States Eye New York Whistle-Blower Law as Tax Fraud Tool

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By Michael J. Bologna

State lawmakers and tax administrators are taking a closer look at enacting whistle-blower statutes as a strategy for prosecuting big-ticket incidents of tax fraud and scooping revenue into state coffers.

At least four jurisdictions—Arkansas, Michigan, Pennsylvania and the District of Columbia—are considering legislation that would add tax code violations to the list of actionable frauds to come under the umbrella of their false claims acts (FCAs). In addition, Illinois is considering revisions to its law as it pertains to tax violations.

If the efforts are successful—some officials and tax attorneys hope they aren’t—the jurisdictions would join nine states that permit whistle-blowers to prosecute tax code frauds on behalf of the state.

Tax policy makers are motivated in part by victories in New York that have swept about $60 million in unpaid taxes and penalties into the state treasury. New York revised its FCA in 2010 to explicitly invite whistle-blowers to file what are known as qui tam claims seeking to remedy tax code violations.

The most prominent example came on April 18 when New York Attorney General Eric Schneiderman (D) announced a $40 million settlement with Alabama-based Harbert Management Corp., the fund sponsor for hedge fund Harbinger Capital Partners. The settlement is regarded as the single largest tax-related recovery under a state FCA.

“The Harbert settlement demonstrates that a responsible tax whistle-blower law can lead to better tax enforcement and large state recoveries,” said Gregory Krakower, who served as senior counselor to Schneiderman until last year and helped draft New York’s false claims law. “And there is no doubt that states are looking at the success of New York and realizing that tax-fraud loopholes in their false claims acts need to be closed.”

Money on the Table

Dennis Ventry, a professor at the University of California Davis School of Law who has written extensively on false claims statutes, said the bills in state legislatures are “explicitly inspired” by New York’s law. If enacted, he said, the measures would serve as important complements to conventional tax enforcement and collection, while deterring fraud.

“There is interest because these cases are money left on the table,” Ventry told Bloomberg BNA. “It’s also a supplement to traditional tax enforcement that benefits both the tax agency and taxpayers. It’s helping the treasuries of each state.”

These legislative campaigns, however, are being opposed by corporate interests and the defense bar. Opponents say whistle-blower actions interfere with the traditional audit, collection and enforcement channels in state revenue departments.

“As we have seen in jurisdictions like New York and Illinois, opening the door to tax-related false claims can lead to significant headaches for taxpayers and usurp the authority of the state tax agency by involving the state Attorney General in tax enforcement decisions,” Stephen Kranz, a partner in the Washington D.C. offices of McDermott, Will & Emery, said.

State FCAs, typically modeled after the federal law, allow whistle-blowers to step into the shoes of the government to sue persons who knowingly perpetrate frauds against the state. The classic whistle-blower is an insider holding specific knowledge of misconduct. FCAs typically incentivize whistle-blowers to come forward, permitting them to share in any proceeds coming to the state. Whistle-blowers are also entitled to litigation costs and reasonable attorney fees.

Ventry said 29 states have enacted FCAs, with most laws structured to enforce Medicaid frauds. New York is the only state that explicitly includes qui tams aimed at incidents of tax code fraud, but 11 states specifically exclude tax qui tams. FCAs in Illinois, Indiana and Rhode Island allow actions on some types of tax violations. Delaware, Florida, Hawaii, Nevada and New Hampshire don’t specify tax, but create opportunities for tax whistle-blowers.

Large-Scale Tax Frauds

Randall Fox, a partner with Kirby McInerney LLP in New York and the former chief of Schneiderman’s Taxpayer Protection Bureau, said New York’s 2010 FCA amendments were structured to focus on large-scale tax frauds and minimize low-stakes nuisance claims.

The amendments stipulate that defendants subject to a tax qui tam action must net more than $1 million annually and knowingly defraud the state of more than $350,000 in taxes. The attorney general retains stewardship of the tax cases. New York also established the Taxpayer Protection Bureau under the Office of the Attorney General to attract and manage strong whistle-blower cases.

While New York’s law is relatively new, Fox said it has netted impressive results.

In total, 10 tax cases have been resolved, netting $71.4 million. Whistle-blowers’ share of the settlements totaled $11.8 million, leaving New York with nearly $60 million. The cases alleged frauds involving the income, sales and franchise tax programs. The defendants included art dealers, a hedge fund, a custom tailoring business and an online sales company.

“New York clearly signals that states are leaving money on the table,” Fox told Bloomberg BNA. “There are state-specific tax issues out there which the IRS is never going to wade into because they don’t affect the federal fisc.”

The settlements have come at minimal cost to the state. Fox pointed to a 2,250 percent gross return on investment in the 10 resolved cases.

New York FCA Case Resolutions
Larger Awards?

New York’s $60 million collected in just four years, however, could be a modest down payment on much larger awards.

New York is currently litigating a case aimed at Sprint Nextel Corp., claiming the wireless carrier failed to collect proper sales taxes on flat-rate plans. Sprint has argued state tax law doesn’t impose sales tax on interstate mobile voice services sold as part of a fixed-rate plan, but New York has alleged that Verizon Communications Inc., AT&T Inc., T-Mobile US Inc. and Metro PCS all complied with the law. The case could leave Sprint with a bill for up to $400 million in back taxes and damages.

And Krakower, currently of counsel to Getnick & Getnick LLP, predicted the Harbinger settlement would serve as a “wake-up call” to accountants in hedge funds and financial companies operating in the state, setting off a wave of new tax fraud qui tams.

