The implementation of the Schedule UTP contributes perhaps the most significant increase in tax reporting in recent memory and will greatly affect the Service’s audits for years to come.
—American Bar Association, Section of Taxation, May 3, 2012
The accounting for uncertain tax positions (UTP) lies at a complex crossroads of financial reporting and taxation, fraught with legal perils for financial statement issuers, audit committees, and independent auditors. The introduction of Schedule UTP and the IRS’s Policy of Restraint were intended to bring clarity to accounting for UTPs, aid corporate directors in evaluating tax risk, and better define when the IRS may request tax accrual workpapers.
The details contained in an independent auditor’s working papers often include the work products of tax attorneys that would otherwise likely be protected under attorney-client privilege. Independent auditors and tax consultants can be placed in untenable positions when tax accrual workpapers are subpoenaed by the IRS in an investigation of a CPA’s client. Such workpapers often contain information that would provide the IRS with a clear roadmap for successfully identifying and challenging the “soft spots” of tax positions assumed by corporations.
Recent notices by the IRS to corporate filers indicate that there may be a lack of clarity in the expected nature of the disclosures relating to uncertain tax positions. Uncertainty about whether the IRS’s Policy of Restraint will fuel adversarial actions against corporate filers makes it imperative that CPAs, especially independent auditors and tax consultants, understand the complexities surrounding Schedule UTP.
In 2010, the IRS introduced Schedule UTP, which requires corporate taxpayers to list these uncertain positions if—
- ▪ they have set aside a reserve relating to their position, or
- ▪ no reserve was made, but the taxpayer anticipates litigation.
In 2010, all corporations with assets exceeding $100 million were required to file Schedule UTP; in 2012, those with assets exceeding $50 million were required to file; and by 2014, all those with assets exceeding $10 million were required to file. Exhibit 1 provides the most recent IRS statistics describing Schedule UTP filings.
IRS Schedule Uncertain Tax Position (UTP) Filing Statistics, as of October 21, 2014
The IRS has adopted a Policy of Restraint as to workpapers in that it does not seek them out absent unusual circumstances or unless the taxpayer takes advantage of certain listed transactions generally considered to be tax avoidance schemes. In adopting Schedule UTP, the IRS restated the policy to not request documents that are subject to attorney-client privilege, IRC section 7525 tax advice, or part of the work product of the independent auditor to support an uncertain tax position. However, questions regarding the scope of the policy arose in the decision of the U.S. District Court in Wells Fargo v. United States (D. Minn., June 4, 2014). The decision in the Wells Fargo case, which has not been appealed, indicates that the Policy of Restraintis not absolute and, in certain circumstances, the IRS may summon workpapers that would otherwise be off limits in their examination of uncertain tax positions.
In a speech before the National Association of Corporate Directors’ 2009 Governance Conference, IRS Commissioner Douglas Shulman related the authoritative guidance of FASB’s Interpretation (FIN) 48, Accounting for Uncertainty in Income Taxes, with an underlying motive of the IRS’s identification and disclosure requirements of Schedule UTP:
FIN 48 paints a picture of tax risk by indicating how much money a corporation has to book in tax reserves to reflect the risk should one or more of its tax positions go south. … the audit committee needs to know and influence what tax posture the tax planners are taking. They and you need to know whether that multimillion—or in some cases multibillion—dollar bet you and your company are making could be too aggressive and risky.
The unique nature of the relationship between the independent auditor and the client gives rise to an equally unique set of legal questions concerning the status of a CPA’s workpapers. Most notably, questions often arise concerning the confidential status of the independent auditor’s work product and documents, and what, if any, privileges those may be afforded in a legal proceeding. Issues are often complex, especially when the independent auditor’s workpapers include otherwise privileged documents and communications prepared by tax counsel that would otherwise be protected from the IRS.
Prior to the 2014 Wells Fargo decision, the case law regarding when the IRS may summon workpapers provided important guidance on the protections afforded accounting professionals, particularly independent auditors. In order to clarify these issues, and in keeping with the controlling legal precedents that have emerged from cases such as United States v. Arthur Young & Co. [465 U.S. 805, 812 (1983)], United States v. Textron, Inc. [577 F.3d 21 (1st Cir. 2009)], and United States v. Deloitte LLP [610 F.3d 129 (D.C. Cir. 2010)], the IRS issued authoritative guidance regarding CPA documentary privilege and the nature of the disclosures required for Schedule UTP. Corporations must make a complete statement of their uncertain tax positions annually, thereby making discovery of relevant documents in future tax disputes a more definitive process.
