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United States v. Roxworthy: what does it mean to taxpayers?

In 2002, then-IRS Chief Counsel B. John Williams delivered a speech to the Texas Law Institute in which he made several references to the "Alamo" in the course of setting forth the Internal Revenue Service's view of the scope of the attorney-client privilege in tax matters. (1) Since that time, there has been renewed focus on the limits of attorney-client privilege and work-product doctrine for protecting tax advice. With the change in the IRS policy on tax accrual workpapers and increased auditor demands for tax opinions that might underlie companies' positions on tax reserves, there has been greater pressure on claims of privilege. (2) This has been accompanied by speculation that the only viable means of protecting sensitive advice is the work-product doctrine.

Against this backdrop comes the decision by the U.S. Court of Appeals for the Sixth Circuit in United States v. Roxworthy, (3) on August 10, 2006. The opinion is welcome news to taxpayers and practitioners because it reaffirms the validity of a work-product privilege claim for tax advice before an audit commences, but also highlights the limits to this privilege. First, as students of privilege and work-product cases know, these cases are fact intensive and, consequently, are typically decided by trial judges or magistrates, and a appellate decision is rare and therefore noteworthy. Roxworthy is particularly significant to taxpayers and tax advisers because it adopts the analysis in United States v. Adlman (Adlman II) and goes further by holding that the documents at issue were covered by the work-product doctrine, whereas the Second Circuit in Adlman II remanded the case to the district court to make the ultimate determination. (4) The Roxworthy case also serves as both a cautionary tale and a roadmap for taxpayers who would rely on the work-product doctrine to protect tax advice from discovery.

Summary of the Case

At issue in Roxworthy were two memoranda prepared by KPMG LLP for the general counsel of Yum! Brands, Inc., analyzing creation of a captive insurance company and related stock transfers. The IRS issued an information document request in the course of its audit of Yum's 1997, 1998 and 1999 tax years, in response to which Yum asserted privilege for seven documents including the two memoranda it believed were protected under the work-product doctrine. The IRS then issued a summons to Patrick Roxworthy, Yum's Vice-President, Tax, for the documents on the privilege log. After entering into a limitation of waiver agreement, Yum produced five of the seven documents.

When the two KPMG memoranda were not produced, the IRS brought a summons enforcement action in district court. The case was assigned to a magistrate judge who concluded that the summons should be enforced on the ground that the documents were created to assist Yum in connection with preparation of its tax return in case the IRS asserted penalties on audit. Yum objected to the magistrate's findings and provided the court with additional affidavits to support its position that the documents were prepared in anticipation of litigation. The district court nevertheless adopted the magistrate's report and recommendation. Yum appealed.

In sustaining Yum's appeal, the Sixth Circuit followed Adlman II in defining documents prepared "in anticipation of litigation" as "prepared or obtained because of the prospect of litigation" and found that the work-product doctrine protected the two memoranda because the taxpayer established, based on surrounding facts and circumstances in addition to the substance of the documents themselves, that the documents were prepared in anticipation of litigation.

Lessons Learned

A. The Sixth Circuit Is a Good Place to Raise a Work-Product Claim

With Roxworthy, the Sixth Circuit joins the Second Circuit (Adlman II) as a jurisdiction more friendly to claims of work product (although, as explained below, "friendliness" isn't without its limits). (5) In particular, the court found that the work-product doctrine could protect a document prepared before the issue was raised on audit and even before the return was filed; the court, however, expressly declined to rule that the taxpayer's anticipation of an audit was sufficient to trigger the doctrine). By contrast, the Tax Court remains an unfriendly place after Bernardo v. Commissioner. (6) 104 T.C. 677 (1995). In that 1995 case, the Tax Court found that documents were not prepared "in anticipation of litigation" if they were prepared before the IRS raised the issue on audit. (7) Thus, had Yum's work-product claim arisen in the context of Tax Court litigation, the IRS might well have secured the two KPMG memoranda.

