Tax documents such as tax accrual work papers or tax memorandums often become case preparation materials when the taxpayer later presents himself in court to contest a deficiency assessed by the Internal Revenue Service (IRS). Case preparation materials are usually afforded protection under the “work product doctrine.” Because the language of Fed. R. Civ. P. 26(b)(3) indicates that “work product” consists of “documents and tangible things that are prepared in anticipation of litigation,” tax documents from which business decisions are made or from which financial statements are developed potentially results in their exclusion from work product despite their ultimate use in litigation.

In U.S. v. Deloitte, 610 F.3d 129 (D.C. Cir. 2010), the D.C. Circuit permitted work product protections to extend to a memorandum that was generated as part of a routine audit process. In Textron v. U.S., 577 F.3d 21, 30 (1st Cir. 2009), however, the First Circuit refused to consider tax accrual workpapers that were to be used to establish and support the tax reserve figures for the audited financial statements as work product.

The different results can be attributed to what each Circuit considered to be “in anticipation of litigation.”

The court in Textron viewed the workpapers in question as documents created in the ordinary course of business for a nonlitigation purpose, specifically for the purpose of preparing financial statements. Specifically, the court described work product as follows:

It is only work done in anticipation of or for trial that is protected. Even if prepared by lawyers and reflecting legal thinking, materials assembled in the ordinary course of business, or pursuant to public requirements unrelated to litigation, or for other nonlitigation purposes are not under the qualified immunity provided by this subdivision. . . [t]he work product protection does not extend to documents that would have been created in essentially similar form irrespective of the litigation.

Textron, 577 F.3d at 30.

The government argued that even if litigation were “remote,” the company would still have to prepare work papers to support its judgment. Id. at 28. Conversely, Textron argued that “without the possibility of litigation, no tax reserves or audit papers would have been necessary.” Id. at 27.

Ultimately, the court “balanced policy concerns instead of applying abstract logic” and found that “the underlying prudential considerations supported the IRSs position” to deny work product protection, stressing that “tax collection was not a game” and that “underpaying taxes threatens the essential public interest in revenue collection.” Id. at 31. The court found that the workpapers did not reflect work done for litigation but was merely work done to prepare financial statements. Id. at 31

Conversely, the DC Circuit in Deloitte applied the majority approach of the “because of” test to determine whether the document was prepared in anticipation of litigation. Id. at 137. The “because of” test asks whether, in light of the nature of the document an factual situation in the particular case, the document can fairly be said to have been prepared or obtained because of the prospect of litigation. Id.

Like Textron, the government in Deloitte asserted that the document was not prepared because of the prospect of litigation, but was prepared as part of a routine audit process. Id. The DC Circuit differentiated between relying on a documents function instead of its content to determine whether it was work product. Id. “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.” Id. at 138.

Additionally, the DC Circuit, in its interpretation of the holding of United States v. Adlman, 134 F.3d 1194 (2d Cir. 1998), found that “material developed in anticipation of litigation can be incorporated into a document produced during an audit without ceasing to be work product.”

The language from Adlman, relied upon by the DC Circuit, coincides with the taxpayers argument in Textron.

[a] document created because of anticipated litigation, which tends to reveal mental impressions, conclusions, opinion 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 Rule 26(b)(3).

Adlman, 134 F.3d at 1195.

The Textron court did not want to extend the protections of work product to documents created proactively by a business where litigation, especially with the IRS, was a definite future possibility but not yet a definite future occurrence. The Deloitte court, however, seems to reflect a more flexible approach for the proactive decisions made by these businesses.

If you have any questions regarding the protections afforded by work product, litigation with the IRS, or any other tax provision, please contact Fuerst Ittleman, PL at contact@fidjlaw.com.