Use of Disclosed Information by the IRS
A tax preparer is required under IRC section 6694 to ensure that any position must be supported by substantial authority, also known as the “more likely than not” standard. Schedule UTP takes this requirement one step further by requiring certain corporations to disclose which primary sources support their position and claim of substantial authority.
With the implementation of Schedule UTP, the IRS has taxpayer-disclosed information at its disposal to identify returns, including areas in which the IRS position would be supported in its examination. This information can be used to select returns for examination. When a return is selected for examination, the burden of proof is on the taxpayer to prove that the IRS’s position is incorrect. Furthermore, the obligation to produce evidentiary matter falls to the taxpayer. Anything reported on a return is subject to examination. Some observers are concerned about the degree to which the IRS will use reported information on Schedule UTP to focus its examinations.
In a directive issued to the Large Business and International (LB&I) Division personnel on September 24, 2010, the IRS Deputy Director for Services and Enforcement stated that a new centralized process would be established within the LB&I Division to enable the division to “select issues and returns for audit” using Schedule UTP. To enable this new process, the IRS budget request included additional funding for oversight of “complex financial situations including … uncertain tax positions.”
The IRS has the ability to track items reported on Schedule UTP and has requested funding for additional personnel to analyze the information reported. Because the burden of proof is on the taxpayer, the IRS can place the taxpayer in the untenable position of having to provide otherwise privileged information in order to prove the taxpayer’s compliance with the IRC.
Documentary Privilege Applied to CPAs
Legal issues associated with independent CPA documentary privilege arise in the context of the discoverable nature of documentation related to an uncertain tax position and its admissibility as evidence before a court. In federal courts, including the Tax Court, the Federal Rules of Evidence (FRE) are controlling with regard to the question of what may be admitted as evidence at trial, while the Federal Rules of Civil Procedure (FRCP) determine what materials may be reviewed during pretrial discovery.
Under the FRE, privileges are granted only when confidentiality of communication is considered to be traditionally recognized and in a crucial aspect of a given professional or personal relationship. Privileges may apply with regard to communications between husbands and wives, confessions before clergy, and medical and legal consultations.
The FRE provides no privilege for consultations in accounting and tax planning. Traditionally, the privileged nature of legal consultation has only been extended to communications with a CPA while representing a client in a matter of taxation under the IRC, that is, when the controversy is already pending before the Tax Court. Conversely, an independent CPA conducting an audit under the Securities and Exchange Act is afforded no privilege regarding communication or work product.
The U.S. Treasury Department has established a general rule for tax preparers to furnish any information requested by the IRS under Subpart B of Circular 230. The tax preparer must provide such information unless the preparer believes that the request is of doubtful legality or the information is privileged under Circular 230 section 10.20(a). Under the provisions of section 10.20(a)(1), the assertion must be made in good faith and on reasonable grounds. Determination of the legality of the assertion is subject to interpretation by the courts, although it generally includes attorney communications and legal opinions.
Pursuant to IRC section 7602, Treasury agents may summon and examine books, records, papers, or other data that may be relevant or material to a tax inquiry. The IRS has claimed such workpapers as discoverable under section 7602.
Independent auditors prepare workpapers to document work completed and to support positions taken regarding the financials, including UTPs. In performing their substantive procedures, auditors may perform quantitative analysis and gather sensitive documentation, including legal opinions of counsel. The underlying documentation of the independent auditor, especially when the opinion of tax attorneys is included, often provides rich sources of evidentiary information for the IRS to successfully challenge a corporation’s tax positions.
Legal Decisions on CPAs’ Documentary Privilege: Wells Fargo v. United States
The decision in Wells Fargo has significant and potentially long-term implications for when an auditor’s work papers may be summoned in litigation involving UTPs. Although the case involved tax returns from 2007 and 2008, before the introduction of Schedule UTP, the facts and decisions may shed light on the way courts will interpret the power of the IRS to obtain sensitive documents. The case does not represent a controlling precedent; however, the decision is instructive for CPAs who may rely on it in arguing issues of documentary privilege.
