Firm's Comments Address Proposed Regs on Payment of Whistleblower Rewards

The Ferraro Law Firm respectfully submits herein comments on behalf of its clients who have to date made hundreds of tax whistleblower submissions to the Internal Revenue Service ("IRS") representing more than $82 billion in tax underpayments. Specifically, we write to comment on the Proposed Treasury Regulations under section 7623 of the Internal Revenue Code ("IRC") that were published in the Federal Register on January 18, 2011 (the "Proposed Regulations"). These Proposed Regulations at section 301.7623-1(a)(2) address the definition of "proceeds of amounts collected and collected proceeds" for purposes of IRC section 7623. Because we understand that a broader Treasury Regulation project is underway that addresses other issues raised by section 7623, we will confine our comments at this time to only those raised by the definition of "collected proceeds."

First, we would like to applaud the Treasury Department and the IRS for their efforts in writing new regulations for the recently amended IRC section 7623 Expenses of Detection of Underpayments and Fraud, Etc. which are consistent with the plain meaning of section 7623. In several ways, we recognize that these Proposed Regulations are contrary to some of the guidance and decisions that have been released by the IRS since the creation of the IRS Whistleblower Office ("WBO"). When Congress passed the Tax Relief and Health Care Act of 2006 (P.L. 109-432) (the "Act"), therein greatly increasing the awards available to tax whistleblowers, their intent was to entice persons with high value and high quality information about tax underpayments to come forward. While the Act did greatly increase the numbers of high quality submissions to the IRS, there remains work to be done to encourage other whistleblowers to come forward.

In summary, our comments can be broken down into four categories:

Comment #1) Refunds -- We are pleased that the Proposed Regulations provide that a denial of a refund claim should constitute "collected proceeds," but we are concerned that the language used in the Proposed Regulations is too narrowly drafted to cover common scenarios in which refunds are effectively denied in the course of a tax controversy, particularly with respect to complex corporate tax returns.

Section 7623(b)(1) defines collected proceeds from which an award can be paid to a whistleblower under IRC section 7623(b). Specifically, it says that if a whistleblower's information substantially contributed to the IRS's action against a taxpayer, a whistleblower shall receive an award of between 15 to 30 percent of the "collected proceeds (including penalties, interest, additions to tax, and additional amounts) resulting from the action (including any related actions) or from any settlement in response to such action."

From an economic perspective, when the IRS either (i) makes an assessment of a tax deficiency, or (ii) denies a claim for refund, the net effect on the public treasury (or "FISC") is the same. Section 7623 was designed to award individuals who bring additional revenue into the FISC, and in the same way, it should award individuals who protect the FISC from paying out erroneous refunds. We are pleased that through the Proposed Regulations, the Treasury Department implicitly acknowledges this fact. However, we are concerned that the language used in section 301.7623-1(a)(2) of the Proposed Regulations to effectuate this simple tenet of economics is too narrowly drafted to achieve the desired result.

We agree with Senator Grassley when he wrote in a June 21, 2010 letter to Treasury Secretary Geithner that denying an award when information leads the IRS to withhold a requested refund -- as was contemplated by the IRM provisions released on June 18, 2010 -- creates "a perverse incentive for the whistleblower to wait until the IRS has paid an improper refund." We have seen several instances of this exact situation in practice and have advised our clients accordingly. However, there are several scenarios that typically arise in a tax controversy that have the same practical effect as a denial of a claim for refund, but as a technical matter, they would not fit within the language of the Proposed Regulations, which currently state that awards can be paid from: "amounts collected prior to receipt of the information if the information provided results in the denial of a claim for refund that otherwise would have been paid." Prop. Treas. Reg. section 301.7623-1(a)(2).

In many tax controversies, in response to deficiencies proposed by the IRS, a taxpayer will file affirmative claims for refund on an amended tax return for the period under examination that can, if allowed, practically act as an "offset" against the proposed deficiencies. The IRS can then examine these claims for refund and either allow them in whole or in part, resulting in a reduction of the deficiency and potentially even a tax refund, or the IRS can deny the claims for refund in whole or in part, resulting in either no change, a reduction of the deficiency, or a denial of a claim for refund. First, the Proposed Regulations should not distinguish between a formal full or partial disallowance of a claim for refund as compared to the full or partial reduction in a deficiency. Second, the Proposed Regulations should not distinguish between cases in which the whistleblower submission contains information that relates to the issues in the affirmative claims for refund, so long as information contained in the whistleblower submission ultimately leads to either a deficiency or denial of refunds.

