Thinking About ‘Avoiding’ NY Tax Increases? Then Think About The False Claims Act

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According to Justice Learned Hand, “Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.” [FN: Gregory v. Helvering, 69 F.2d 809, 810 (2d Cir. 1934)] Stated differently, taxpayers have the right to pay only the amount of tax legally due.

Having said that, taxpayers have, over the years, demonstrated varying degrees of aversion to their tax obligations – especially in high-tax states like New York. Those New York taxpayers who are willing to “roll the dice” are hopefully aware of the associated audit risk, but many of them may be ignorant of the exposure they face from New York’s False Claims Act.

Federal Taxes Increases…

Last week, President Biden introduced the first part of his two-part plan to rebuild America’s infrastructure.[i] Under the American Jobs Plan proposed by the President,[ii] the federal government would spend almost $2.3 trillion over a period of eight years[iii] to repair the nation’s infrastructure and to accomplish a whole lot more.[iv]

To help pay for this very ambitious and very expensive plan, the President also introduced the Made in America Tax Plan, pursuant to which the federal income tax rate on corporations would be increased from a flat rate of 21 percent to 28 percent,[v] the minimum tax on a domestic C corporation’s unrepatriated taxable foreign income would be doubled from 10.5 percent to 21 percent,[vi] the taxable portion of such income would be increased by eliminating  the 10 percent “net deemed tangible income return,” and a 15 percent minimum tax would be imposed on the income that “the largest” corporations use to report their profits to investors.[vii]

According to the White House, the second part of the President’s plan – the American Families Plan – will be introduced “in a few weeks.” It is expected that this Plan will be accompanied by its own companion tax plan, that will likely propose individual tax increases for ordinary income, long-term capital gain, qualified dividends, and perhaps a reduction in the unitary federal estate and gift tax exemption amount.[viii]

…and New York Tax Increases

In the spirit of what may turn out to be a Federal tax frenzy, and not to be outdone by another taxing jurisdiction, the New York Legislature last month proposed approximately $7 billion in new taxes on wealthy New Yorkers and on businesses for the upcoming fiscal year.[ix]

How will wealthier New Yorkers respond to this tax onslaught?

Some will resign themselves to biting the proverbial bullet – the combined Federal and New York tax increases are going to hurt,[x] but these individuals are not yet ready to leave the State, let alone expatriate to a tax haven.[xi]

Others will recognize that, although they cannot eliminate their Federal taxes, they can reduce their state and local taxes by leaving New York for warmer climes.[xii]

Most will consult their tax advisers to formulate some reasonable strategies for reducing their taxes or otherwise mitigating the economic impact thereof.

Then there are those for whom tax increases are anathema, and who will employ almost any method to avoid[xiii] paying them.

Query whether the individuals who fall within this last group of taxpayers sleep soundly at night? Many of them certainly do – their hubris is such that they are nearly blind to the nature and potential consequences of their acts. Then there are those who have implemented what they believed, at the time, was the “perfect” tax-avoidance scheme, but who live in constant dread of being audited.[xiv]

Increased Enforcement…

This last group of taxpayers may have greater cause for concern these days. For instance, the President’s American Jobs Plan calls for “a broader enforcement initiative” and aims to provide the IRS with the resources it needs to enforce the tax laws.

Moreover, unlike many other parts of the President’s legislative agenda, there is bipartisan support for increased enforcement efforts.

But why should a New York taxpayer be concerned about Federal enforcement activity when considering their state income tax liability?

