United States: A Decade Of Lessons Learned From State Tax False Claims Act Cases

The last decade has witnessed a large upswing of False Claims Act (FCA) cases filed in the state tax arena.  New York, particularly in the last few years with Attorney General Eric Schneiderman at the helm, has sharpened its tools and upped its enforcement efforts.  The New York False Claims Act was amended in 2010 to allow private citizens acting on behalf of the state to bring a tax claim alleging fraud against taxpayers who met a certain financial threshold.  The amendments provide for treble damages, rewards of up to 30 percent of liability and a 10-year statute of limitations, which is years beyond the statute of limitations governing state tax audits.  In Illinois, hundreds of state tax FCA cases have been filed by a single plaintiff law firm, triggering a State House Revenue and Finance Committee hearing on the abuse of the Illinois FCA, as well as proposed legislation that would put significant limitations on the filing of such claims.  Across the United States, unclaimed property laws also have seen their fair share of FCA litigation.

At present, 29 states, the District of Columbia, New York City, Chicago, and Allegheny County, Pennsylvania, have FCA statutes.  Of those jurisdictions, eight (Delaware, Florida, Nevada, New Hampshire, New York, Washington, Wisconsin and Chicago) permit state tax FCA claims involving any type of tax.  Three others (Illinois, Indiana and Rhode Island) bar only income tax FCA actions; any other type of state or local tax is fair game.  The remaining jurisdictions either bar all tax-related claims or are limited to Medicaid-related claims.

FCA laws, also referred to as qui tam or whistleblower laws, allow third-party private citizens ("whistleblowers" or "relators") acting on behalf of a government to sue persons who knowingly make or use a false statement material to an obligation to pay money to the government.  In the tax arena, such claims frequently are brought as "reverse" false claims, alleging a knowing concealment or avoidance of a tax obligation.  "Knowingly" is broadly defined by the FCA laws as actual knowledge, deliberate ignorance of the truth or falsity of information, or acting in reckless disregard of the truth or falsity of information.

The penalties associated with an FCA violation are severe, and the potential reward to a whistleblower is significant.  Persons found to have violated a state FCA may be found liable for three times the amount of unpaid tax, interest and penalties, plus per-occurrence civil penalties (up to $11,000 per false claim in Illinois) and costs.  Up to 30 percent of the proceeds of any judgment or settlement may be awarded to the whistleblower, together with its costs, expenses and reasonable attorneys' fees.

The groundswell of such litigation appears to be rising.  Although one state (Tennessee) amended its statute to bar the use of FCA cases in the tax arena, proposed legislation to amend the Illinois statute to limit tax-related claims has stalled in committee.  Recently, the Multistate Tax Commission Income and Franchise Tax Uniformity Subcommittee formed a working subcommittee to begin drafting a model provision for state false claims acts.

With no universal shutdown of state tax FCA actions on the horizon, this article offers the following practical recommendations to the taxpayer community for defending against third-party FCA claims.  A subsequent article will offer practical tips for guarding against FCA claims brought by insiders, including employees. 

1.  Oppose the enactment of these laws.  Be a strong voice against the use of FCA litigation in the tax arena.  Emphasize the powerful enforcement mechanisms that already are present and available for use by state tax departments against tax cheats.  Explain the risks created when private citizens, with no tax experience, are armed with legislation that gives them the power to drive tax policy by filing whistleblower claims.  Do not accept any assurance that a state statute is a copy of the federal FCA, which "has a tax prohibition."  Smart whistleblowers recognize that there is ample opportunity to bring tax-related state FCA litigation under such statutes, because they only prohibit income-tax-related claims.  See, e.g., the Illinois FCA and related litigation, all of which involve sales and use tax-related claims under a state statute modeled on the federal FCA.  The Indiana and Rhode Island statutes are similarly worded.

2.If you are sued, expect a healthy dose of skepticism for your point of view, even if the case filed against you is, from your perspective, completely without merit.  Generally speaking, the general public, judges included, believe whistleblower lawsuits serve a useful purpose because they ferret out fraud against the government.  Rightly or wrongly, many people view fraud on the government as a rampant problem.  In the tax arena, these views are exacerbated by the fact that everyone hates a tax cheat.  These ingrained beliefs can present a significant hurdle that must be overcome in order to prevail in the defense of FCA litigation.

3.Be prepared to present your case to the court, and perhaps also the state lawyer assigned to the matter, in a simplistic manner.  Because FCA litigation typically arises outside the context of a traditional state tax proceeding, such lawsuits often are assigned to courts and state's lawyers with little or no tax background.  In fact, the state taxing authority may not even be named as a party to the litigation.

Individuals without a background in taxation frequently take frivolous claims more seriously than would a more experienced opponent or jurist (see "everyone hates a tax cheat," above).  As a result, it is critical for you to explain your tax position clearly and succinctly.  It is difficult for a judge to agree to dismiss a case as meritless if he or she does not understand the defect in the whistleblower's tax claim.

If your jurist also lacks experience with FCA litigation, analogize your arguments to other legal concepts that the jurist frequently addresses in other types of litigation.  For example, in a motion to dismiss, argue that FCA litigation is like fraud litigation, in that a relator's claims must be pled with specificity.