The following examples illustrate this premise:

Treas. Reg. section 301.7623-1(a)(2) should read as follows:

The Proposed Regulations currently state that awards can be paid from collected proceeds resulting from "a reduction of an overpayment credit balance used to satisfy a tax liability incurred because of the information provided." Prop. Treas. Reg. section 301.7623-1(a)(2). Similar to the refund issue, the Proposed Regulations are simply too narrowly drafted with respect to the impact of credits on complex corporate returns. An "overpayment" credit balance is just one of the many types of credit balances that exist under the IRC. Any Fortune 1000 taxpayer has a complicated mixture of credits and tax attributes that greatly affect what they actually pay in tax during any taxable year. To ignore the impact of these credits, NOLs, and tax attributes on "collected proceeds" is to ignore large swaths of the IRC and pretend they simply aren't there, even though they are in many respects analogous to an "overpayment credit balance" situation as described in the Proposed Regulations.

We share Senator Grassley's concern about how the IRS may treat credits for award purposes under section 7623. In his June 21, 2010 letter to Treasury Secretary Geithner, Senator Grassley said, "the IRM says that satisfaction of a taxpayer's liabilities by reducing a credit balance is not within the scope of collected proceeds so the whistleblower would receive no award." Clearly the Proposed Regulations would change that rule with respect to "overpayment credit balances," but we believe that the Proposed Regulations should be more broadly written to cover the "credit balances" that Senator Grassley wrote about. The Proposed Regulations, to the extent they only cover only "overpayment credit balances," fail to address Senator Grassley's concern.

A few admittedly overly simple examples follow to illustrate the effect of tax attributes in a whistleblower case. There are any number of scenarios involving NOLs, credit carrybacks or carryforwards, and other adjustments relating to tax attributes which could be addressed by the Proposed Regulations. The following scenarios would be more relevant than the "overpayment credit balance" scenario that the Proposed Regulations already contemplate, but by no means is this an exhaustive list of examples. Instead, we believe the best approach that can be taken in the final regulations would be to leave the rule broad enough for the WBO to make a determination of how the whistleblower's information effected the taxpayer's tax position including not just deficiencies and refunds, but also the use of tax attributes.

Example 1, just as in the first example under Comment #1 above, a tax whistleblower submission contains information only about issue A, and the taxpayer agrees at the conclusion of an examination that issue A led to an underpayment of $10 million. However, when tax computations are done at the conclusion of the examination, the taxpayer utilizes an excess Alternative Minimum Tax credit under IRC section 53(a) to reduce the deficiency owed by $3 million. The taxpayer then pays the $7 million deficiency. The section 7623 award should still be based on the $10 million underpayment that the taxpayer agreed to that was attributable to issue A. But for the information provided by the whistleblower, the taxpayer would have still had a $3 million tax attribute available to them to use at any time. Instead the taxpayer paid $7 million and used up a $3 million tax attribute, resulting in net "collected proceeds" of $10 million.

Example 2, a taxpayer has a foreign tax credit under IRC section 901 that it is carrying forward from the current taxable period to a future year because it is in an excess credit limitation position under section 904, and a whistleblower submits information that leads to a determination that the taxpayer is not entitled to that credit. While this determination will have no impact on the amount of tax the taxpayer will pay in the current year, it will result in a payment of additional tax in the subsequent year when the taxpayer could have used that credit to reduce their U.S. tax liability. If this information had led to the denial of the credit in the current year, thus increasing the U.S. tax liability in the current year and leading to a deficiency in the current year, we believe that the Proposed Regulations as currently drafted would already pick up that additional payment as "collected proceeds." However, to the extent that it has a future or past year impact the Proposed Regulations are not clear. Even though, in either situation, the net "collected proceeds" are equal to the amount of the denied credit, because due to the information provided by the whistleblower, the taxpayer no longer has the credit available for use.