On December 17, 2010, the Internal Revenue Service (IRS) “eliminated a perceived ambiguity in the temporary regulations that was brought to light by the Tax Court in Intermountain Insurance Service of Vail v. Commissioner, 134 T.C. No. 11 (9th Cir. 2010)” by publishing a final rule in the Federal Registrar. Definition of Omission From Gross Income, 75 Fed. Reg. 242, 78,897 (December 17, 2010) (to be codified at Treas. Reg. §301.6501(e)-1).  Specifically, the final regulation defines an omission from gross income for purposes of the six-year period for assessing tax.

In Intermountain, the United States Court of Appeals for the Ninth Circuit found that overstatements of basis in cases outside of the trade or business context were not omissions from gross income as discussed in IRC §6501(e)(1) and Treas. Reg. §301.6501-1T. Additionally, the court in Intermountain indicated the “applicable period for assessing tax” for these overstatements in basis was the general three year limitation. In reaching its decision, the Ninth Circuit relied on the Supreme Court interpretation of the predecessor of IRC §6501(e) in Colony v. Commissioner, 378 U.S. 28 (1958).

The IRS rejected this position, relying on National Cable & Telecommunications Association v. Brand X Internet Services, 545 U.S. 967 (2005), inwhich the Supreme Court held that “the Treasury Department and the Internal Revenue Service are permitted to promulgate a reasonable construction of an ambiguous statute that contradicts any court’s interpretation.” The IRS indicated in its final regulation that “the interpretation adopted by the Supreme Court in Colony represented that court’s interpretation of the phrase “omits from gross income,” but this was not the only permissible interpretation of it.”  Definition of Omission From Gross Income, 75 Fed. Reg. 242, 78,897 (December 17, 2010) (to be codified at Treas. Reg. §301.6501(e)-1). 

Note, however, that the IRS’s position depends entirely on whether IRC §6501(e) is in fact ambiguous.  In its final regulation, the IRS indicates that the Supreme Court stated in Colony that the statutory phrase “omits from gross income” is ambiguous. Id.

The Ninth Circuit in Intermountain suggests that the Supreme Court in Colony came to a contrary conclusion: 

Although the Supreme Court initially found the statutory provision ambiguous, that was only a preliminary conclusion before considering the statute’s legislative history. After thoroughly reviewing the legislative history, the Supreme Court concluded that Congress’ intent was clear and that the statutory provision was unambiguous.

Intermountain, 134 T.C. No. 11 at 7.

Additionally, the IRS does not respond to Ninth Circuit’s application of the test from Chevron U.S.A. Inc. v. Natural Res. Def. Council, 467 U.S. 837, (1984),to determine whether the statutory provision at issue was ambiguous.

The first step in Chevron’s two-step analysis is to ask “whether Congress has directly spoken to the precise question at issue” If the intent of Congress is clear, that is the end of the matter, for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress.

Intermountain, 134 T.C. No. 11 at 8.

Notably, when answering the first step of the Chevron analysis, the Ninth Circuit relied upon the 1958 Supreme Court’s examination of the legislative history of IRC §6501(e)’s predecessor in Colony, IRC §275(c) to determine whether Congress had spoken to the question at issue.

The Supreme Court found the legislative history to be persuasive evidence that Congress was addressing itself to the specific situation where a taxpayer actually omitted some income receipt or accrual in his computation of gross income, and not more generally to errors in that computation arising from other causes. It further indicated that this history shows to our satisfaction that the Congress intended an exception to the usual three-year statute of limitations only in the restricted type of situation already described [an omission of an item of gross income] The statute’s legislative history clarified its otherwise ambiguous text and, as a result, explicated Congress’ intent and the meaning of the statutory provision.

Id.

The predecessor statute, IRC §275(c), contains the exact same statutory language as IRC §6501(e).  “Thus, the Supreme Court’s opinion in Colony, Inc. v. Commissioner, supra, “unambiguously forecloses the agency’s interpretation” of sections 6229(c)(2) and 6501(e)(1)(A) and displaces respondent’s temporary regulations.” Id. 