A central issue of Wells Fargo was whether KPMG, the independent auditor, was required to turn over its workpapers that contained facts and calculations regarding UTPs. Specifically, the IRS sought to discover the workpapers that documented the recognition and measurement of certain UTPs taken by Wells Fargo. The analysis applied under FIN 48 included probability estimates used in determining proper reserve amounts. The court found that the recognition and measurement documentation created under the authoritative guidance of FIN 48 included mental impressions and opinions, and therefore was protected work product not subject to being turned over to the IRS. This conclusion was applied to the workpapers of both KPMG and Wells Fargo.
The Wells Fargo case appears to limit the ability of the IRS to claim a waiver of privilege on the auditor’s workpapers; however, the complexities of the decision could bear on future decisions as to the powers of the IRS. The court reasoned that the identification of the UTPs was information created in the ordinary course of business and not in anticipation of litigation, and hence the information was discoverable. However, the court found that the recognition and measurement process undertaken to confirm the tax reserves under FIN 48 was protected because it involved legal analysis prepared in anticipation of litigation.
The decision in Wells Fargo raises questions about the role of independent auditors and their staff in evaluating tax strategies and positions taken by their clients. The court reasoned that because the audit workpapers included documents supplied by Wells Fargo attorneys detailing potential challenges by the IRS, the nature of possible litigation, and outcomes, they were protected. In performing its substantive procedures in evaluating the tax reserves under FIN 48, the auditor had properly relied on the work of experts, in this case, its client’s attorneys.
In protecting KPMG’s workpapers from discovery by the IRS, the court recognized the two-step recognition and measurement process that Wells Fargo undertook to determine the proper amount of its tax reserve per FIN 48. The quantification of the reserve amount required reliance on the work of tax attorneys and ultimately rested on the professional judgment and impressions of legal counsel to establish outcome probabilities. In this case, due diligence required KPMG to rely heavily on the work of attorneys in their substantive testing of Wells Fargo’s tax reserves.
The language of the decision, however, indicates that had the auditor’s workpapers not incorporated the work of the tax attorneys to the degree to which they did, such protection might not have been afforded. The extent to which attorneys act as business advisors rather than counselors at law would likely affect future decisions, given that ordinary work product is generally not protected from an IRS summons. Because KPMG relied on significant legal opinion in the audit of the tax reserves under FIN 48, the Wells Fargo court concluded that their workpapers at issue were protected from the IRS.
The decision in Wells Fargo raises questions about the IRS’s Policy of Restraint with respect to UTPs and its practice of summoning the working papers of independent auditors. In its arguments, Wells Fargo cited the IRS’s history of seeking the workpapers underlying UTPs. Wells Fargo cited past practices of the IRS’s Policy of Restraint back to 1982, when the IRS would only seek workpapers when factual data could not be obtained from taxpayer records or from third parties. Those practices were revised in 2002 when the IRS changed its policy to seek such papers only when benefit was derived associated with certain listed abusive tax-avoidance transactions. Thus, in Wells Fargo, it was concluded that the workpapers could not be sought by the IRS because there was no benefit claimed from a listed transaction. The court avoided this argument by declaring that the Policy of Restraint was just that, a policy, and that is not enough to prevent the IRS from seeking workpapers when there are legitimate grounds to do so.
United States v. Arthur Young & Co.
In United States v. Arthur Young & Co. [465 U.S. 805 (1984)], the U.S. Supreme Court reviewed a decision from the U.S. Court of Appeals for the Second Circuit upholding the privilege claimed by the auditor, Arthur Young, in protecting tax accrual papers from summons by the IRS. A routine IRS audit of Amerada Hess showed questionable transactions related to a special reserve account. Based on that finding, the IRS began a criminal investigation and demanded all of Arthur Young’s workpapers. The Second Circuit had relied on an early Supreme Court decision [Hickman v. Taylor, 329 U.S. 495 (1947)] which found that the tax accrual papers were protected as work product because they were created for federal securities compliance.
In Arthur Young, the court described the auditor’s function as critical to the information needed by investors in a publicly traded market, but would not go so far as to say that the auditor’s workpapers could be protected:
An independent certified public accountant performs a different role. … By certifying the public reports that collectively depict a corporation’s financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation’s creditors and stockholders, as well as to the investing public. This “public watchdog” function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust. To insulate from disclosure a certified public accountant’s interpretations of the client’s financial statements would be to ignore the significance of the accountant’s role as a disinterested analyst charged with public obligations.
