Law Student Suggests Changes, Clarifications to Proposed Regs on Payment of Whistleblower Rewards

I. Introduction

I welcome and appreciate the opportunity to express my views on this proposed regulation aimed at providing clarity and guidance to the general public as well as officers and employees of the IRS who review claims under 26 U.S.C. § 7623. I am a third-year law student at Villanova University School of Law and I am interested in tax policy and the many facets of society this proposed regulation could potentially affect.

This comment pertains to various aspects of the Notice of Proposed Rulemaking published in the January 18, 2011 edition of the Federal Register by the Internal Revenue Service ("IRS"), an agency within the Department of the Treasury, entitled "Rewards and Awards for Information Relating to Violations of Internal Revenue Laws." The proposed regulation is an amendment to 26 CFR Part 301 relating to the payment of rewards under 26 U.S.C. § 7623 of the Internal Revenue Code ("IRC"). I generally support the proposed regulation as a measure taken in furtherance of Congressional intent pursuant to the Tax Relief and Health Care Act of 2006 and also as a useful tool in pursuing diminution of America's substantial tax gap. However, I do have a few comments on ways to potentially improve the proposed regulation and additional items of necessity that are absent from the regulation.

This comment will briefly provide necessary background to the proposed regulation at hand and then proceed to address the benefits of the proposed regulation including addressing concerns that have arisen in public fora. Thereafter, this comment will address some areas of improvement that may be imperative for the IRS and IRS Whistleblower Office to consider in order for this regulation to have its intended effect. Specifically, expanding the proposed revised definition of collected proceeds and including examples to improve the clarity and guidance of the regulations. Lastly, I will briefly conclude the positions taken within the comment.

II. Background

The proposed rule at issue aims to amend 26 C.F.R. § 301.7623-1, currently entitled "Rewards for information relating to violations of internal revenue laws." The proposed regulation alters the framework of subsection (a) by splitting it into two parts and also altering the effective date enumerated in subsection (g). Most importantly, the regulation adds substantive language indicating that additional items will be considered proceeds of amounts collected and collected proceeds. The purpose of these regulations is to provide clarity and guidance to the public and officers and employees of the IRS who review claims submitted pursuant to § 7623.

III. Benefits of Proposed Regulation

1. Clarity and Guidance

As intended, the proposed amendments to Treas. Reg. § 301.7623-1, provide clarity and guidance to the general public. This guidance is necessary because there has been some confusion as to what type of information provided by a whistleblower merits consideration for an award. Specifically, there are concerns that whistleblowers are only able to attain eligibility for the award program if the information submitted concerned the actual payment of monies by the IRS to the fraudulent individual or corporate taxpayers whom were reported on by the whistleblower. These concerns stem from the June 2010 section of the IRM covering § 7623. In IRM § 25.2.2.1.7 the IRS states:

Example 1: Corporation A, files a fraudulent tax return whereby it is set to receive funds from the IRS in violation of the IRC. However, prior to payment of this refund, a whistleblower provides information that leads to the detection of the fraudulent return thereby preventing payment to Corporation A. Under the current regulations, the whistleblower would not be eligible for a reward or award under § 7623 because no money was physically paid, rather, money was prevented from being paid. No money changed hands. Notwithstanding the value of this information, somehow whistleblowers are denied eligibility for awards in this scenario which leads to situations such as Example 2.

Example 2: Corporation A files a fraudulent tax return whereby it is set to receive funds from the IRS in violation of the IRC. The whistleblower learns of this prior to the refund payment but withholds the information from the IRS until the funds are actually paid by the IRS. The whistleblower knows that if he disseminates the information to the IRS prior to actual payment he will not be eligible for a reward. After the refund is paid by the IRS to Corporation A, the whistleblower discloses the information he was withholding. In this case, under the current regulations, the whistleblower is eligible for consideration of a reward because the currency actually changing hands qualifies under the definition of collected proceeds.

In a sense, under the current regulations, a potential whistleblower has the disincentive to report information immediately to the IRS and instead wait until currency is actually paid to an individual or corporate entity as shown in Example 2. The proposed amendments, in my opinion, achieve what Senator Grassley intended when he wrote the law that created the Whistleblower Office. This intention was that information relating to detecting tax underpayments or violations of internal revenue laws may be disseminated to the Whistleblower Office quickly and without delay so that the honest taxpayer who provides valuable information may be rewarded appropriately under § 7623.

