Tax Analysts Blog

Gambling on IRS Whistleblower Payouts

Posted on Jun 10, 2010

Hedge funds are continually searching for investment opportunities that hold the potential for huge financial returns, regardless of the associated risk. Their latest strategy is remarkably clever, although something about it rubs me the wrong way.

No doubt you're aware of the tax evasion scandals that have transpired during the last two years. Principle among these is the notorious UBS affair, which caused a major diplomatic spat between the U.S. and Switzerland. Due to the actions of various informants, thousands of U.S. account holders may have had their offshore bank accounts disclosed to the IRS. In some cases the whistleblower is a disgruntled private banker -- such as Bradley Birkenfeld -- who at one time helped bank customers conceal taxable income. In other cases the informant might be a disgruntled business partner or ex-spouse. (Query whether the adjective "disgruntled" is superfluous when used in conjunction the term "ex-spouse".)

You may also know that Congress has specifically authorized such informants to profit from their actions. The Internal Revenue Code contains a provision -- section 7623(b) -- that allows informants to claim a percentage of the tax revenues the government eventually collects as a result of their disclosures. Their reward may range from 15% to 30% of what the IRS collects, and there's no ceiling on the size of the payout.

In effect, this law permits whistleblowers to get a cut of the action. That outcome seems to fair to a lot of people. If the IRS is serious about getting informants to come forward, then dangling an economic incentive in front of them only makes sense. But like most aspects of our tax system, the process of claiming the reward can take forever. After all, any payment requires that a series of tax enforcement procedures are first completed: audit, review, litigation, appeal, etc. That can take many years.

Turns out the financial sector has figured out a way to take advantage of that delay by monetize these potentially lucrative claims. Rather than wait years to receive their payout from the IRS, impatient whistleblowers can assign their recovery claims to third party investors -- who have nothing whatsoever to do with the underlying tax evasion or its disclosure to the IRS -- in exchange for an immediate payment. The size of the up-front payment features a large discount, otherwise there would be no point for the hedge fund to participate. The investors' profit is the annualized spread between the up-front payment to the informant, and the eventual payout from the IRS.

Every deal has it's pros and cons. In this case, the upside to the informant is that they get money sooner rather than later. And later might never come around at all, should the IRS determine their claim lacks merit.The downside is that they forfeit their right to full payment for pennies on the dollar. By some estimates only 35 cents on the dollar. That's a steep discount; but hey -- it's a contingent claim. Section 7623(b) comes with strings attached. For instance, the informant must have clean hands with respect to the tax evasion that occurred.

The downside for the hedge fund is that the IRS might deny the informant's claim altogether, in which case the investors are out the money paid up-front. Their upside is that if the IRS does pay the claim, they can achieve a very impressive rate of return.

I do understand that these arrangements are economically sound. At the most basic level, the transaction results in an intangible asset being exchanged for what two rational parties deem to be adequate consideration. Once the dust settles, the risk of loss is borne by a party that's perfectly content to accept it. That's what hedge funds do; they assume wild risks knowing there's a possibility of a big return. And history has proven this a successful model for the right type of investor.

What we have here is a casino mentality applied to the world of tax enforcement. Sky Masterson, the compulsive gambler from the Broadway classic Guys and Dolls, would certainly approve. But I'm not sure that I do. Call me crazy or old fashioned, but I don't like how these deals look. I have no objection to gambling on the Super Bowl, or the NCAA basketball tournament. But something about gambling on federal tax administration makes me a bit uneasy. Guess I'm a hopeless purist.

What do you think?

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