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June 23, 2014
Qui Tam Troubles, Part 2: A Relator Seeking to Second-Guess Audits
by Amy Hamilton

Full Text Published by Tax Analysts®

A situation in Illinois that practitioners and tax administrators alike already described as a nightmare has taken a turn for the worse.

The Chicago-based class action law firm that for more than a decade has been stepping into the role of whistleblower and filing hundreds of qui tam actions of questionable merit under the Illinois False Claims Act is now starting to claim the right to second-guess completed audits.

"This is causing all sorts of problems," said Jordan Goodman, partner at Horwood Marcus & Berk Chartered. "The Department of Revenue and taxpayers have closed out the years under audit. They've done an audit and they looked at the issue specifically and came to a conclusion. And now they've got an outsider who doesn't really know much about tax second-guessing their positions."

Goodman is referring to Stephen Diamond, a director at Schad, Diamond & Shedden PC and the relator in hundreds of qui tam tax actions filed in Illinois over the last 10 years. Diamond did not respond to multiple requests for comment from Tax Analysts.

The first article in this series provided an overview of the two rounds of Schad Diamond's qui tam tax litigation that is driving much of the national discussion about potential abuses of state false claims acts that extend to taxes. Critics argue that the firm isn't a true insider that whistleblower laws were meant to reward but a financially motivated third party exploiting the qui tam process, the lack of clarity surrounding the laws in question, and the threat of triple damages to force businesses to settle unwarranted suits.

In this article, Mark Dyckman, the Illinois Department of Revenue's deputy general counsel for sales tax litigation, says the possibility that Illinois judges will allow the relator to get his hands on audits is causing heartburn for businesses and their tax advisers. It's also raising serious administrative and policy concerns for the DOR and the Office of the Attorney General, Dyckman says.

Meanwhile, taxpayers and their advisers argue that the attorney general should be jumping in to exercise its prosecutorial discretion in cases in which the taxpayer has already been audited. That's not what's happening.

According to Dyckman, the state's experience with the first round of Schad Diamond qui tam tax actions and with the relator in the second round of litigation is shaping the attorney general's current policy on intervening to dismiss cases. But businesses and their advisers are frustrated that the state is allowing the suits to proceed on a case-by-case basis rather than issuing a blanket order or intervening to dismiss more cases in which the DOR has already audited the retailer and examined the specific issue for the years in question.

The final installments of the series will feature an interview with an advocate for the use of false claims acts in the state tax arena, and an article highlighting the components of New York's approach to litigating qui tam tax actions that officials say are critical for success.


No Blanket Intervention

Schad Diamond purports to conduct its own investigations into the sales and use tax practices of online retailers by buying items over the Internet. When the retailer fails to collect tax -- on the purchases in the first round of cases, and on a portion of shipping and handling charges in the second -- Schad Diamond files a qui tam action alleging that the retailers have committed fraud by knowingly failing to collect tax. The firm can file these whistleblower actions as the consumer in the transactions.

"The cases have clearly interfered with the administration and enforcement of tax law and may have even ultimately cost the state money, though it's impossible to quantify how much," Dyckman said.

But according to Michael Wynne, a partner at Reed Smith LLP, "The Department of Revenue is suffering the unintended consequences of doing nothing."

Last decade, Schad Diamond brought the same kind of nexus qui tam tax actions in Nevada and Tennessee, but attorneys general in those states intervened early on, and they won dismissal of the suits on the grounds that the actions were inconsistent with the states' obligation to enforce and interpret the tax law. By contrast, the Illinois attorney general intervened in support of the plaintiff in some of Schad Diamond's nexus qui tam actions.

Now Schad Diamond is filing qui tam tax actions when retailers fail to collect tax on a portion of shipping and handling charges, a complicated issue in Illinois. A recent state supreme court decision said there is tax due when the charges are inseparable from the underlying purchase, while a DOR regulation (86 Ill. Adm. Code section 130.415) provides that there is no tax due when the shipping charges are separately contracted for and negotiated.

According to Reed Smith advisers, several of the pending shipping and handling qui tam tax actions involve:

  • retailers that have received DOR approval of their tax treatment of shipping charges under audit;
  • retailers that have completed general sales and use tax audits -- though it's unclear whether the DOR specifically considered the treatment of shipping charges as part of the audit; or
  • retailers with pending audits in which the shipping and handling issue has been raised but not resolved because of the ongoing litigation.

Taxpayers are filing motions to dismiss the Schad Diamond complaints based on the fact that the DOR has already audited them and the audit period had been closed. But aside from a handful of early cases, the attorney general is declining to intervene, Wynne said.

Dyckman said there are generally three ways these cases can go: The attorney general can move to dismiss on prosecutorial discretion, the case can be settled, or the retailer can try to build a case to win on the merits.

