Wednesday October 22, 2014

Two Options for Tax Whistleblowers

The new whistleblowing rule under Dodd-Frank poses an interesting comparison to the existing IRS rule as it relates to tax fraud. The IRS recently paid a whistleblower $4.5 million for providing a tip that netted the IRS $20 million in taxes and interest.  The identity of the whistleblower remains anonymous.

While politicians and practitioners have touted the Dodd-Frank provisions as an advancement in corporate governance, these provisions may provide less incentive for whistleblowers to come forward in tax-related matters than the existing rules on which they are based, Section 7623 of the Internal Revenue Code. More specifically, whistleblowers may elect to report unlawful actions to the Internal Revenue Service (IRS) as opposed to the SEC due to greater perceived anonymity and monetary rewards; a lower materiality threshold for tax assessments than financial statements; and the administrative structure of the IRS and SEC’s whistleblower programs.  These items effectively undercut the potential impact of Dodd-Frank for tax whistleblowers.

Harry Cendrowski (l) and Walter McGrail (r).

Whistleblowers often face significant pressure to remain quiet rather than report unlawful actions.  Though many whistleblower laws including Dodd-Frank contain anti-retaliation protection, evidence demonstrates that whistleblowers risk, in the words of the Senate Banking Committee, “committing ‘career suicide.’” Recent studies, including those highlighted in testimony before the House Financial Services Subcommittee on Capital Markets, indicate between 82 percent and 90 percent of whistleblowers are fired, quit under duress, or are demoted. For individuals working in a geographical area with few employers, or in an industry with little competition, the effects of whistleblowing can be substantial.  Whistleblowers may find themselves ostracized by local, regional, and national businesses for their actions. They may also face adverse social consequences.

In light of these consequences, whistleblowers often desire retaliation protection and anonymity.  Whistleblower provisions of Dodd-Frank provide for anti-retaliation protection and state that the SEC will protect the identity of the whistleblower to the largest extent possible; however, a whistleblower must satisfy numerous conditions to receive these benefits.  For example, a recent court ruling, Egan v. TradingScreen, Inc., found that a whistleblower must provide information regarding unlawful actions to the SEC in order to state a retaliation claim.  Whistleblowers reporting information solely to boards of directors and executives of their employing organization may not necessarily receive retaliation protection in spite of Dodd-Frank’s encouragement of such actions.

Additional conditions imposed by Dodd-Frank effectively incentivize individuals to report unlawful, tax-related actions to the IRS as opposed to the Commission.  For example, according to the SEC:

“…[Dodd-Frank] would authorize disclosure of information that could reasonably be expected to reveal the identity of a whistleblower…For example, in a related action brought as a criminal prosecution by the Department of Justice, disclosure of a whistleblower’s identity may be required, in light of the requirement of the Sixth Amendment of the Constitution that a criminal defendant have the right to be confronted with witnesses against him.”

Other Dodd-Frank provisions seemingly protect the confidentiality of whistleblowers in civil actions brought by the SEC or related government body.  However, because numerous exceptions exist to these confidentiality provisions, a whistleblower would likely assume he would eventually be exposed.  In contrast, the IRS can initiate an audit of tax records without likely subjecting the whistleblower to the Sixth Amendment.  Audits occur in the normal course of business and, barring appeal, do not require legal action or disclosure of a whistleblower’s identity.  As such, a whistleblower with knowledge of unlawful tax-related actions would likely select to report the issue to the IRS as the Service may be better able to protect his identity.  For example, the IRS recently paid a whistleblower $4.5 million for providing a tip that netted the IRS $20 million in taxes and interest.  The identity of the whistleblower, who worked for a Fortune 500 professional services firm, remains anonymous.

In addition to anonymity concerns, whistleblowers are monetarily incentivized to report unlawful actions to the IRS.  Under Dodd-Frank whistleblower provisions, the SEC must pay an award of between 10 and 30 percent of the amount recovered to eligible whistleblowers.  Section 7623 of the Internal Revenue Code, however, “mandates a whistleblower award of between 15 and 30 percent of the amount recovered” by the IRS.  While the upper bound of the potential bounty received by a whistleblower is 30 percent in both instances, the IRS is required to minimally pay a 50 percent larger award than the SEC for information resulting in successful enforcement of unlawful actions.

Whistleblowers may also turn to the IRS over the SEC due to the concept of materiality.  In enforcing securities laws (including the Sarbanes-Oxley Act of 2002), the SEC is largely concerned with matters that are material to financial statements, as these matters may change, according to the Financial Accounting Standards Board, “the judgment of a reasonable person” relying upon them.  The concept of materiality thus constrains the SEC’s actions:  if the SEC feels an item is immaterial, the Commission may forego investigation of the issue, and the whistleblower will not receive a monetary reward.  The concept of materiality, however, largely does not apply to tax assessments.  Thus, a whistleblower with knowledge of tax issues is incentivized to report the issue to the IRS as the Service is unconstrained by the concept of the materiality; the IRS may elect to investigate an issue that the SEC would otherwise not investigate.

Lastly, the IRS’s organizational structure, with its separate whistleblower office, may incentivize potential whistleblowers to report their concerns to the Service as opposed to the Commission. Currently, the SEC lacks an independent whistleblower office to handle tips.  While Sean McKessy was recently tapped to head the SEC’s whistleblower office, the office remains under the direct supervision of Robert Khuzami’s Division of Enforcement:  McKessy does not report directly to SEC Chairman Mary Schapiro.  On the contrary, the IRS has a separate, independent whistleblower office, which serves as the central repository for all whistleblower claims.  The director of this independent office reports to the IRS Commissioner, decreasing the possibility that a claim remains uninvestigated by lower-level IRS managers.  This difference in structure between the SEC’s whistleblower office with that of the IRS was highlighted in a May 10, 2011 letter by Sen. Charles Grassley to Mary Schapiro.  Sen. Grassley is the author of numerous whistleblower protection statutes, including the 2006 amendments to the IRS whistleblower program and Sarbanes-Oxley whistleblower protections for employees of publicly traded companies.

While numerous politicians and practitioners have applauded the whistleblower provisions of Dodd-Frank, these provisions are less attractive to potential whistleblowers than those already existing in the Internal Revenue Code.  With respect to tax-related issues, a whistleblower is likely incentivized to report issues to the Service rather than the Commission due to greater perceived anonymity and monetary rewards; a lower materiality threshold for tax assessments than financial statements; and the administrative structure of the IRS and SEC’s whistleblower programs.  Unless these provisions are substantially modified, Dodd-Frank represents at best an incremental step in incentivizing whistleblower activity for tax-related issues.

Harry Cendrowski is a founding member and Walter McGrail is a senior manager of Cendrowski Corporate Advisors.

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