Because federal tax adjustments may require state tax adjustments; if the taxpayer fails to report these adjustments to the state, the regular New York statute of limitations for the assessment of a tax deficiency[xv] will be suspended, and New York may assess the resulting tax liability at any time.[xvi]

In addition, of late, New York has taken the initiative in examining taxpayers’ income tax returns on a substantive level – interpreting the Code when New York tax law conforms with such federal law – rather than waiting for the IRS to do so, and then riding on the federal agency’s coattails, as it were.[xvii]

But Wait – There’s More

“More?” you may ask. “Something worse than increased enforcement activity?”[xviii]

You may recall that, early last month, New York Attorney General James and New York City Corporation Counsel Johnson announced the recovery of $105 million in back taxes and damages from a hedge fund manager, Thomas Sandell, who defrauded the State and City out of income and employment taxes on deferred compensation.[xix]

The above sum was paid pursuant to a settlement agreement that was reached in February of this year.[xx]  According to the agreement, Sandell – who was a New York State and City resident for the periods at issue – sought to avoid the recognition of approximately $450 million in deferred management and performance fees and, thereby, avoid paying State and City taxes thereon, notwithstanding that the fees were earned from investment management services performed in the City.[xxi]

Sandell was advised by certain tax professionals that he could reduce or eliminate his New York tax liability by, among other things, removing his business and its operations from New York.

In reliance upon this advice, Sandell opened a three-person office in Florida (really a shell with three back-office employees) which was held out as his principal office. To bolster this position, he took steps (often with the assistance of an accounting firm) to make it appear as though he no longer operated in New York; for example, to conceal the New York presence of his business, Sandell arranged to funnel its rent and payroll expenses (for which the business remained responsible) through another entity that he controlled. Sandell, himself, left New York to live in London.

When Sandell filed his New York State and City personal and business tax returns for the year at issue, he claimed no taxes owing, even though his business continued, in fact, to operate in New York City.

Almost immediately after the above tax returns were filed, a qui tam action[xxii] was filed against Sandell and his business entities pursuant to New York’s False Claims Act (the “Act”).[xxiii] This action is basically a whistleblower lawsuit in which a private party (the “relator”), who has not been directly harmed by the defendant, brings an action essentially on behalf of the government.[xxiv]

In Sandell’s case, the relator (Tooley, LLC[xxv]) alleged that Sandell “made, used, or caused to be made or used, false statements that were material to [Sandell’s] obligation to pay or transmit money [i.e., taxes] to the State and to the City.”

The Attorney General commenced an investigation in connection with the allegations made in the relator’s complaint. The investigation found that Sandell performed the investment services that generated the deferred fees at issue exclusively in New York City, that his deferred fees were therefore taxable in New York State and the City, and that Sandell owed back taxes to both jurisdictions.

The outcome of the Attorney General’s findings was the February 2021 settlement agreement and the March 2021 payment.

The Whistleblower

“You know how to whistle, don’t you, Steve?

You just put your lips together and… blow.”[xxvi]

In its March 2, 2021 press release announcing the Sandell settlement, the Office of the Attorney General expressed its appreciation to the whistleblower – the relator, Tooley LLC – “without whose information the misconduct might not have been discovered.”[xxvii]

More important than the Attorney General’s “appreciation,” however, at least from the relator’s perspective, was the $22 million that was payable to the relator pursuant to the Act; as explained in the press release, “whistleblowers are entitled to receive a percentage of settlement proceeds for bringing this misconduct to light.”

According to the Attorney General’s Whistleblower Portal,[xxviii] “[t]he New York Attorney General welcomes and encourages whistleblowers, tips, and complaints. Whistleblowers are essential to fulfilling our mission – protecting the citizens of New York.”

The foregoing statements from the Attorney General’s press release and from its website have two purposes: first, to encourage individuals who have information regarding the kinds of wrongdoing covered by the Act – i.e., potential whistleblowers – to come forward; and second, to dissuade potential wrongdoers from doing wrong by giving them a reason for doubting the loyalty or “discretion” of those individuals with, or to, whom they necessarily share or disclose information regarding their activities.

The Act[xxix]

The Attorney General’s statements echo the history of the 2010 legislation[xxx] by which New York extended the reach of the Act to include taxes, and expanded the protections provided to whistleblowers.[xxxi]

Taxes

According to the Act, any person who “knowingly”[xxxii] makes, uses, or causes to be made or used, a false record or statement material to an obligation to pay or transmit taxes (for example income taxes and withholding taxes, respectively) to the State,[xxxiii] or who conceals, or knowingly and “improperly” avoids or reduces their statutory obligation[xxxiv] to pay or transmit taxes to the State, shall be liable to the State for a civil penalty of not less than $6,000 and not more than $12,000 (as adjusted to be equal to the civil penalty allowed under the federal False Claims Act), plus an amount equal to three times the amount of all damages which the State sustains because of that person’s acts.[xxxv]

The foregoing rule applies to claims, records, or statements made under the tax law only if (i) the net income or sales of the person against whom the action is brought equals or exceeds $1 million for any taxable year subject to any action brought pursuant the Act,[xxxvi] and (ii) the damages (i.e., the tax deficiency) pleaded in such action exceed $350,000.[xxxvii]

Qui Tam

The Act provides that any person may bring a qui tam civil action for a violation of the tax laws on behalf of the State.[xxxviii]

The State may choose to supersede or intervene and proceed with this action. The Attorney General is required to consult with the Department of Taxation and Finance prior to intervening in any qui tam action that is based on the filing of false claims, records or statements made under the tax law. If the State declines to participate in such an action, the qui tam plaintiff must obtain approval from the Attorney General before making any motion to compel the Department of Taxation and Finance to disclose tax records.[xxxix]

Award

If the Attorney General elects to convert the qui tam civil action into an enforcement action, or if the Attorney General elects to intervene in the qui tam action, then the person who initiated the qui tam action may be entitled to receive between 15 and 25 percent of the proceeds recovered in the action or in settlement of the action. It is up to the court to determine the percentage of the proceeds to which a person commencing a qui tam action is entitled, by considering the extent to which the plaintiff substantially contributed to the prosecution of the action. If the Attorney General does not elect to intervene or convert the action, and the action is successful, then the person who initiated the qui tam action which obtains proceeds may be entitled to receive between 25 and 30 percent of the proceeds recovered in the action or settlement of the action.[xl]

Forewarned is Forearmed

The Sandell whistleblower case is the most recent example of how New York’s False Claims Act has assisted the State in tracking down tax cheats who may otherwise have gotten away; it is also the largest such case involving an individual.

That said, the Sandell case is far from being an isolated matter. For example, in 2018, the Attorney General announced a record $330 million settlement of a New York False Claims Act lawsuit filed against Sprint and some of its subsidiaries in connection with their failure to collect and remit State and local sales taxes.[xli] The investigation leading to that settlement began with a whistleblower lawsuit filed under the Act.[xlii]

As we enter a period of Federal and New York tax increases, there will be individuals and businesses that may be inclined to push the proverbial envelope. Considering what is expected to be a more aggressive tax enforcement environment, and in recognition of the very real threat presented by the State’s False Claims Act, any tax-saving strategy that is to be implemented by such a taxpayer will have to be thoroughly researched and documented if it is to have a reasonable chance of withstanding scrutiny, either by the State or in a qui tam action brought by a less than civic-minded individual.

[i] https://www.whitehouse.gov/briefing-room/statements-releases/2021/03/31/fact-sheet-the-american-jobs-plan/ . Remember “Build Back Better?”

[ii] By the way, did you notice the pattern here: the American Rescue Plan (the $1.9 trillion economic stimulus bill enacted into law last month), the American Jobs Plan, the Made in America Tax Plan the American Families Plan?

[iii] I guess Mr. Biden is counting on being re-elected and on retaining control of both Chambers of Congress. Pie-in-the-sky? Perhaps. After all, the Republicans need to win only one seat in the Senate in 2022 to neutralize the Vice President and put the break on most legislation that may be introduced by the Democrats.

