New IRS Whistleblower Rules Still Need Substantial Changes

In specific terms, the definition of Collected Proceeds should be expanded:

1) to include rules that quantify the value of taxpayer benefits in future years; and
2) to include the value of tax attributes that carry over to provide taxpayer benefits in future years.

In addition, the “policy” never subjected to public notice and comment of requiring a new two-year delay after taxpayer settlement before paying whistleblower claims should be rejected, especially since we understand no such “policy” existed under the pre-2006 system that the current statute was intended to broaden. This fundamental change requiring clarification is the need for a rule or a policy that allows payment of whistleblower claims upon taxpayer settlement with the IRS, rather than having to await an additional two years as is currently the case.

Each of the above issues is dealt with in greater depth below.

Include Rules to Quantify the Value of Treasury Benefits in Subsequent Years
In a number of instances, whistleblowers have come forward with information that may have limited or no impact on the tax payable for the current and prior years, yet will likely cause a significant increase in the tax payable in one or more future years.

This has occurred in a variety of instances, covering elaborate tax evasion schemes as well as situations where the tax effect will take place over a number of years (for example, depreciation or ongoing structures); and may also cover situations where the information will impact tax or taxable income directly, or where the information will impact tax or taxable income via one or more tax attributes such as those listed below.

Where Tax Effect Will Take Place Over a Number of Years
The term “Collected Proceeds” needs to cover the situation where the tax effect of the whistleblower submission will continue beyond the current year.

For example, some tax evasion schemes are set up to generate illegal tax benefits over lengthy periods which could be ten years or more, and may even be “open-ended,” with no potential end to the scheme. Where the whistleblower reports schemes of this nature early in the evasion cycle, it is appropriate that the whistleblower reward is calculated not only with reference to tax collected for current and prior years, but also with reference to the tax that will be collected in future years, due to the fact that the evasion has been brought to an end.
Less sophisticated evasion occurs where, for example, the basis of a depreciable asset has been illegally increased, with the result that the deduction claimed annually for depreciation will be illegally overstated. Assuming an asset qualifies for tax depreciation over ten years on a straight line basis, and the whistleblower claim is both submitted and settled immediately after the first year depreciation is overstated, under current rules Collected Proceeds will be based on no more than 10% of the likely evasion.

In the example above, the Treasury benefits from the whistleblower information based on 100% of the illegal overstatement in basis, yet under current rules Collected Proceeds – and the calculation for the whistleblower reward – will be based on a small fraction of this amount.
In a number of these cases, it is the future tax evasion that is significant, which sometimes may be far more that the current or past tax evasion. Cases encountered to date that fall into this category include an abusive foreign partnership scheme to generate tax losses, the illegal increase in basis, the invalid exercise of an election to step-up basis, and the illegal manipulation of earnings and profits.

It is submitted that Collected Proceeds should be expanded to include the value of future tax evasion that is circumvented through whistleblower information. Not only is this in keeping with the intent of the legislation, but it also prevents the prospect of whistleblowers holding back on making submissions to ensure the evasion actually takes place.

No doubt that the expansion of Collected Proceeds to include future tax evasion will make the calculation of whistleblower rewards slightly more complex. However, the Internal Revenue Code is itself highly complex, and it would be naïve to assume that an effective whistleblower program based on such complex legislation could escape without at least some element of related complexity.

Adjust Collected Proceeds for Future Benefits
By blocking future tax evasion, the benefits to the Treasury accrue over the period that the evasion was set to take place. In recognition that the benefit to the Treasury accrues over time, it is submitted that a discount factor should be applied to the Collected Proceeds that relate to future tax evasion. Applying a suitable discount factor will result in a present value of the future evasion in a fashion broadly similar to that used elsewhere in the Internal Revenue Code and Treasury Regulations.

For example, if whistleblower information has blocked tax evasion of $3 million a year for the next 10 years, and assuming a discount factor of say 6%, the present value of the future tax evasion is approximately $22 million, compared to the face value of $30 million.

Adjust Collected Proceeds for Contingency
The present valuation of future tax evasion necessarily involves an element of contingency (for example, it may be that the taxpayer would not have evaded tax for all of the 10 years). In order to deal with this type of contingency, it is submitted that the valuation of all future tax evasion should be discounted by, say, one-third. On this basis, the amount to be included in Collected Proceeds under the example above would be approximately $14.7 million compared to the face value of $30 million.

Make Rule for “Open-Ended” Evasion
In at least one whistleblower case we have encountered so far, the future tax evasion has been “open-ended” in the sense that the taxpayer could potentially continue evading year after year, without the evasion mechanism coming to an end.

To deal with such open ended evasion situations, it is submitted that the present value of future tax evasion should be “capped” at a maximum number of years (say 10 years). Imposing a reasonable cap in the number of years will also limit the value of long term evasion schemes where the length of the scheme would otherwise make a present value calculation speculative.

Collected Proceeds Must Include Tax Attributes
A number of tax attributes have significant value to taxpayers, yet do not necessarily reduce tax liability in the year they arise or are changed. In many cases the value of these attributes lies in their ability to reduce taxpayer liability in taxable years either before or after the year they arise or are changed.

In the context of IRS whistleblower claims on which we have worked, we have come across large scale tax evasion in the form of illegal manipulation of these tax attributes. In some cases, sophisticated techniques have been employed by taxpayers to illegally manipulate these attributes by large amounts, potentially resulting in large reductions in taxpayer liability if left unchallenged.

Notwithstanding the significant potential for tax evasion through illegal manipulation of tax attributes, the benefits illegally derived by taxpayers are not covered under the Proposed Regulation’s current (and overly narrow) definition of “Collected Proceeds.” It is therefore necessary to expand the definition of Collected Proceeds to cover illegal taxpayer benefits from these attributes. Examples of the illegal manipulation of specific tax attributes are discussed in more detail below.

Net Operating Losses
A Net Operating Loss (NOL) operates to reduce or even eliminate taxpayer liability for certain previous “carryback” years, as well as for future “carryover” years.

NOL’s have significant value given their ability to reduce taxable income for these years on a Dollar for Dollar basis. The value of NOL’s is implicitly recognized by provisions of the Internal Revenue Code (“IRC”) which seek to limit “trafficking” of NOL’s (see IRC § 382) or other specific illegal manipulation of NOL’s (see for example IRC § 381(c)(1), IRC § 172(b)(1)(e), IRC § 172(b)(1)(h)).

Notwithstanding these provisions, the illegal manipulation of NOL’s frequently occurs, and the definition of Collected Proceeds should be expanded to include the value of NOL’s that are created or increased illegally.

Net Capital Losses
A Net Capital Loss operates to reduce or eliminate capital gains and the resultant tax liability from these gains for certain carryback years as well as for future carryover years.
Net Capital Losses have significant value given their ability to reduce taxable gains for these years on a Dollar for Dollar basis. The potential value of Net Capital Losses is implicitly recognized by IRC provisions which seek to regulate the manner and extent to which Net Capital Losses may be offset against capital gains (see for example IRC § 1212, IRC § 381(c)(3)).

Although perhaps less frequent than with NOL’s, the illegal manipulation of Net Capital Losses nonetheless occurs. Collected Proceeds should include the value of Net Capital Losses that are created or increased illegally.

Excess Foreign Tax Credits
Subject to certain limitations, Excess Foreign Tax Credits are available for offset against U.S. tax on foreign income earned in certain carryback years, as well as future carryover years.
Depending on taxpayer circumstances, excess foreign tax credits may have significant value, particularly for corporations that expect to earn future income in no or low tax foreign jurisdictions. Subject to certain limitations, Excess Foreign Tax Credits have significant value, given their ability to reduce tax on foreign income for these years on a Dollar for Dollar basis.
To help prevent the illegal manipulation of Excess Foreign Tax Credits, Collected Proceeds should include the value of Excess Foreign Tax Credits that are created or increased illegally.

Earnings and Profits
Earnings and Profits of a corporation often operate to limit future taxable income and therefore the tax payable in future years.

Earnings and Profits potentially impact the calculation of taxable income and tax in a number of ways, including:

1) Earnings and profits limit any future corporate distributions that may be taxed as a dividend. Distributions up to Earnings and Profits are generally taxed as dividends, while distributions above this amount are generally not subject to tax.

2) Earnings and Profits of controlled foreign corporations limit the amount potentially subject to tax in the hands of the U.S. parent as a Subpart F inclusion. Deficits in Earnings and Profits can be carried over to future years in certain cases.

3) Earnings and Profits of controlled foreign corporations limit the amount potentially subject to tax in the hands of the U.S. parent in the future as an investment in U.S. property.
4) The inverse of Earnings and Profits of a foreign corporation limits any deemed paid foreign tax credits that can be claimed by the U.S. parent in future years.