“If you are a financial executive or an accountant faced with a client or company committing a tax fraud, it is better to be a potential whistle-blower than a potential defendant,” he said. “The message out of New York is clear: accountants, CFOs or others well-situated to expose financial tax frauds can file whistle-blower suits and make a difference.”

The New York Model

Jackson Brainerd, a tax policy associate with the National Conference of State Legislatures, said New York’s example is resonating with lawmakers in several jurisdictions.

  • Arkansas state Sen. Jake Files (R) sponsored S.B. 548, creating the Arkansas False Claims Act. The bill contains provisions allowing for tax actions aimed at persons with sales or income over $500,000 who knowingly defraud the state of more than $100,000. The measure stalled in the Senate Judiciary Committee when the Legislature adjourned May 1.
  • District of Columbia Council member Mary Cheh is sponsoring DC B 166, the False Claims Amendment Act of 2017. The proposal is very similar to New York’s law, allowing tax claims against defendants with sales or income of more than $1 million that knowingly defraud the district of more than $350,000 in taxes. Cheh is hoping for movement on the bill in the fall.
  • Illinois has at least three bills pending before the General Assembly that seek to overhaul the Illinois False Claims Act, particularly as the law applies to tax frauds. The attention is due in part to a single Chicago law firm that has filed more than 900 lawsuits alleging minor violations of Illinois’ sales and use tax. S.B. 9 would simply bar tax actions. H.B. 1814 and S.B. 1250 would grant the Department of Revenue authority to review and intervene in FCA actions and limit whistle-blowers’ ability to profit from such litigation.
  • Michigan state Sen. Steve Bieda (D) is sponsoring S.B. 65, creating the Michigan False Claims Act. The proposal is very similar to New York’s law, allowing tax claims against defendants with sales or income of more than $1 million that knowingly defraud the district of more than $350,000 in taxes. The bill is in the Judiciary Committee, and Bieda is hoping it will be called for a hearing soon.
  • Pennsylvania state Rep. Brandon Neuman (D) has sponsored H.B. 1027, creating the Pennsylvania Taxpayer Protection Against Fraud Act. The bill focuses on frauds perpetrated against the state, but doesn’t bar tax qui tams. The measure has been referred to the Judiciary Committee.

The Revenue Gap

Lawmakers say they are motivated by the daunting revenue gaps in their tax regimes. The IRS has estimated the net federal tax gap at $406 billion annually, but firm numbers at the state level have never been properly analyzed. James Alm, an economics professor at Tulane University, recently estimated the annual tax gap for Georgia alone at between $1.4 billion and $2.9 billion.

But D.C. Council member Cheh said lawmakers are also motivated by tax fairness and deterrence.

“This is, of course, about revenue collection, but it’s also about cheating—very large taxpayers cheating the public,” Cheh said. “We should have people paying their proper share. We also see this can be a deterrent to fraudulent activity.”

Doubts About FCAs

While effective revenue collection, tax fairness and fraud deterrence are important goals, some tax administrators and practitioners aren’t sure a landscape of state FCAs is the best medicine for the disease.

The Multistate Tax Commission studied the issue between 2012 and 2015 through its Tax Overcollection Class Action & Tax Undercollection False Claims Act Work Group.

The group, which included tax administrators, academics and practitioners, discussed a role for FCAs in state tax enforcement, but also talked about drawbacks, such as the potential for nuisance suits and the erosion of taxpayer confidentiality protections. The group debated options for model legislation that would empower whistle-blowers in state tax enforcement without creating a negative environment for taxpayers.

MTC counsel Sheldon Laskin said the project was eventually shelved after the work group failed to reach consensus. State tax administrators concluded primary authority for enforcement should rest within their agencies. The group, however, left a door open for action on model FCA language for a future date.

“The project ended because, generally speaking, the states took the position that tax disputes should be handled through the tax procedures they administer,” Laskin said. “And they felt creating a parallel procedure was going to be problematic.”

‘This Is a Bad Idea’

Many tax practitioners are more emphatic about their frustration with state FCAs.

“This is a bad idea,” wrote Peter Faber, Alysse McLoughlin and Mark Yopp, all state and local tax partners at McDermott Will & Emery, in a tax policy essay published by Bloomberg BNA April 26.

Faber and his coauthors warned against any replication of the New York model on multiple grounds, calling it a “cumbersome,” “expensive” and “wholly unnecessary” structure. The authors faulted FCA proceedings as more formal and adversarial than typical tax department audits, preventing frank discussions on tax issues and creating impediments for resolution.

The McDermott authors, however, emphasized that a more expansive FCA regime would interfere with state tax departments’ audit and enforcement functions. Agencies are staffed with competent and efficient audit teams that understand large taxpayer systems and may have audited the taxpayer in previous cycles, they said. In contrast, the authors argued, law enforcement agencies and qui tam attorneys are probably unfamiliar with the relevant tax issues, leading to inefficient and adversarial interactions.

If state revenue departments are lacking, the McDermott authors argued, more resources should be devoted to their audit and enforcement capacities rather than new enforcement mechanisms.

“Giving state revenue departments the funds to expand their audit staffs and modernize their auditing and collection procedures is the right way to do this,” the attorneys wrote. “Setting up a parallel enforcement structure in another government agency makes no sense.”

To contact the reporter on this story: Michael J. Bologna in Chicago at mbologna@bna.com

To contact the editor responsible for this story: Cheryl Saenz at csaenz@bna.com

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