The attorney general has made a policy decision against blanket intervention in most of the shipping and handling qui tam tax cases, Dyckman said. He said that decision is based partly on the state's experience with the earlier nexus qui tam actions and the amount of resources and time it took the state to deal with those 104 individual cases.

Dyckman said that this time around, instead of getting involved in 266 different shipping and handling qui tam tax actions, the attorney general's office is monitoring a number of the suits.

"They would prefer, for the greater good, that some of the taxpayers' attorneys go forward and file their own motions, in which case the attorney general may intervene on behalf of the substance of those motions and try to win that particular issue on the merits," Dyckman said. If a judge were to rule on the merits in one of the test cases supported by the attorney general, that might set a precedent and permanently resolve the matter in another two dozen cases with similar facts, Dyckman said.

Dyckman said there's another important reason why the attorney general is taking this approach: "Whenever the attorney general wants to push for prosecutorial discretion for dismissal or a settlement, the relator has a tendency to allege collusion between the department and the taxpayer and the attorney general."


A Judge Weighs In

During Schad Diamond's first round of qui tam litigation, an Illinois appellate court ruled in one consolidated case that Stephen Diamond was not the original source and thus couldn't proceed with a whistleblower complaint in the action. But each new qui tam action stands on its own, and the Illinois courts and attorney general generally are very protective of False Claims Act litigation, providing the relator a lot of leeway.

There is a late-breaking development that practitioners find encouraging: In a June 5 bench ruling in the first Schad Diamond shipping and handling case to go to trial, Judge Thomas Mulroy not only ruled against Schad Diamond but wondered aloud why the case was even before him.

"One cannot but wonder why this case is authorized by the State of Illinois and brought under these facts," Mulroy said, according to a transcript of the proceedings. "It stands logic on its head in my opinion to hold the taxpayer to a higher standard of knowledge on the taxation of delivery charges than the Illinois Department of Revenue."

The case, State of Illinois Ex Rel. Schad, Diamond and Shedden v. FansEdge, Inc., involved an online retailer of professional and collegiate sports apparel and products. Schad Diamond alleged that the company's sales tax returns were false because they omitted tax on shipping.

The transcript of the bench ruling indicates that Diamond had deposed the controller who signed the company's sales tax returns and subjected the controller what Mulroy called "a detailed, aggressive, and loud examination" about how he concluded that FansEdge did not owe tax on shipping and handling. In addition to conducting his own extensive research and legal review, the controller had been told by DOR auditors during one examination that FansEdge did not owe tax on the shipping and handling charges.

It turns out the DOR conducted not one but two detailed audits of FansEdge in which it had considered the issue of tax on shipping charges; both times the DOR concluded that the company did not owe tax on the charges. In his bench ruling, Mulroy said that because the DOR was the alleged victim, he had looked at the evidence of what the DOR knew at the time of the two audits.

"I find that they're the experts, not the taxpayer, about whether tax was due," Mulroy said.

He added that he did not consider any of the hearsay statements that Diamond elicited from the controller regarding the controller's conversations with the DOR's auditors, which the judge said Diamond found objectionable.

Mulroy ruled from the bench that Schad Diamond failed to meet the burden of proving that the defendant "intentionally, knowingly, or recklessly" concealed from the DOR that it was not collecting tax on its shipping charges. Mulroy also assessed court costs against Schad Diamond.

However, in another case, a judge has already rejected motions to dismiss Diamond for not being the original source and ruled that even a prior audit is not a "prior public disclosure" unless one can factually establish that shipping and handling was looked at in the audit.

Dyckman acknowledged that the state's decision not to intervene in more cases where the taxpayer has already been audited is causing tensions. He also said the new trajectory the story is taking in Illinois raises a corollary concern of the government and asked, "If a taxpayer has been audited by the Department of Revenue on that issue, do they have the ability to rely on those findings?" He said he believes the courts will ultimately have to decide the answer.


Second-Guessing Audits

Dyckman then discussed what is starting to happen when the attorney general attempts to intervene to dismiss a shipping and handling case on the grounds that the DOR has already conducted an audit or when a taxpayer files a dispositive motion saying the DOR has already audited them.

"The relator is saying, 'I want to see the results of the audit. I want you to prove that the department did the audit right,'" Dyckman said.

Dyckman said the relator hasn't made this argument a lot yet and that it's possible that the facts will be developed in one of the motions in such a way that a judge would rule that if the DOR has already audited the business, then that's the end of the discussion. "But we just don't know," he added.

That a relator could question an auditor on the stand about an examination completed almost a decade earlier raises serious concerns for the government, Dyckman said. When the DOR hasn't assessed additional tax on an issue, it might not be clear when looking at an audit file several years after the fact whether the DOR gave the business a clean bill of health on the issue or never even looked at it, Dyckman said.