In all the above cases, taxpayers benefit from a reduction in Earnings and Profits, so it is hardly surprising that there are numerous schemes (some of which are illegal) to reduce Earnings and Profits. To help prevent the illegal manipulation of Earnings and Profits, Collected Proceeds should include the value of Earnings and Profits that are reduced illegally.

Increases in Basis
Illegally increasing the basis of an asset will in many cases operate to reduce taxable income in future years by increasing depreciation deductions, and will also reduce future taxable income by reducing the gain that will arise when the asset is sold.

An illegal increase in basis may result in little if any reduction in taxable income or tax payable for the year of the increase, with the result that the effect on taxable income will only manifest in later years as depreciation is claimed or when the asset is sold.

Illegal increases in basis occur for example where the cost of an asset has been overstated in the year of acquisition or an election to step-up basis has been invalidly exercised.

Collected Proceeds should include the value of illegal increases in basis.

Summary Tax Attributes
It is submitted that the definition of Collected Proceeds should be expanded to include reference to the value of illegal changes in tax attributes, including specifically Net Operating Losses, Net Capital Losses, Excess Foreign Tax Credits, Earnings and Profits, and Increases in Basis.

Do Away with “Two Year Policy” Where IRS and Taxpayer Reach Tax Settlement
Although not covered explicitly in the Proposed Regulation, the two year policy is raised here owing to its fundamental importance and the fact that the current position not only deters some whistleblowers from coming forward, but may place the viability of the program as a whole in question.

As noted, we understand no “two year” rule existed under the “old” system for rewarding informants. Nothing in the 2006 amendments to § 7623 show any intent by Congress to create such a two year delay, which will discourage Whistleblowers, and thus undermine the program.

Clearly the two year rule operates as a significant detracting factor, not only deterring some potential whistleblowers from coming forward, but also encumbering the program with an unnecessarily lengthy term over which cases will need to remain open.

It is submitted that the two year rule should not apply in cases where taxpayers have waived their rights to claim a refund.

Furthermore, it is submitted that tax settlement agreements between the IRS and taxpayers should contain a standard waiver of the taxpayer’s right to claim a refund. It is submitted that such a waiver will not only improve the effectiveness and viability of the whistleblower program, but will improve the efficiency of tax administration and collection in general.

Conclusion
As the IRS continues to improve its Whistleblower Program, the guiding principle should be the plain intent of Congress to attract a greater number and variety of tax whistleblower claims than the pre-2006 program. The Proposed Regulation and certain current policies for applying it, however, would instead narrow and restrict the types of whistleblower claims included, as discussed above. The solution is to modify the Proposed Regulation as described above to reward all whistleblowers whose information results in a financial “benefit to the Treasury,” including tax attributes, and to eliminate the counterproductive two-year wait for rewards that did not exist under the “old” system.

FOOTNOTES

1 The authors of these comments are Michael A. Sullivan and Richard Rubin. Mr. Sullivan is a former federal prosecutor and now a private attorney who has worked with the nation’s major “whistleblower” law, the False Claims Act, since the late 1980s. He has both prosecuted and defended whistleblower cases under the False Claims Act. Since the beginning of the new IRS Whistleblower Program authorized in December 2006, he has also represented IRS whistleblowers and has worked with the IRS Whistleblower Office staff in presenting programs on the “best practices” in pursuing whistleblower claims. He now also represents whistleblowers with claims in the SEC and CFTC Whistleblower Programs created by Dodd-Frank. Richard Rubin is a federal and international tax attorney based in Atlanta and was formerly with Arthur Andersen. He has worked closely with Michael A. Sullivan on diverse IRS whistleblower matters, many involving international and offshore issues. Their whistleblower submissions to the IRS to date involve billions of dollars lost by the Treasury through unlawful tax schemes.

2 January 17, 2011 Memorandum from Senator Charles Grassley, at http://www.iowapolitics.com/index.im1?Article=223421.

3 http://www.justice.gov/civil/frauds/fcastats.pdf.

4 Treasury Inspector General for Tax Administration (TIGTA), The Informants’ Rewards Program Needs More Centralized Management Oversight, 2006-30-092, at 3 (June 6, 2006).

5 Id. at 4.

6 http://finance.senate.gov/newsroom/charman/release/?id=8b41009c-2bfb-47f8-9724-17fc4684ef89.

7 Eli Lilly and Co. v. Medtronic, Inc., 496 U.S. 661 (1990); Gwaltney of Smithfiled , Ltd. v. Chesapeake Bay Foundation, Inc. 484 U.S.49 (1987)

8 For example, the present value methods employed in the actuarial tables under IRC § 7520.