B. Don't Be Greedy

Roxworthy involved only two documents (and the original privilege log included only seven documents) reminding us that in a privilege fight less usually is more. Although there may be many sensitive documents in the tax reserve file, taxpayers and advisers should carefully review each document and assert a work-product claim only for those documents for which they can make a showing that the document was prepared in anticipation of litigation or controversy. To be sure, there may be a temptation to withhold all documents that include any assessment of likely outcomes in audit workpapers, but the reality of privilege law is that many documents cannot satisfy the "prepared in anticipation of litigation" standard and thus are not protected under the work-product doctrine. Claiming work-product protection for documents without strong evidence of "anticipation of litigation" may cause a court to view all of the privilege claims skeptically. By overreaching, taxpayers can jeopardize those documents for which they may have strong claims.

C. Be Careful about Labeling Documents

Labeling documents carefully is a corollary to claiming privilege wisely. The Sixth Circuit commented that the two KPMG memoranda bore the label "attorney-client privilege" but not "work-product doctrine." Although the mislabeling in Roxworthy did not affect the outcome, the court's commenting on it suggests that labels can be a factor. Before marking documents as privileged, taxpayers and advisers should evaluate whether the documents are in fact privileged; if so, how (attorney-client, work-product, or both); and, more particularly, whether the documents are intended to be kept confidential or were prepared in anticipation of litigation.

D. Proof Is Important (and So Is a Little Luck)

The Sixth Circuit considered both the content of the memoranda (that they discussed the strengths and weaknesses of the taxpayer's case) and also the circumstances under which the memoranda were prepared. In finding that Yum had demonstrated that the documents really were prepared in anticipation of litigation, despite the lack of any "overt" indication that the IRS would pursue litigation against Yum, the appeals court enumerated four key facts that Yum had established: "[1] a specific transaction that could precipitate litigation, [2] the specific legal controversy that would be at issue in the litigation, [3] the opposing party's opportunity to discover the facts that would give rise to the litigation, and [4] the opposing party's general inclination to purse this sort of litigation." The court also took note of the memoranda's "highly detailed discussions of hypothetical legal arguments." This provides a convenient roadmap for taxpayers seeking to sustain a work-product privilege claim.

The appeals court also explained that the original affidavits provided to the magistrate judge were conclusory assertions that the documents were created in anticipation of litigation but Yum was permitted to supplement the record and provide more concrete and detailed support for its work-product claim. Because privilege and work-product cases are so fact intensive, taxpayers should pay careful attention to their proof and should not assume they will be given a second chance.

E. Documentation of that Proof Is Important

To strengthen a potential claim, taxpayers should contemporaneously document the elements identified by the court in Roxworthy. Thus, at the time the taxpayer receives the advice or analysis it seeks to protect, it should include in its files a memorandum setting forth the specific issue, the specific challenge the IRS might mount, why the taxpayer (or adviser) thinks the IRS is likely to discover the issue, and why the IRS is likely to litigate this issue. Such proof must go beyond the likelihood that the transaction will be audited and discuss the likelihood of litigation or controversy with the IRS, for example, by specifying the grounds on which the IRS might challenge a taxpayer's position. Contemporaneous documentation can help to establish the key elements of a work-product claim--that the taxpayer really did anticipate litigation or controversy with the IRS at the time it received the document, and why it was reasonable to anticipate such litigation or controversy. The more specific and concrete the proof of anticipation is, the stronger the taxpayer's position will be if the claim of privilege is later challenged.

Unanswered Questions

A. Who in a Company Should Receive the Advice?

The Sixth Circuit emphasized the role of Yum's general counsel in obtaining the tax advice and assessing litigation risks generally for the company. It is unclear whether the court would have reached a different conclusion had the advice been obtained by the tax director. As long as the taxpayer can show that the tax director anticipated litigation or controversy with the IRS, sought advice because of the anticipated litigation or controversy, and would not have sought the advice (or at least not in the same form) in the absence of the anticipated litigation or controversy, a court should sustain a work-product claim.

B. How Important Is Timing?

Because the KPMG memoranda in Roxworthy were received just before the due date of the tax return, rather than before the transaction analyzed, the magistrate judge and district court seemed to assume that they must have been meant to assist the taxpayer in preparing its return. The appeals court, by contrast, concluded that the memoranda's receipt after the transaction was entered into might even strengthen the taxpayer's position that the advice was given in anticipation of litigation rather than used for ordinary business purposes. The Sixth Circuit also accepted the taxpayer's assertion that it always sought an extension of time to file its returns, which meant that the memoranda were received months rather than days before the return was filed. The court did not consider, however, that the memoranda's receipt before the return was filed was important to the taxpayer's ability to rely on the advice for penalty protection. (8)

Despite the attention to timing in Roxworthy, it is difficult to know how much weight if any to assign this particular timing issue--whether the memoranda were prepared before the transaction or rather before the return was filed--when evaluating the core issue whether the document was prepared in anticipation of litigation or controversy with the IRS. In either case, the taxpayer might well anticipate an IRS challenge.

C. How Much Proof Really Is Required?

Although the case emphasizes the importance of facts, the opinion does not fully address how much proof is required to sustain a work-product claim. For example, in the case of a Coordinated Industry Case (CIC) taxpayer that is continually under audit, it goes without saying that the IRS has a higher likelihood of discovering the transaction and the taxpayer a higher risk of litigation. Neither the magistrate judge nor the district court in Roxworthy found likelihood of audit to be significant, however, and the Sixth Circuit bypassed that issue and emphasized the next step in the analysis--the likelihood of, and grounds for, controversy with the IRS over the particular transaction.

Conclusion

Despite these questions, Roxworthy is a welcome addition to the law on the work-product doctrine, providing helpful guidance to taxpayers regarding how to strengthen privilege claims for their most sensitive documents.

(1.) See 2002 TNT 110-29 or Tax Analysts Doc. No. 2002-13696.

(2.) Interestingly, one of the leading cases on the work-product doctrine, United States v. Adlman (Adlman II), 134 F.3d 1194 (2d Cir. 1998), included as an example a situation in which a company's independent auditors request a memorandum prepared by the company's in-house counsel estimating the company's likelihood of success in litigation and an accompanying analysis of the company's legal strategy to assist it in estimating what to reserve for potential losses in litigation. The court found that example (along with two others) fell squarely within the zone of protection articulated by the Supreme Court in Hickman v. Taylor, 329 U.S. 495 (1947).

(3.) No. 05-5776, 98 AFTR 2d 2006-5964 (6th Cir. 2006), reversing United States v. Roxworthy, No. 04-MC-18-C, (W.D. Ky 2005) (unpublished opinion), available at 2006 TNT 155-8.

(4.) Adlman II was significant because the court found that the work-product doctrine could apply to a document prepared to inform a business decision because litigation over the business decision (specifically, over the tax treatment of the restructuring at issue) was anticipated. Following this holding, the question for the court was whether the memorandum analyzing the restructuring would have been prepared in substantially the same form regardless of whether the litigation was anticipated. Because this was not answered in the district court's findings, the case was remanded.

(5.) Other circuits that have adopted the "because of the prospect of litigation" standard are the Third, Fourth, Seventh, Eighth and DC Circuits. See WRIGHT & MILLER, CHARLES ALAN WRIGHT, ARTHUR R. MILLER & RICHARD L. MARCUS, 8 FEDERAL PRACTICE & PROCEDURE [section] 2024, at 343 (1994). In contrast, the Tax Court has held that the doctrine cannot apply until after the IRS raises the issue.

(6.) 104 T.C. 677 (1995)

(7.) Pursuant to section 7453 of the Internal Revenue Code, the Tax Court follows the procedural rules of the United States District Court of the District of Columbia for non-jury trials.

(8.) Long Term Capital Holdings v. United States, 330 E Supp.2d 122 (D. Conn. 2004), aff'd, -- F.3d -- (2d Cir. 2005) (No. 04-5687-cv).

Cary D. Pugh is Counsel to Skadden, Arps, Slate, Meagher & Flom LLP in Washington, D.C. A graduate of Duke University, Ms. Pugh received an M.A. degree from Stanford University and a J.D. degree from the University of Virginia School of Law. She has served as Tax Counsel and Minority tax Counsel to the Senate Finance Committee and Special Counsel to the Chief Counsel of the Internal Revenue Service. She may be reached at cpugh@skadden.com.
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Author:Pugh, Cary D.
Publication:Tax Executive
Date:Sep 1, 2006
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