The Ninth Circuit emphasized the clarity of the Congressional Intent when enacting the predecessor of the statute at issue.  Despite the holding in Colony finding the statutory language to be “unambiguous”, however, the phrase “omits from gross income” as used in IRC §6501(e) is pending before several United States Courts of Appeals.  Definition of Omission From Gross Income, 75 Fed. Reg. 242, 78,897 (December 17, 2010) (to be codified at Treas. Reg. §301.6501(e)-1).

The IRS, relying on the Supreme Court’s language in Colony finding the language to be ambiguous, promulgated its own interpretation of IRC §6501(e). The IRS’s construction of IRC §6501(e) as it pertains to overstatements in basis is provided in the recently published final rule:

The term gross income, as it related to any income other that the sale of goods or service in a trade or business has the same meaning as provided under IRC §61(a), and includes the total of the amounts received or accrued, to the extent required to be shown on the return.  In the case of amounts received or accrued that relate to the disposition of property, and except as provided in paragraph (a)(1)(ii) of this section, gross income means the excess of the amounts realized from the disposition of the property over the unrecovered cost or other basis of the property.  Consequently, except as provided in paragraph (a)(1)(ii) of this section, an understated amount of gross income resulting from an overstatement of recovered cost or other basis constitutes an omission from gross income for purposes of IRC §6501(e)(1)(A)(i). 

Id. at 78,899.

In the recently finalized regulation, the IRS clearly includes the overstatement of basis in the sale of property within the phrase “omission from gross income” regardless of whether the property was sold in course of trade or business.

The IRS indicated that the regulation applies to taxable years with respect to which the six-year period for assessing tax under IRC §6501(e) was open on or after September 24, 2009. Id. at 78,900. Thus, this includes (but is not limited to) all taxable years for which six years have not elapsed from the later of the date that a tax return was due or actually filed, all taxable years that are the subject of any case pending before any court of competent jurisdiction in which a decision has not become final, and all taxable years with respect to which the liability at issue has not become fixed pursuant to a closing agreement. 

If you have any questions regarding overstatements of basis in previous or current tax returns, omissions of income in previous or current tax returns, the applicability of Treas. Reg. §301-6501(e)-1, or questions pertaining to any other tax provision, please contact Fuerst Ittleman, PL at contact@fidjlaw.com

As the IRS increases its efforts at combating tax evasion by taxpayers who hide their assets offshore in countries with favorable bank secrecy laws, practitioners at the annual ABA criminal tax institute lobbied for the IRS to extend its popular and effective voluntary disclosure program. Under the IRS voluntary disclosure program, which ended in October, over 15,000 taxpayers self disclosed offshore accounts without threat of criminal prosecution.

The calls for an extension to the voluntary disclosure program come as the IRS Criminal Investigation Unit is partnering with the Department of Justice (“DOJ”) and partners around the world to combat international tax fraud and evasion. As we have previously reported, the US has been active in negotiating with countries that are traditional havens for tax evasion in an effort to curb such practices. Most recently, the US and Panama entered into a tax information exchange agreement. Additionally, in August the US and Switzerland entered into an information exchange agreement that led to information on over 7,500 previously unreported accounts being turned over in the wake of the deferred prosecution agreement between the US and Swiss banking giant UBS.

As the IRS moves beyond UBS, it is focusing on regions where it can make the greatest strides in tax compliance. On November 24, 2010, the Treasury Inspector General for Tax Administration (“TIGTA”) released a report documenting the IRSs increased efforts. According to the report, the amount of civil examination closings involving the Report of Foreign Bank and Financial Accounts (“FBAR”) has increased by 145 percent since 2004 yielding penalty assessments of over $20 million.

The IRS has seen successes in combating international tax evasion as a result of the combination of voluntary disclosures and international enforcement. In fact, even after the formal voluntary disclosure program ended, the Service has received 3,000 voluntary disclosures from people with accounts around the world. Practitioners believe that if the program is brought back it will yield even greater results if the IRS gives disclosers advanced notice of the tax penalties that will be assessed.

If you are facing criminal tax prosecution or have questions about tax law provisions please contact our attorneys at contact@fidjlaw.com.