The focus of the decision involved the scope of IRC section 7602 and whether it could be used by the IRS to subpoena the workpapers of an independent auditor. The court interpreted section 7602 to give a clear and unambiguous direction from Congress of full disclosure of all relevant information in a tax proceeding.
We are unable to discern the sort of “unambiguous directions from Congress” that would justify judicially created work-product immunity for tax accrual workpapers summoned under section 7602. Indeed, the very language of section 7602 reflects … a congressional policy choice in favor of disclosure of all information relevant to a legitimate IRS inquiry.
The court went on to note that there exists no accountant-client privilege on the federal level, and even in those states that have recognized such a privilege it has never been enforced federally. A distinction was made between the role of the auditor and that of the attorney in that the former acts as a public watchdog while the latter is a personal advocate and confidant. Auditors’ primary obligation is to the public trust—hence their workpapers cannot be subject to a client privilege.
The IRS guidelines on access to accrual work papers are limited to cases of “unusual circumstances” and only as a source of collateral data. In fact, the IRS has provided a list of suspect transactions that will likely give rise to an examination and possible request to examine workpapers. These listed transactions are similar to those identified as tax-avoidance vehicles. However, the broad precedent created by Arthur Young would lead an auditor to conclude that tax accrual workpapers will be subject to discovery should the IRS select a client’s return for examination.
This raises the troublesome issue of a client’s willingness to be forthcoming with the auditor. If a corporate manager knows that the IRS will have access to an auditor’s workpapers, the manager may not disclose the tax liability computations to the auditor, as such disclosure might be interpreted as a waiver of the privilege. While the lack of privilege runs to the benefit of the IRS in its investigations, it would also lead to an inability on the part of the auditor to give an unqualified opinion because of a lack of information, thus creating a potential scope limitation. Depending upon the potential materiality of the uncertain tax position, fieldwork standards would require an auditor to obtain whatever evidence necessary to support its conclusion about the accuracy of the account.
Congress passed IRC section 7525 to include some tax preparer-client privilege, but section 7602 continued to include documents prepared in response to tax accruals. IRC section 7525 states the following:
With respect to tax advice, the same common law protections of confidentiality which apply to a communication between a taxpayer and an attorney shall also apply to a communication between a taxpayer and any federally authorized tax practitioner to the extent the communication would be considered a privileged communication if it were between a taxpayer and an attorney.
This privilege can only be asserted if the matter is noncriminal and the written communication does not pertain to the promotion of participation in a tax shelter. Because Arthur Young involved an initiated criminal proceeding, it is not clear that the analysis would have been the same under different facts.
United States v. Textron
Another significant case dealing with accrual work papers involved Textron and its subsidiaries. The IRS had conducted a perfunctory audit on Textron but discovered that one of its subsidiaries had engaged in a SILO, a same-day salein and lease-out of property. SILOs are suspect transactions according to the IRS. Textron had prepared workpapers dealing with the SILO and contingent tax liability and shown these workpapers to its auditor, Ernst & Young, but the company had refused to turn them over to the IRS. The IRS issued a summons, and Textron asserted all privileges, work product immunity, and qualified protections on the basis that the documents were prepared in anticipation of litigation. The papers in question included summary spreadsheets of the disputable items, their amounts, and the probability of winning a challenge against the IRS. Also included were backup e-mails and notes discussing the spreadsheets.
The district court found that the IRS had a legitimate purpose in seeking these workpapers and that any attorney-client privilege had been waived by Textron showing the papers to its auditor. On appeal, the U.S. Court of Appeals for the First Circuit held that these workpapers were required by the audit and were not protected by the work product privilege. The court did struggle, however, with the issue of why the document was prepared. In Arthur Young, the “prepared for litigation” test governed, yet the documents in question here were prepared for other reasons but related to a subject that could be litigated—in this case, the special reserve set aside for the tax liability.
Furthermore, Textron argued that tax preparer-client privilege under IRC section 7525 protected the workpapers from the IRS. Prior to this case, the court had found that the privilege did not apply when the papers concerned exercising tasks not related to lawyers’ work. However, Textron’s accountants participated in advising Textron regarding its tax liability in areas in which the law was uncertain and in estimating litigation expenses. The IRS countered with the argument that the communication was in regards to a tax shelter, the SILO (making it excludable under section 7525). The court found this argument unpersuasive because the communication did not pertain to the “promotion” of Textron in the SILO transactions in question.