If the Proposed Regulations do not finally address tax attributes through the use of broader language, then the IRS will be in the position of still having to pay awards to whistleblowers under the plain language of section 7623 in a future year when the current loss of a tax attribute results in an additional tax being paid. This creates what we call a "springing award," such that the whistleblower will be eligible for an award in whatever such future year additional tax is paid, due to the loss of or utilization of the tax attribute (resulting from the whistleblower's information). In practice, this then results in an administrative burden on the WBO and the IRS who would be required to monitor the taxpayer's utilization of tax attributes for many years, perhaps even decades. Such a rule would also unfairly penalize a whistleblower who provided information that resulted in the reduction of a taxpayer's valuable tax attributes, instead of a deficiency or the denial of a refund.

Whether a taxpayer pays cash to settle a deficiency or utilizes a tax attribute is a distinction without an economic difference. The Proposed Regulation should reflect that truth.

Suggested Language for the Proposed Regulation to Address Comment #2:

Treas. Reg. section 301.7623-1(a)(3) should be added to the Proposed Regulations and should read as follows:

Monies collected as criminal fines or restitution in tax cases are properly included in the definition of collected proceeds even though IRS's current position, as stated in the Internal Revenue Manual ("IRM'"), incorrectly excludes criminal fines from collected proceeds and is silent as to restitution. Criminal fines are properly included in collected proceeds pursuant to the plain language of section 7623 and Treasury Regulation section 301.7623-1(c), and the IRS has traditionally included criminal fines as part of collected proceeds. Restitution payments are properly included in collected proceeds because the amount under a restitution order pursuant to section 3556 of Title 18 for failure to pay any tax imposed under Title 26 is assessed and collected as if such amount were a tax according to section 6201(a)(4).

While criminal fines are properly included in collected proceeds, the IRS has chosen to exclude most criminal fines from collected proceeds. To the extent that IRM 25.2.2 Whistleblower Awards (06-18-2010) says that criminal fines are not part of collected proceeds, it is flatly contrary to the statute. Specifically, IRM 25.2.2.12 Funding Awards (06-18-2010) says:

The statutory language of section 7623(b)(1) states that collected proceeds include penalties, interest, additions to tax, and additional amounts. Criminal fines are reasonably included in the plain and ordinary meaning of additional amounts. The ordinary meaning of additional amounts is amounts not otherwise listed, which reasonably includes criminal fines. Additionally, the language of the statute that specifies what is included in collected proceeds should be read as an exemplary, rather than an exclusive list. The statute prefaces the list of monies included in collected proceeds with the term "includes," which "when used in a definition contained in this title shall not be deemed to exclude other things otherwise within the meaning of the term defined," according to 26 U.S.C. § 7701(c). Therefore, the list included in the statutory language should not be treated as an exhaustive list of the types of monies that fall into collected proceeds, but rather as examples of types of monies that that are included in collected proceeds.

The current regulations, specifically Treasury Regulation section 301.7623-1(c), expressly include fines in the types of monies collected that are used to pay an award. That section currently states:

Prior to the release of IRM 25.2.2.12 Funding Awards (06-18-2010), the IRS had traditionally included criminal fines as part of collected proceeds. The statue was silent on what monies should be included in collected proceeds prior to the 2006 amendments to section 7623, except for an express exclusion of interest from collected proceeds. Nevertheless, the IRS had a long-standing policy of including criminal fines in collected proceeds when it did pay an award under section 7623. IRS policy Statement 4-27 (Aug. 13, 2004) provides:

Restitution payments should also expressly be included in the definition of collected proceeds because these payments are assessed and collected as if they were a tax under section 6201(a)(4). If these payments are assessed and collected as though they were a tax, then logically they should be treated as a tax for award purposes under section 7623. Additionally, by excluding restitution payments from collected proceeds the IRS will receive a windfall. Restitution payments are supposed to put the victim of a crime back in the position they would be in but for the crime. In the case of violations of internal revenue laws, the victim is the United States Treasury and restitution orders are entered for the amount of the underpayment of tax arising from the crime. Had the IRS assessed the underpayment through a civil audit the whistleblower would clearly be entitled to an award; therefore, in order to place the IRS in the same position it would have been in had the assessment been made under a civil audit, the restitution payment should be treated as collected proceeds. The windfall the IRS would receive by excluding these payments from collected proceeds would be at the expense of the whistleblower program as a whole.

