682 F.2d 530 (5th Cir. 1982), 81-2484, United States v. El Paso Co.

Docket Nº:81-2484.
Citation:682 F.2d 530
Party Name:UNITED STATES of America and Revenue Agents Clarence H. Isabel and John S. Reid of the Internal Revenue Service, Petitioners-Appellees, v. The EL PASO COMPANY, Respondent-Appellant.
Case Date:August 13, 1982
Court:United States Courts of Appeals, Court of Appeals for the Fifth Circuit

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682 F.2d 530 (5th Cir. 1982)

UNITED STATES of America and Revenue Agents Clarence H.

Isabel and John S. Reid of the Internal Revenue

Service, Petitioners-Appellees,


The EL PASO COMPANY, Respondent-Appellant.

No. 81-2484.

United States Court of Appeals, Fifth Circuit

August 13, 1982

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[Copyrighted Material Omitted]

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Walter P. Zivley, D. Mitchell McFarland, Jack L. Underwood, Lee K. Boocker, Houston, Tex., for respondent-appellant.

Michael L. Paup, William A. Whitledge, Attys., Tax Div., U. S. Dept. of Justice, Washington, D. C., for petitioners-appellees.

Appeal from the United States District Court for the Southern District of Texas.

Before GOLDBERG, WILLIAMS and GARWOOD, Circuit Judges.

JERRE S. WILLIAMS, Circuit Judge:

The United States and two agents of the Internal Revenue Service (IRS) petitioned the district court to enforce two summonses issued to the El Paso Company (El Paso) with regard to a tax audit. One summons sought El Paso's "tax-pool analysis"-a summary of El Paso's contingent liability for additional taxes should it ultimately be determined that El Paso owed more taxes than indicated on its return. After a hearing, the district court enforced the tax pool analysis summons and El Paso brought this appeal. We affirm.

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El Paso is the holding company for several large corporations, including 67 subsidiaries. The principal operations in the El Paso conglomerate are the El Paso Natural Gas Company, the El Paso Products Company, and the El Paso LNG Company. All are based in Texas. Because of the size and variety of El Paso's business, the calculation of El Paso's tax liability is an immense task. To prepare a return for a single year, El Paso's in-house staff expends over 10,000 hours.

The IRS, as it does with most giant corporations, annually audits El Paso and has been doing so since the 1940s. To perform the audit, the IRS assembles a team of revenue agents. Even with a team specifically assigned to El Paso, however, the IRS has time to review and inspect only a small sample of the documents that underlie El Paso's returns. The audit of El Paso that triggered the summons in this case was not conducted on suspicion of fraud; rather, it was a routine audit occasioned by the amount of taxes at stake.

Each audit of El Paso covers several years of tax returns. The relevant cycle in this case includes the years 1976, 1977, and 1978. Early in the audit of the 1976-1978 cycle, the IRS team coordinator delivered a document request to El Paso for "all analyses prepared by the El Paso Company regarding potential tax liabilities and tax problems" for the years covered by the cycle. Five days later, Jack McCarthy, the head of El Paso's tax department, returned the request form marked "refused". 1

Shortly after receiving El Paso's refusal to respond to the potential tax-liabilities document request, the IRS issued a summons to McCarthy covering "any document, memorandum, letter, or work papers which identify potential tax liabilities or tax problems for the period beginning January 1, 1976 and ending December 31, 1978, inclusive." McCarthy also declined to comply with the summons, stating his reasons in a letter written to the case manager of the El Paso audit.

On May 27, 1981, the IRS filed its petition to enforce the summons under 26 U.S.C. § 7604. 2 El Paso defended against enforcement on grounds of burdensomeness, relevance, attorney-client privilege, and work product doctrine. After a hearing at which both sides were permitted to call and cross-examine witnesses, the district court rejected El Paso's defenses and concluded that El Paso must comply with the summons.

El Paso appealed and sought a stay of the district court's judgment from this Court. Because of the importance and the novelty of the issues raised with respect to the IRS's summons powers, we granted the stay pending our resolution of the case.


This appeal is centrally concerned with documents known to the accounting profession under various names-the noncurrent tax account, the tax accrual work papers, and the tax pool analysis. Because the nomenclature is not standardized, the IRS chose to request El Paso's version of these documents under a loose descriptive label-documents analyzing potential tax liabilities or tax problems. No matter what alias is used, however, the documents are of similar nature. It is useful to explain what these documents are before proceeding to determine whether the IRS may have access to them.

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The income tax laws, as every citizen knows, are far from a model of clarity. Written to accommodate a multitude of competing policies and differing situations, the Internal Revenue Code is a sprawling tapestry of almost infinite complexity. Its details and intricate provisions have fostered a wealth of interpretations. To thread one's way through this maze, the business or wealthy taxpayer needs the mind of a Talmudist and the patience of Job.

Even endowed with these qualities, however, no taxpayer completes a return with the certainty that the IRS will agree with the bottom line, or the many steps taken to get there. There is no tax oracle one may consult to learn how a return will fare under the scrutiny of the revenue agents and the courts. The Code, after all, is a finite system of rules designed to apply flexibility to an infinite variety of situations. There are many "gray areas" in the tax world, twilight zones in which one may only dimly perceive how properly to treat a given accretion to wealth or given expenditure of funds.

When a large corporation like El Paso completes its return, the number of decisions in the gray areas is enormous. To characterize a sale as ordinary income or capital gain, to depreciate equipment over ten years or twenty, to attribute a transaction to this year or to the next: these decisions recur over and over in a course of preparing a return and guarantee that a large corporation has many opportunities to choose in good faith an interpretation of the tax code that leans toward lessening its taxes. The return is filed with the understanding, however, that the IRS may challenge some of these questionable positions and, through settlement or litigation, the corporation may end up owing more taxes than it initially acknowledged.

Business reality compels corporations to recognize on their financial sheets that the return as filed is not the last word in determining the taxes owed. Public companies subject to the securities laws must file financial statements with the Securities and Exchange Commission (SEC), 15 U.S.C. § 78l. SEC regulations require that independent accountants verify these financial statements in accord with Generally Accepted Auditing Principles, 17 C.F.R. § 210.1-02(d). To demonstrate to the accountant that a balance sheet does not portray an overly-rosy view of a corporation's financial health, the balance sheet must provide for contingent future tax liabilities. In short, the corporation must set aside an account to cover additional taxes that it may become liable to pay above and beyond the amount indicated on the initial return.

To comply with the securities laws, therefore, companies such as El Paso must prepare in-house or have prepared by outside auditors an analysis of their contingent tax liabilities. 3 The analysis pinpoints the soft spots on the corporation's tax returns and indicates those areas in which the taxpayer has taken a position that may, upon challenge, negotiation, or litigation, require the payment of more taxes. The analysis is known in the trade as the tax pool analysis, the noncurrent tax account, or tax accrual work papers.

Several points are worth noting about the tax pool analysis. First, it is not prepared to assist in filling out a tax return. The tax pool analysis is undertaken only after the return is filed. Although the same corporate employees or outside auditors may prepare both the return and the tax pool analysis, there is no necessary connection between the two jobs.

Second, the tax pool analysis may be performed either in house or by outside accountants. El Paso happens to prepare its own tax pool analysis, but many firms retain outside accountants to accomplish that task. See United States v. Arthur Young & Co., 677 F.2d 211 (2d Cir. 1982). It is not

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essential to consult an attorney to prepare the tax pool analysis.

Finally, the tax pool analysis is "(p)repared for financial reporting purposes alone...." Caplin, IRS Toughens Its Stance on Summoning Accountant's Tax Accrual Workpapers, J. Tax 130 (Sept. 1980). While the analysis must forecast the cumulative results of IRS audit, settlement, and litigation, the tax pool analysis itself is not prepared to respond to a specific charge by the IRS or to any pending or impending lawsuit. The tax pool analysis is undertaken solely to insure that the corporation sets aside on its balance sheet a sufficient amount to cover contingent tax liability.


Before we turn to the objections raised by El Paso to the enforcement of the "potential tax liabilities" summons, we must determine the scope of the judgment below. El Paso contends that the judgment requires production of much more than the tax pool analysis and backup memoranda and files. In El Paso's view, the district court's judgment encompasses all El Paso documents that treat "tax problems." This category, El Paso tells us, is so broad as to comprise all files in El Paso's tax department.

El Paso also protests that it relied on IRS representations at trial that the government sought only the tax pool analysis and backup files, and defended the case on that basis. To expand the judgment beyond the tax pool...

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