In considering why the papers had been produced, the court focused on the need of the company to obtain an unqualified opinion. The court decided that the papers had been produced to obtain an unqualified opinion from the auditor by fixing the amount of the tax reserve, making book entries, and preparing the requisite financials.
In applying the work product protection to the papers, the court went back to Hickman v. Taylor and FRCP 26. In keeping with the finding in Hickman, the Textron court found that papers that were produced in preparation for possible litigation could qualify for protection. “It is only work done in anticipation of or for trial that is protected.” This work can be prepared not only by legal counsel but by others. The court concluded that the only purpose for the preparation of the tax accrual papers was to support an independent audit of the financial statements, therefore making them susceptible to an IRS request. In this case, the tax accrual workpapers provided to Ernst & Young also waived the protection under IRC section 7525 as tax preparer-client privilege. The court did not view the auditors’ review of the workpapers as “tax advice” and so set it outside the scope of section 7525.
United States v. Deloitte
The most important recent court ruling on whether the IRS can subpoena documents from independent auditors came from the U.S. Court of Appeals for the District of Columbia Circuit in United States v. Deloitte [610 F3d 129 (D.C. Cir. 2010)]. This case centered around a draft memorandum prepared by Deloitte summarizing a meeting with its audit client, Dow Chemical Company, which addressed possible litigation involving a UTP of a subsidiary. This draft memorandum was an integral part of three documents in the audit workpapers concerning the tax position; the other two were protected under attorneyclient privilege because they had been prepared by Dow’s tax counsel.
The IRS sought to discover the draft memo, but Deloitte maintained its work product privileges. The court said that the work product doctrine was designed to “protect mental impressions, conclusions, opinions or legal theories of counsel or other representatives.” The court reasoned that just because Deloitte, the auditor, had prepared the draft did not preclude the possibility that the document could contain protected work product.
The court applied the “because of” test more broadly than it had been applied in the Textron case. It reasoned that just because Textron had concluded that tax accrual papers are prepared in the ordinary course of business and cannot meet the privilege test, there is no reason to doubt that some documents prepared in the ordinary course of business could also be prepared in anticipation of litigation and those portions of documents should be protected. The court remanded the case with instructions to hold an evidentiary hearing and make a finding as to whether portions of the Deloitte memorandum contained the thoughts and analyses of legal counsel and should therefore be redacted before being turned over to the IRS.
The issue of the power of the IRS to gain access to the tax accrual work papers remains a complex crossroads of financial accounting and reporting, taxation, and legal constructs defining the scope and nature of the privileges protecting documents underlying corporate tax positions. Although the Deloitte decision opens the door to the possibility of portions of tax accrual workpapers being protected from the IRS, court decisions and individual facts surrounding these protections create uncertainty for independent auditors.
The IRS has implemented a self-reporting mechanism through the introduction of Schedule UTP. In a sense, the IRS heeded the admonition of the Arthur Young court and addressed the tax accrual workpapers issue by requiring that corporations provide the factual basis for their tax positions—thus minimizing the informational value of the independent auditor’s workpapers.
Independent auditors face uncertain outcomes when confronted with an IRS demand to provide tax accrual workpapers. If these documents are prepared in anticipation of litigation, the case law is clearer that such documents are protected from IRS seizure. Cases involving less definitive facts surrounding workpapers that are a product of an independent auditor’s due diligence in ascertaining the accuracy of tax reserves may lead the IRS to be successful in efforts to claim that the documents lack privilege. Such outcomes could potentially harm an audit client if sensitive information detailing the soft spots of the corporation’s tax positions is thus shared.
The solution may lie in the characterization of the independent auditor’s workpapers. Although disclosure of the nature of the uncertain tax position is required in Schedule UTP, the rationale behind it may be subject to protection, provided that there are no unusual circumstances and the subject matter of the transaction has not been targeted by the IRS.
In highly material and difficult uncertain tax transactions, independent auditors may want to rely on the expertise of tax attorneys, whose privilege is less subject to question. The attorneyclient and section 7525 privileges can be upheld only if the advisor is performing legal-type work. When there are questions about the nature of the protections afforded tax accrual workpapers, independent auditors should work closely with tax attorneys, with only minor clerical duties left to non-attorneys.