Example: Taxpayer, John Smith files Form-1040X within the requisite time constraints asserting that he overpaid his taxes by $100,000 in the previous year and requesting that the overpaid funds be used to satisfy his tax liability for the current year. Whistleblower, Jane Doe provides information to the IRS that shows John Smith in fact did not overpay and therefore has no overpayment credit balance. Without the provided information, the IRS would not have discovered that John Smith had acquired an overpayment balance. However, despite blowing the whistle on $100,000 of funds, under the previous definition of collected proceeds, Jane Doe would not be eligible for an award because "monies are not obtained" as a result of the information.

The current proposed amendment, quoted above, provides guidance to the proposed whistleblower by eliminating the above described situation. Under the proposed revised language of the rule, whistleblowers are now eligible to receive an award if the information they provide results in the reduction or elimination of John Smith's overpayment credit balance as in the example above which he aimed to use to satisfy his tax liability. Such information is extremely valuable to whistleblowers and the Federal government, especially in situations where the whistleblower qualifies under § 7623(b).

Moreover, this revised language allows for expanded opportunity for potential receipt of an award under § 7623. Such increased opportunities are likely to result in an increase in the number of tips the IRS Whistleblower Office will process, investigate, and collect upon. In fact, even since the enactment of the 2006 law that created the Office, as indicated in the IRS's 2009 Annual Report to Congress on the Use of Section 7623, tips have already increased significantly. In the year preceding enactment of the Tax Relief and Health Care Act of 2006, the IRS received 2,740 cases, whereas in 2009, the IRS received 5,678 cases. With this additional opportunity for whistleblowers to receive award eligibility, the receipt of these tips by the IRS could potentially double and lead to an even bigger intake of delinquent or underpaid taxes.

Therefore, these revisions to the current rule ensure greater clarity for the general public, especially for potential whistleblowers and most importantly, IRS officials within the Whistleblower Office and other offices that investigate tips delegated to them by the Whistleblower Office.

2. Diminution of the Tax Gap

The efforts of the IRS to expand the opportunities for whistleblowers to obtain awards should be applauded for the potential effect these proposed regulations will have on the diminution of the tax gap. The tax gap is the difference between taxes owed and taxes paid and is a constant albatross around the neck of honest taxpayers. The tax gap and those that fail to pay their equal share create substantial negative implications for honest taxpayers. First, it results in honest taxpayers paying even higher taxes to make up for those who do not; second, it increases the national deficit which again increases taxes; and third, it reduces the level and quality of services offered by the government.

The tax gap is enormous and imposing. According to the Tax Policy Center, in 2001, when the IRS last conducted a comprehensive tax gap study, it was estimated that there was a gross tax gap of $345 billion dollars. Through enforcement and voluntary payments, that bewildering sum, which makes up almost one/fifth of total tax liability, was reduced by only $55 billion. Further, in pie charts released by the Tax Policy Center from IRS data, it can be seen that the largest component of the tax gap is underreporting, of which the largest portion of offenders are individual tax payers.¹ Considering the sheer amount of underreporting that exists, and the difficulty of determining underreporting by individuals and sole proprietorships especially, the assistance of honest tax payers in obtaining otherwise unavailable information and decreasing the tax gap is imperative.

The IRS and the Department of Treasury announced in July 2009 that it was intensifying its efforts to narrow the tax gap. This included working closely with Congress to find ways to decrease the burdens of the tax gap and also to upgrade its efforts to regularly assess the amount of the tax gap. These proposed regulations serve to perpetuate the aforementioned initiatives of the IRS. With increased opportunity to discover information and receive rewards from the Whistleblower Office, honest taxpayers play an important part in assisting with the diminution of the tax gap. As the whistleblowers role expands in the quest for increased enforcement, it is only logical that the reward eligibility for information disseminated to the IRS by the whistleblower should expand as well.

Whistleblowers serve as a powerful tool for combating tax underpayment. Corporate whistleblowers are willing to risk employer retaliation despite the confidentiality provisions of the Tax Relief and Health Care Act of 2006, to provide important, valuable information for tax enforcement in order to help alleviate the burdens of the tax gap. Thus, the proposed amendments of the IRS are essential in expanding, utilizing, and promoting the role whistle blowers play in tax enforcement and the quest for diminution of the tax gap.

The intent of Senator Grassley in championing the formation of the IRS Whistleblower Office within the Tax Relief and Health Care Act of 2006 is echoed by the quest to decrease the tax gap. Both that intent and the goal for increased diminution of the tax gap are simultaneously achieved by the proposed amendment to the whistleblower regulations which allow for greater opportunity for honest tax payers to perform a civic duty and receive an award for that service.

IV. Suggested Improvements for the Proposed Regulation

The benefits of the proposed regulations are clear, as the expanded definition of collected proceeds set forth by the IRS will promote honest taxpayers to bring to light the activities of those fraudulent individuals and entities whom are placing an inordinate burden on those who do pay their fair share of taxes. Notwithstanding these benefits, I have several suggestions that may improve these regulations by enhancing the clarity of whistleblower provisions and providing precise guidance for citizens and IRS officials alike.

1. Reductions in Refund Claims

The proposed amendments to the whistleblower regulations state that "if the information provided results in the denial of a claim for a refund that otherwise would have been paid" then the whistleblower is eligible for an award. While this language is clear in that information provided which leads to a refund denial renders a whistleblower eligible for a reward or award, the regulation remains ambiguous. Specifically, it is unclear whether information provided by a whistleblower which leads to a reduction in a refund claim would qualify the whistleblower for a reward or award.

Example: A is set to receive an Income Tax Refund from the IRS of $4,000,000. B knows that a portion of that refund would be received by A fraudulently and subsequently provides that information to the IRS leading to a reduction in A's refund of $2,000,000.

Ambiguities in the current and proposed language seem to indicate that the whistleblower would be ineligible for an award or reward in the example above because the information given to the IRS by B did not lead to the denial of A's refund, only to the reduction. It seems illogical to deny the whistleblower an opportunity for an award for this type of information when a reduction in refund money could be as valuable, if not more valuable, depending on the circumstances, than information leading to a denial of a refund. Further, considering that the proposed regulations provide that information leading to a reduction in an overpayment credit balance qualifies a whistleblower for the monetary incentives of § 7623, it should follow that a reduction in a refund claim should qualify as well, considering both involve a reduction in funds but still save the federal government and honest taxpayers from bearing an even larger brunt of tax responsibility.

While it could be argued that the proposed language covers both denials and reductions in refunds, in order to effectuate the intent and purpose of the current amendments it is suggested that reductions be specifically enumerated in the regulation. This ambiguity could be cured by simply changing the above quoted language to read "if the information provided results in the denial or reduction of a claim for refund that otherwise would have been paid." This change effectively covers all information pertaining to fraudulent tax return claims and thereby enables these regulations to have the power that Senator Grassley and other proponents for expansion of the whistleblower program intended them to have.

2. Conflicting Authority: Criminal Penalties

The definition of collected proceeds under the proposed regulations includes "tax, penalties, interest, additions to tax, and additional amounts collected by reason of the information provided." This language echoes the language of the statute promulgated by the Tax Relief and Health Care Act of 2006 which similarly includes 'penalties' under § 7623(b) as part of the definition of collected proceeds. While these two sources clearly delineate that penalties are included within the scope of collected proceeds, the IRS has published contradictory information within the IRM which brings the clarity of 'penalties' treatment under the whistleblower statute into question.

In IRM 25.2.2.1(7), published by the IRS in June 2010, collected proceeds is said not to include "Criminal fines, which must be deposited into the Victims of Crime Fund, [and] cannot be used for payment of whistleblower awards." This provision is at odds with both the language of the statute and regulation, leaving the public, potential whistleblowers, and IRS officials with ambiguous authority upon which to rely. Remedying this ambiguity is necessary in order to promulgate a rule that is efficient and clear.

Following the legislative intent to increase the role of the whistleblower by providing increased incentives for the dissemination of information, it is suggested that the IRS resolve this ambiguity in favor of allowing whistleblowers to recover rewards and awards from criminal penalties. The IRS resolving the issue otherwise creates an inequitable situation whereby a whistleblower who provides valuable information to the IRS could come away empty handed.

Example: A provides valuable information regarding a tax fraud perpetrated by B in excess of $2,000,000. The IRS chooses to pursue only a criminal action against B which results in $1,000,000 in assessed penalties.

In this Example, if criminal penalties are not included within the definition of collected proceeds, the whistleblower who took great risk in bringing the tax fraud to the attention of the IRS is left uncompensated, without any reward for the information they provided. Moreover, this situation marginalizes the whistleblower and does a disservice for the important role the whistleblower played in the prosecution of B. If the IRS continues to interpret criminal penalties as outside the scope of collected proceeds, taxpayers with valuable information may resist turning into whistleblowers and withhold that valuable information because they know the IRS may simply decide to proceed only with an action resulting in such penalties or forfeitures. However, if the IRS does as suggested and clarifies that criminal penalties are included within the scope of collected proceeds, not only would the inequity created by the Example be averted, but the intent of the legislature would be furthered.

This ambiguity could be resolved by simply changing the wording of the regulation to say "tax, civil and criminal penalties, interest, additions to tax, and additional amounts collected by reason of the information provided."

3. Net Operating Losses (NOLs)

The proposed amendment to the regulations states that an award or reward may be available to a whistleblower if the information provided results in the reduction of an "overpayment credit balance used to satisfy tax liability." While the benefits of this addition are apparent and applauded, they generally apply only to individual tax payers. In the tax and corporate industry, the term 'credit balance' is not generally associated with the corporate entity because a corporation rarely overpays its taxes. However, corporations do employ a sort of credit balance called a Net Operating Loss (NOL). A corporation has a NOL when their business costs and expenses exceed taxable income.

NOLs are covered by the IRC in 26 USC § 172, which is geared towards assisting the corporation with a NOL in offsetting taxable income incurred in past years or even in the future. Specifically, a corporation with a NOL may carry back a loss up to two years or carry forward a loss for up to twenty years. This carry back and carry forward of a NOL can help eliminate or reduce tax liability in prior or successive years enabling a corporation to survive periods of economic uncertainty. Thus, NOLs are an asset both valuable and potentially substantial to a corporation. However, under the current and proposed regulations, information provided by whistleblowers leading to a reduction or elimination of a corporation's NOL is not considered collected proceeds and therefore is not eligible for award or reward consideration. Failure to include NOLs in the regulations creates an additional inequity for the whistleblower that reduces the overall effectiveness and impact of the regulations. However, there are differences in the administrative demands that result from inclusion of NOL carry backs versus NOL carry forwards. Despite such differences, both NOL carry backs and carry forwards should be included in the regulation because the benefits of both outweigh the negatives associated with them.

NOL carrybacks present little issue for the IRS to process and include in the regulations.

Example: Corporation A files its taxes in such a way as to qualify for a $5,000,000 NOL that it intends on using to satisfy the tax liability it incurred the previous year. B, an employee of Corporation A, discovers that a large portion of the costs and expenses of Corporation A were inflated in its filing such that the NOL would be reduced by $4,000,000. B gives the information to the IRS who subsequently reduces the NOL of Corporation A.

Including NOL carry backs in the regulation is logical for two reasons: 1) the concept underlying inclusion of overpayment credit balances is analogous to the situation of the NOL carry back and 2) the IRS has procedures in place to quickly recognize and pay NOL carry backs thus alleviating administrative burden.

NOL carry forwards present more of an issue for the IRS to include in the regulation because of the associated administrative burden.

Example: Corporation A filed its taxes in Year 1 in such a way as to qualify for a $5,000,000 NOL that it uses to satisfy the tax liability it incurs in Year 2. B, an employee of Corporation A, discovers that this NOL is fraudulent and that Corporation A does have to pay taxes on it. B gives the information to the IRS who subsequently eliminates the NOL of Corporation A and forces the Corporation to pay taxes on the $5,000,000.

Here, the information from B, the whistleblower, leads to the IRS collecting funds. Notwithstanding the fact that the concept of the NOL carry forward is similar to overpayment credit balances, inclusion of NOL carry forwards present an issue for the IRS because there is an administrative burden for the IRS to track and monitor the payments associated with a carry forward. Specifically, tracking and coordinating the payment of tax by the taxpayer with the payment of an award or reward to the whistleblower. However, the sheer value of corporate NOL carry forwards outweighs this burden solely because of the billions of dollars at stake.

The absence of NOLs from the proposed regulation could be remedied by adding language such that the new amendments would read in part, "reduction of an overpayment credit balance or corporate Net Operating Loss (NOL) used to satisfy a tax liability." NOLs are an important and integral part of the corporate landscape, whistleblowers that aide in bringing to light corporate entities that evade taxes and connive to commit tax fraud through this legal tax tool deserve to and should be rewarded.

4. Applicability and Effective Date

There is a concern that the proposed regulation leaves whistleblowers that have already come forward to provide information to the IRS unjustly empty handed. Such injustice is further amplified by the fact that the information may have lead to the recovery of potentially substantial amounts of money. Compensating these valuable whistleblowers would provide enhanced credibility to the IRS Whistleblower Office and ensure the future success of the program.

The proposed regulation amends the effective date currently listed in § 301.7623-1(g). The amendment to that section changes the title of the subsection to "Effective/Applicability Date," and adds language saying that the provisions of proposed subsection (a) would apply once the regulations are published as a final rule in the Federal Register. These amendments essentially preclude retroactive application of the revised definition of collected proceeds, thereby denying whistleblowers that were denied rewards or awards under the previous misinterpretation just compensation.

Example: In July 2010, Whistleblower A provided information to the IRS that Taxpayer B was set to fraudulently receive over $2,000,000 dollars in the form of a tax refund. Based upon that information, prior to payment of the substantial refund, the IRS was able to void Taxpayer B's fraudulent refund claim.

There is no dispute that the information Whistleblower A provided in the Example above is extremely valuable and helpful towards furthering the purpose of the IRS Whistleblower Office. Such information is what Senator Grassley intended to incentivize Whistleblowers to divulge by promulgating the expansion of Whistleblower rewards and awards. However, under the prior interpretation of collected proceeds, Taxpayer B would be precluded from recovering at least 15% of the $2,000,000 fraudulent refund. The proposed provisions of (g) do nothing to cure the injustice perpetrated against whistleblowers like Taxpayer B. The IRS should consider rectifying this situation affecting the class of whistleblowers that would qualify for a reward or award under the new definition of collected proceeds but were denied eligibility based on the misinterpretation of the legislative intent under the prior definition by the IRS.

In order to rectify this situation, the proposed provisions of (a) should apply retroactively to all claims for rewards and awards instituted by whistleblowers after the effective date of § 7623(b). If these whistleblower claims have already been denied a reward or award by the IRS, then an opportunity to appeal such denial should be provided, if one does not already exist, in order to rectify the injustice suffered by this class of whistleblowers. To do otherwise marginalizes whistleblowers who came forward immediately with information pertinent to the purpose of the IRS Whistleblower Office but were denied compensation for their valuable services due to the misinterpretation of § 7623(b). If the IRS repairs the plight of this class of whistleblowers, the credibility of the IRS Whistleblower Office will be bolstered thereby enabling the Office's mission and directive to be maximized.

5. Examples

While the proposed regulations do amplify the guidance that the current rules provide and further enhance the clarity of the whistleblower provisions, areas still exist where the regulations remain vague, unclear, and ambiguous. Such ambiguity and vagueness is evidenced by the suggestions within this comment as well as those suggestions listed in other comments previously submitted to the IRS by the interested public.

One way that the ambiguity of the regulations can be remedied is by adding examples representative of what is and what is not permitted under the terms of the rule. Examples provide a concrete rubric for whistleblowers, government officials, and the public in general to follow in understanding what the terms of the regulations mean. Moreover, examples provide comfort to a potential whistleblower that may be wavering on whether the information they have makes them eligible for a reward or award. Such comfort may be the very thing needed in order to increase the amount of tips that come in to the Whistleblower Office and subsequently spark the collection of additional funds lost in the tax gap.

Since the goal of the proposed amendments is to provide "needed guidance," adding an example for each item listed in the definition of collected proceeds will truly provide a pathway for public understanding. While these examples need not be exhaustive of every possibility that exists for each item, even one representative example would be extremely helpful.

6. Notice and Comment

While the efforts of the IRS are not to be denigrated, in order to fully provide the public with the guidance and understanding they seek and deserve, the public should have input on the provisions of the Internal Revenue Manual pertaining to whistleblowers. IRM 25.2.2.1-14 was published by the IRS on June 18, 2010 without public input. It is undisputed that large portions of these provisions are procedural in nature; however, it could be argued that there are substantive portions of the section as well. Portions of these provisions create or eliminate the rights of a potential whistleblower. These substantive provisions should be put up for public comment. Even arguing that these are not substantive in nature, the IRS should consider placing the provisions of the IRM up for notice and comment rulemaking in order to allow the American citizens whom the Whistleblower Office relies so heavily upon to provide their input.

V. Conclusion

The enactment of the Tax Relief and Health Care Act of 2006 and the subsequent promulgation of 26 U.S.C. § 7623(b) were important initiatives passed by Congress that increased the opportunities and incentives for whistleblowers. This proposed regulation takes another step forward for the whistleblower program by providing much needed guidance to the general public and IRS officials by clearing up some previous interpretative confusion. However, while the overall intent and direction of this proposed regulation is applauded, there is still room for improving the regulation with clearer language and the addition of provisions that eliminate other ambiguities concerning the statute. Promulgating a regulation that gives the whistleblower and the IRS Whistleblower Office the most clear guidance will maximize the efforts of the whistleblower program and go a long way towards the ultimate goal of substantial diminution of the tax gap. Notwithstanding the suggestions given herein, I commend the IRS for amending the current regulations to reflect the intent of the legislation enacted by Congress.

Thank you for the opportunity to comment on these important issues and I respectfully request that the suggestions provided herein be considered by this agency in assessing possible improvements for the proposed regulation.