[iv] For example: fix the nation’s highways and bridges, upgrade its ports, airports and transit systems, renew the electric grid, bring high-speed broadband to all parts of the country, revitalize manufacturing and secure the nation’s supply chains, invest in research and development, create a network of small business incubators, and invest in workforce development.

[v] Before the 2017 Tax Cuts and Jobs Act (“TCJA”), the federal corporate income tax was determined on a graduated scale with a maximum rate of 35%.

[vi] The TCJA introduced a new class of income – global intangible low-taxed income (“GILTI”) – that must be included in the gross income of a U.S. Shareholder of a CFC (other than subpart F income), and which further eroded a U.S. person’s ability to defer the U.S. taxation of foreign-sourced business income.

This provision requires the current inclusion in income by a U.S. Shareholder of (i) their share of all of a CFC’s non-subpart F income (other than income that is effectively connected with a U.S. trade or business and income that is excluded from foreign base company income by reason of the “high-tax” exception), (ii) less an amount equal to the U.S. Shareholder’s share of 10% of the adjusted basis of the CFC’s tangible property used in its trade or business and of a type with respect to which a depreciation deduction is generally allowable (the “net deemed tangible income return”); the difference is the shareholder’s GILTI.

In the case of an individual, the maximum federal tax rate on GILTI is currently 37%. This is the rate that will apply, for example, to a U.S. citizen who directly owns at least 10% of the stock of a CFC.

More forgiving rules apply in the case of a U.S. Shareholder that is a C corporation. For taxable years beginning after December 31, 2017, and before January 1, 2026 – yes, that is right, the Plan merely accelerates a scheduled increase in the rate – a regular domestic C corporation is generally allowed a deduction of an amount equal to 50% of its GILTI; thus, the federal corporate tax rate for GILTI is actually 10.5% (the 21% flat rate multiplied by 50%).

[vii] Their “book income.”

[viii] See IRC Sec. 1(h): long-term gains and qualified dividends are currently subject to federal income tax at the maximum rate of 20%.

Mr. Biden has proposed increasing the maximum federal individual income tax rate on ordinary income from 37% to 39.6%.

[ix] https://www.rivkinradler.com/publications/new-york-is-poised-for-some-significant-tax-increases/ .

[x] Especially in the absence of an itemized deduction for SALT. It should be noted that, last week, several Democratic Representatives (including Tom Suozzi from Long Island) indicated that they would not support tax hikes to fund the President’s infrastructure plans unless the $10,000 cap on the deduction of state and local taxes was eliminated from the Code. Under current law, this cap is set to expire after 2025.

[xi] Although almost any of the Caribbean tax havens is enticing, the “exit tax” imposed upon the deemed sale of the assets of “covered expatriates” under IRC Sec. 877A will dissuade many individuals from giving up their status as U.S. persons.

For shits and giggles, you may want to check out the IRS’s quarterly publication which discloses the name of every individual giving up their U.S. citizenship during the preceding quarter.

[xii] In one of his radio shows, the humorist and writer, Garrison Keillor, “explained” that the migration from the northern to the southern parts of the country has increased the average IQ of both. Ha!

[xiii] “Avoidance” is not, per se, a bad thing. Evasion is.

[xiv] Like the narrator in Poe’s The Tell-Tale Heart, who, after murdering and dismembering his victim, hides the “body” under the floorboards of his room. It’s not long after that he starts to “hear” what he believes is the beating of the dead man’s heart.

[xv] In general, three years from the filing of the tax return.

[xvi] N.Y. Tax Law Sec. 659 and Sec. 683.

If the taxpayer omits from their tax return an amount of gross income that exceeds 25% of the gross income reported on their tax return, the limitations period for assessment of the additional tax becomes six years.

There are other exceptions to the general three-year rule.

[xviii] This question reminds me of a story. Once, when I was in college in the early ‘80s, I took the Broadway Local down to the garment district to drop off something with my dad. He introduced me to his employer, who was kind enough to sit with me for a while, and to discuss my future. At some point, he complained about his accountant. When I suggested that he find another accountant, he replied: “Louie, I wish I could, but this guy knows every skeleton in my closet.”