4.Recognize that the state has competing interests in the litigation.  In all likelihood, the state did not initiate the FCA litigation.  The state's lawyers may even agree with you, at least privately, that the whistleblower's claim lacks merit.  Despite this fact, the state may not have the resources to take an active role in the matter.  It may simply decline to intervene, which frees the whistleblower to proceed with the litigation on its own.  This is cheaper for the state, but it does not relieve the litigation expense for the taxpayer defendant.

Even more importantly, recognize that a state's interest in helping taxpayer defendants named in unworthy cases is compromised by the fact that the state will benefit if the cases are settled rather than dismissed.  At least 70 percent of the dollars paid in any settlement go to the state's coffers.  In some states, a portion of the funds collected in FCA litigation go straight to the budget of the state attorney general, rather than to the general revenue funds into which tax payments typically are deposited.  As a result, you may find it far easier to persuade a state official to support a nominal settlement of an unworthy FCA case than to publically support your claim that the lawsuit is meritless.

Be aware also that states must analyze their actions in the broader context of all state FCA litigation, not just tax cases.  A state's lawyer may be unwilling to publically express a view that a case lacks merit for fear that it may compromise the state's ability to use the FCA in other, more worthy disputes.

5.  Be wary of the power of the state.  It is the "real party in interest," with strong rights of control over the litigation, even when it does not intervene, including the right to control discovery and a preferential dismissal standard.  In addition, the state's approval is essential to the settlement of any FCA matter.  Cultivate a strong working relationship with the state's lawyer(s) assigned to your FCA case, even if the state doesn't intervene, so you can call on the state's lawyers for assistance when needed.

6.  Use joint defense groups when appropriate.  If multiple lawsuits have been filed against a number of defendants on the same issue, consider forming a joint defense group to share ideas and work together on common issues.  Be prepared, however, to stand out from the pack in order to emphasize the more favorable aspects of your case.

7.  Call the whistleblower's bluff on unworthy cases.  If the case filed by the whistleblower is meritless and, from your perspective, is worthy of a fight, aggressively defend your position.  Seek to have the case dismissed.  Issue discovery requests that require the whistleblower to disclose evidence supporting the required elements of its claim, including that the whistleblower is an original source, that there was no prior public disclosure of the tax issue, and any evidence of deliberate misconduct.  Consider filing a counterclaim seeking your attorneys' fees and expenses on the ground that the whistleblower's claim is frivolous.  Many whistleblowers file these suits hoping for a quick settlement.  If you make it apparent that you intend to aggressively defend your litigation, the whistleblower may back away, focusing instead on less bothersome opponents.

8.  Be prepared to settle, but recognize that you may be required to pay the whistleblower's attorneys' fees, costs and expenses.  FCA lawsuits can be expensive to defend, even when the underlying tax claims are without merit.  When the amount at issue is small and/or the defense to the underlying tax claim is weak, it may be cheaper for a taxpayer defendant named in FCA litigation to negotiate a settlement. 

Most FCAs provide that a whistleblower that "prevails" in the litigation is entitled to its reasonable attorneys' fees, costs and expenses.  Courts have ruled that a whistleblower is deemed to have "prevailed" when it enters into a court-approved settlement.  In the event you decide to settle, be prepared to compensate the whistleblower for its reasonable attorneys' fees, costs and expenses, without regard to the merits of the underlying claim.  Fees and expenses also can be awarded to the state.

9.  Use state audits for protection.  Take steps now to keep yourself from being named in this type of litigation.  Disclose your "no tax" positions to state auditors and get their approval, in writing if you can (or preserved in an internal memo if you cannot).  Evidence of a state's favorable review of an issue on audit is extraordinarily helpful in defeating a whistleblower's subsequent claim of a deliberate, knowing failure to collect and remit a particular tax.

10.  Recognize the inherent limitation of relying upon secondary sources.  Secondary sources can provide a good overview of a state's tax structure.  Do not assume, however, that such sources are always up to date or accurate, or that your reliance on information contained in such sources can absolve you from any whistleblower claim.  Secondary sources do miss new developments, as well as the nuances that may be created by case law.

Make sure that someone in your organization is responsible for following new state tax developments.  If your organization prepares a regular survey of state tax obligations, keep the document up to date.  Conduct your reviews as frequently as the title (for example "annual survey") of the document suggests.

11.  Consider the risk of FCA litigation in your tax planning.  When deciding whether to take a particular tax position, consider not just the possible penalties and interest associated with an adverse audit determination, but also the risk of FCA or class action litigation.  Risky tax positions can be fodder for such litigation.

12.  Lobby for the amendment of bad laws.  Speak up in favor of the amendment of existing state FCAs to exclude tax claims, or other modifications designed to limit a whistleblower's right to file tax-related claims.  The proposed amendment to the Illinois FCA statute was introduced after the House Revenue and Finance Committee held a public hearing on FCA abuse in the tax arena at which taxpayers testified about the expense and disruption caused by the litigation.

While most would agree that there are contexts in which whistleblower claims are useful in ferreting out government fraud and abuse, the use of such claims in the state tax arena is problematic at best, especially as many of such laws are currently enacted.  If you have the misfortune of being named in one of these suits, rely on the above principles to guide you through the litigation. 

A version of this article originally appeared in State Tax Notes.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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