Tax Litigation practice groups. Thomas F. Carlucci is Chair of the White Collar Defense Practice Group and formerly served in the United States Department of Justice Civil and Criminal Tax Divisions for thirteen years, during which time he received the United States Attorney General's John Marshall Award for excellence in criminal tax prosecution