[xix] https://ag.ny.gov/press-release/2021/attorney-general-james-and-nyc-corporation-counsel-johnson-announce-recovery-105 .

[xx] It is interesting to note that Sandell neither admitted nor denied wrongdoing in the settlement agreement. State of New York, ex rel. Tooley, LLC vs Thomas Sandell, Sandell Asset Management Corporation, and SAMC Partners LP, Supreme Court New York County, Index No. 101494/2018.

https://ag.ny.gov/sites/default/files/2021.02.19._fully_executed_sandell_settlement_agreement_emailed_to_d._counsel_at_651_pm.pdf .

[xxi] The services at issue were performed during the 10-year period ending with 2008; as a result of a change in federal law, the compensation earned for these services was not includible in income until 2017. Sandell “reorganized” his business so as to be outside New York in 2017, or so he thought.

[xxii] For a brief discussion of “qui tam” cases, generally, see https://www.nycbar.org/get-legal-help/article/employment-and-labor/whistleblowers/qui-tam/ .

[xxiii] State Finance Law, Art. 13, Sections 187-194.

[xxiv] In other words, the government becomes the real party-in-interest.

[xxv] The owners of which were not disclosed in the settlement agreement.

[xxvi] Lauren Bacall to Humphrey Bogart, in To Have and Have Not (which was based very loosely on Hemingway’s novel of the same title). It was the debut for the 20-year old from the Bronx.

[xxvii] https://ag.ny.gov/press-release/2021/attorney-general-james-and-nyc-corporation-counsel-johnson-announce-recovery-105 .

[xxviii] https://ag.ny.gov/whistleblower .

[xxix] https://ag.ny.gov/tpb/procedural-regulations-false-claims-act .

[xxx] S7169B. https://www.nysenate.gov/legislation/bills/2009/s7169/amendment/b ;

https://www.csg.org/sslfiles/dockets/2012cycle/32B/32Bbillls/1332b06nywhistleblowerfraud.pdf .

[xxxi] Act Sec. 191. Any current or former employee, contractor, or agent of any private employer who is discharged, demoted, suspended, threatened, harassed or in any other manner discriminated against in the terms and conditions of employment, or otherwise harmed or penalized by an employer, or a prospective employer, because of lawful acts done by the employee, contractor, agent, or associated others in furtherance of an action brought under the Act or other efforts to stop one or more violations of the Act, shall be entitled to all relief necessary to make the employee, contractor or agent whole.

[xxxii] Meaning that a person: (i) has actual knowledge of the information; (ii) acts in deliberate ignorance of the truth or falsity of the information; or (iii) acts in reckless disregard of the truth or falsity of the information; it does not require proof of specific intent to defraud; however, acts occurring by mistake, or as a result of mere negligence, are not covered. Act Sec. 188.3.

[xxxiii] Or to a local government.

[xxxiv] Act Sec. 188.4.

[xxxv] Act Sec. 189.1(g) and (h). Treble damages.

[xxxvi] These threshold figures should cover most businesses and wealthy individuals.

[xxxvii] Act Sec. 189.4.

[xxxviii] Act Sec. 190.2. However, if the allegations in the complaint involve damages only to a city with a population of one million or more (i.e., New York City), then the attorney general may not supersede or intervene in such action without the consent of the corporation counsel of such city.

[xxxix] If the State declines to participate in the action, the qui tam action may proceed subject to judicial review, the civil practice law and rules, and other applicable law.

As to the specificity of the pleadings and the burden of proof, see Act Sec. 192. https://www.nysenate.gov/legislation/laws/STF/192 .

[xl] Act Sec. 190.6.

[xli] https://ag.ny.gov/press-release/2018/ag-underwood-and-acting-tax-commissioner-manion-announce-record-330-million .

[xlii] The whistleblower received $62.7 million.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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