Suggested Language for the Proposed Regulation to Address Comment #3:

Treas. Reg. section 301.7623-1(a)(2) should read as follows:

The IRS will need to change its rule about when awards are eligible to be paid from collected proceeds because the current rule can unnecessarily add up to TWO YEARS to the payment process. As discussed above in Comment #1, the IRS's current position, as stated in IRM 25.2.2.12 "Funding Awards," (06-18-2010) paragraph 8, that awards cannot be paid "under 7623(a) or (b) which are based on information which leads to the denial of a claim for refund which otherwise would have been paid" will need to be revoked to comply with the temporary or final regulations if it therein requires that awards be paid from "amounts collected prior to receipt of the information if the information provided results in the denial of a claim for refund that otherwise would have been paid . . ." see Prop. Treas. Reg. section 301.7623-1(a)(2). Our comment relates to the ramifications of this change on when awards become eligible to be paid to whistleblowers under section 7623.

In the "FY 2009 Annual Report to Congress on the Use of Section 7623," (the "Report") the IRS stated that it will not pay any awards on collected proceeds resulting from whistleblower information until after the period of limitations has expired on claims for refund. On page 7 this Report said:

In the Report the IRS explained that it was the operation of this rule that caused a huge decrease in the number of Section 7623 awards paid by the IRS in Fiscal 2009. Specifically, the Report said: "One factor contributing to the lower award payments in FY 2009 was a change in the IRS definition of the point at which proceeds in a tax case are available to make an award payment." Once this policy was put in place, the number of awards paid fell from 198 to 110 and from $22,370,756 to $5,851,608 (Fiscal 2008 vs. Fiscal 2009, respectively), even though the amounts the IRS collected from taxpayers as a result of the Whistleblower Program increased from $155,985,834 to $206,032,872 during those same years. We know firsthand that the collections amount in Fiscal 2010 has greatly increased, and are expecting an exponential increase in collections in following years.

In many cases a taxpayer resolves their issues in dispute with the IRS on a Form 906, "Closing Agreement on Final Determination Covering Specific Matters" and pays the additional tax deficiency they owe. This agreement is commonly used by the IRS Examination Division to close out cases. The Form 870-AD. "Offer to Waive Restrictions on Assessment and Collection of Tax Deficiency and to Accept Overassessment", is commonly used by the IRS Appeals Division to close out cases with a similar effect. Specifically, the effect is that the taxpayer is barred from any further administrative or judicial appeal of the issues that were settled in either of those agreements, even when the period of limitations under section 6511(a) is still open by operation of time for claims for refund on other issues. Because the Proposed Regulations require that awards be paid when the IRS denies a refund based on the whistleblower's information, then an award should be paid irrespective of the status of the period of limitations under section 6511(a). Why? Because it doesn't matter if the taxpayer claims a refund on some other issue, the taxpayer has already irrevocably paid an assessment on the issue raised by the whistleblower and that will ultimately lead to the government either collecting additional tax or denying claims for refund that would have otherwise been paid. If that same taxpayer had not executed the Form 906 or Form 870-AD and paid the assessment on the issues raised by the whistleblower, then the taxpayer could have received in many cases a refund of previously paid taxes. But because of the whistleblower's information, that refund is effectively denied to the extent of the adjustments agreed to on the Form 906 or Form 870-AD and paid by the taxpayer.

Therefore, the IRS will need to change IRM 25.2.2.12 "Funding Awards," (06-18-2010) paragraph 7, to allow for awards to be paid on issues that have been conclusively and finally resolved. We propose the replacement of the last sentence of paragraph seven with the following language: "The award payment cannot be completed until the statutory period for filing a claim for refund expires or there is an agreement between the taxpayer and the IRS that there has been a final determination of tax for the specific period or specific matter relating to the whistleblower's information."

We do not believe that additional language will necessarily need to be added to the Proposed Regulations to give this change effect so long as the language of Treas. Reg. section 301.7623-1(a)(2) ultimately allows for awards to be paid from "collected proceeds" of denied claims for refund. However, Treasury may want to consider adding the following language to the end of Treas. Reg. section 301.7623-1(a)(2) to avoid confusion by the IRS with respect to their ability to pay awards when a section 6511 period of limitations on refunds is still open on issues that do not relate to a whistleblower claim.

Suggested Language for the Proposed Regulation to Address Comment #4:

Treas. Reg. section 301.7623-1(a)(2) could conclude as follows: