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January 24, 2012

Since the collapse of Enron, Congress has been ratcheting up laws encouraging insiders to rat out financial wrongdoers and tax cheats by offering substantial mandatory cash bounties for information leading to additional tax collections, penalties or other monetary sanctions. Modeled after the False Claims Act, permitting whistleblowers to file suits (called qui tams) on behalf of the United States against those who defraud the government and split the proceeds, mandatory bounties are a relatively new weapon of law enforcement in the financial world. Indeed, many government agencies such as the Securities and Exchange Commission, Commodity Futures Trading Commission and Internal Revenue Service as well as several state taxing authorities have whistleblower programs calling for mandatory bounties, creating a bonanza for informants.

In a recent high-profile whistleblower action involving claims of more than $2 billion accusing BNY Mellon of overcharging its customers for executing currency transactions, the Wall Street Journal has chronicled how the key informant squirreled away documents over a two-year period. Information provided included profiles of his colleagues such as “details about their families, personal problems and financial standing.” According to the Wall Street Journal, the informant is eligible to share in as much as 25 percent of any recovery.

Big dollar tax cases are now stealthily creeping in too. Though not terribly well publicized because of IRS confidentiality rules and the length of time they take to process, these cases are stacking up. One well-publicized pending claim, as reported by the Wall Street Journal, involves $780 million of fines paid by UBS as part of a deferred prosecution agreement over charges of conspiring to defraud the U.S. by providing undeclared offshore accounts to U.S. taxpayers.

More cases like these are on the way. Many people probably have no idea they’ve been turned in by a whistleblower.

Maybe this sounds like good, efficient tax enforcement. After all, who isn’t for catching cheaters and making them pay? Plus, if you’re not doing anything wrong, why should you care? On the other hand, the tax world can be pretty murky and subjective. How free from challenge are issues like transfer pricing, economic substance, independent contractors or valuations? What if the IRS were handed a road map to the soft points? Times are tough and people need money. Do they now have incentive to report innocent mistakes or loose documentation to the IRS rather than to management? All it takes is a disgruntled or financially strapped employee to set things in motion. Spotting a potential motherlode, one law firm representing whistleblowers notes on its website that “details in the tax accrual work papers often make for valuable tax whistleblower submissions.” An accompanying ranking of the Fortune 500 by the size of their uncertain tax positions totals nearly $200 billion.

In the tax world, the Secretary of the Treasury has had the ability to pay discretionary bounties to informants since 1867. This went largely unchanged for 140 years until December 2006, when the Tax Relief and Health Care Act of 2006 created a large awards program under IRC Section 7623(b) calling for mandatory bounties of between 15 and 30 percent of the “collected proceeds” exceeding $2 million. The new law also required the IRS to create a Whistleblower Office and gave whistleblowers the right to appeal their awards to the Tax Court.

Prior to this change, a whistleblower risked his career on the prospect of an uncertain payoff. Now the opportunity for a huge jackpot has informants swarming and a cottage industry of lawyers and consultants ready to facilitate their claims and lobby for more favorable rules.

According to the Internal Revenue Service Whistleblower Office Annual Report to Congress for the fiscal year 2007, only 12 of the 227 pre-amendment claims paid in 2007 involved collections of more than $2 million. In contrast, in the 12 months after the Whistleblower Office was established, the IRS received 116 submissions that each alleged more than $2 million in tax noncompliance. The number of taxpayers that has been fingered annually under the new provision has grown exponentially from 561 in 2007 to 5,358 in 2010, adding up to roughly 9,500 in total since the program’s inception, according to a Government Accountability Office (GAO) report released in August 2011.

Nevertheless, in spite of these numbers, the IRS whistleblower program has been criticized as not being successful enough. For all the whistleblower submissions, the first ever award under the new program was paid in April 2011 in the amount of $4.5 million to a former in-house accountant of a financial services firm, according to his representative. Due to concerns and rules surrounding the privacy of both taxpayers and whistleblowers, the IRS will not comment on individual awards, and data on other large awards isn’t expected until this summer when the Treasury publishes its next annual report to Congress.

Critics like Senator Charles Grassley complain about lack of payouts, the IRS’s slowness in processing claims, and narrow interpretations of definitions and rules by the IRS limiting an informant’s ability to collect. Evolving hot button issues include:

  • Lengthy delays — The GAO report issued in August 2011 noted that whistleblower cases take years (7½ years on average) to complete. Among other reasons, this partly stems from an IRS policy of deferring payment until a taxpayer’s ability to file a refund claim has expired.
  • Retaliation and whistleblower confidentiality — Though the IRS has rules protecting a whistleblower’s identity, its Internal Revenue Manual observes that may not always be possible in a judicial proceeding. Notably, there is nothing protecting a whistleblower from retaliation. In December, whistleblower confidentiality was bolstered in Whistleblower 14106-10W v Commissioner (137 T.C. No. 15), where the Tax Court held that a whistleblower case challenging the determination of an award may proceed anonymously.
  • Collected proceeds — What does the definition of “collected proceeds” include? If the whistleblower’s information does not result in additional cash collections but merely serves to reduce a taxpayer’s net operating loss (NOL), should the whistleblower be entitled to an award? In January 2011, the IRS proposed regulations concluding that the denial of a refund counts, but the IRS does not share the view that a reduction in an NOL should give rise to an award.
  • Confidentiality agreements — A whistleblower may be required to sign a confidentiality agreement as a condition of receiving the details for how an award was calculated. The aim is to protect and keep taxpayer information confidential. The drawback according to critics, however, is that confidentiality agreements can be misused to hush up whistleblowers and coerce them to accept reduced awards.
  • Reduced awards for those who “planned and initiated” — In its Internal Revenue Manual, the IRS states it may reduce a whistleblower’s award where the whistleblower “planned and initiated” the action that led to the underpayment of tax. Broad language in the manual includes those who “knew or should have known that the activity may lead to noncompliance.” Conceivably that fits every whistleblower.

As these kinks get worked out, the whistleblower program is gathering momentum. A GAO report in 2006 notes that examinations initiated through tips are more efficient and effective than those brought about through the Discriminant Index Function scoring system. The IRS has embraced the whistleblower program and, in a letter to Senator Grassley in November of 2010, stated that it has “committed significant resources to the Whistleblower Office,” viewing it “as a critical part of the IRS strategy to uncover tax cheats.” More payments under the large awards program are expected to be announced in the next Whistleblower Report to Congress for fiscal year 2011. As the IRS noted in recent Chief Counsel Advice, “the stakes are extremely high given the sheer size and volume of expected claims.

Alvarez and Marsal Taxand Says:
As the IRS whistleblower program gains traction, businesses will need to assess and limit their potential risk. Aside from greater vigilance, what else might a tax department do? Here are some ideas to explore.

  • Confidentiality and privilege — The IRS cannot use information offered by whistleblowers that is subject to certain doctrines of confidentiality and privilege. According to its Internal Revenue Manual, the IRS must identify and immediately return any tainted information. Does it then make sense to preemptively stamp critical documents with a specific privilege or copy in-house counsel to cut-off further review? Should the tax department even be made a division of the legal department? Though a claim of privilege may ultimately fail if challenged, it may be enough to ward off an uninvited audit.
  • Dealings with advisors — The IRS may not accept information from an informant who is a taxpayer’s “representative.” Furthermore, those who “planned and initiated” the action leading to a tax underpayment risk having the IRS reduce their awards. Given the hurdle that a representative has to clear to receive an award, does it make sense to outsource more of the tax department functions to those having a higher bar?
  • Document retention and destruction — Drafts and analysis, including emails, that detract from the ultimate conclusion or would permit an auditor to begin thinking about alternate views should be reviewed and destroyed in accordance with each firm’s document retention policy.
  • Internal audit — Should the internal audit function be expanded to evaluate the substantive issues dealt with by the tax department?
  • Golden handcuffs — Currently, there are no retaliation rules to protect whistleblowers under the IRS’s program. Does it make sense to raise the stakes for a potential whistleblower by putting more of their compensation at risk through deferral programs?

While none of these strategies are certain, they may help avert an unjust whistleblower audit.

 

Author

Martin Williams
Managing Director, New York
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Jamie Rimmer, Senior Director, and Olga Shestova, Associate, contributed to this article.

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