That absence of information can itself be used against the taxpayers and the state, Dyckman said. The relator could challenge "a perfectly good audit on that basis," he said.


'Horrendous Mayhem'

Wynne said that with the attorney general declining to intervene and seek dismissal of more suits covering tax periods already audited or currently under audit, there are shipping and handling qui tam actions in which a business's tax liability might be $12,000 but attorney fees are mounting to $70,000 before the cases even really get started.

"So when the department says the attorney general is waiting for test cases, it's a horrendous mayhem to taxpayers who have to spend money and pay huge amounts just to settle cases that are unwarranted," Wynne said.

"They leave it to us to explain to a judge why an audit is legally determinative," Wynne added. "Judges have been responsive to the attorney general's office when it steps in. When they don't intervene, it leaves the impression there might have been something wrong."

The attorney general's office declined to comment for this series.

A Reed Smith client alert in February described cases in which defendant retailers filed motions to dismiss a Schad Diamond complaint because the DOR either had already audited the purchases serving as the basis for the qui tam action or were in the process of being audited. The Illinois attorney general declined to intervene in one case, and it opposed efforts in another case to join the DOR as a party so it could make the case itself that its audits cover what was examined and what could have been examined.

In the latter case, the taxpayer filed a third-party complaint against the attorney general and the DOR, claiming that the attorney general had an obligation to file a motion to dismiss because the purchases at issue were specifically under examination in a DOR audit. The attorney general moved to dismiss that third-party complaint, and on January 23 -- without briefing -- the Circuit Court of Cook County granted the attorney general's motion.

"The immediate implication for all Illinois audits underway or about to be initiated by the Department is clear -- Illinois sales tax audits provide no protection at all, except for items one can prove were specifically audited by the Department," the Reed Smith advisers wrote. The rulings "call into question whether a retailer should ever agree to any form of sampling as part of its Illinois sales tax audit," they added.

Goodman said he has not considered whether the DOR could issue a blanket order, but he noted that DOR attorneys are assistant attorneys general, so they may technically have the ability to do that, though not without the attorney general's approval.

"The attorney general could intervene on all those [cases] where an audit has been done -- then when you dig down deep into it, you have what happened to Reed Smith, where the judge said that the department did conduct an audit but didn't look at the issue in question," Goodman said. He added that the attorney general is being too cautious by saying it will intervene only when there's proof that the advice was given by the department.

According to practitioners, all this should be irrelevant when the audit has already been completed. Reed Smith pointed out in its client alert that while a closed audit forecloses the state from later assessing liability for that period, the Illinois courts essentially allow third parties to pursue a liability the state itself could not assess, "unless the retailer can prove as a matter of fact that the prior audit actually examined the tax treatment of the item challenged."

According to Reed Smith, the attorney general pressed this position when arguing that the court should dismiss the retailer's third-party complaint against it and the DOR.

"There's nothing particular to Illinois that lends itself to this result," Wynne said. "The real difference here is that the people who are responsible for administering both the False Claims Act and the tax law aren't stepping in."

Dyckman, however, said that independent of the attorney general, the DOR can't issue a blanket order or policy decision that could handle any class of these cases. "On a case-by-case basis, it's the discretion of the attorney general that drives it, and the department can't intervene and be a party unless the attorney general approves that and gets involved," he said.


Additional Issues

From the practitioners' point of view, Schad Diamond's latest tactic of claiming the right to second-guess audits is basically a way to seek discovery in cases in which the firm is supposed to be a whistleblower already in possession of the requested confidential taxpayer information.

Goodman made two points on this front. First, he said, if the shipping and handling tax issue came up on audit -- and the DOR provided advice one way or another in regard to how the retailer handled it -- "there's certainly an argument that the relator is not the original source because the department was aware of the issue and looked at it." As for the second point, he said, "We don't think the relator is entitled to discovery, because they're supposed to have unearthed this 'fraud' on their own."

Schad Diamond's court motions also are creating administrative nightmares for practitioners and their clients. The Illinois False Claims Act limitation period doesn't expire until up to 10 years from the date of the alleged violation. Practitioners said taxpayers now must consider whether to retain their records after an audit.

From the state's perspective, the turn of events raises all sorts of questions, Dyckman said. For example, even if the DOR did miss something or make a mistake in an audit, he questioned whether it's appropriate to attribute to the taxpayer a state of mind of knowingly filing a false claim.

"That seems to be getting lost in the relator's quest for fees and recovery," Dyckman said. "There's a fundamental difference between a taxpayer who may owe a little bit more money and someone who's attempted to file a false claim or defraud the government."

Dyckman also wondered if one of Schad Diamond's motions claiming the right to second-guess audits were to go to a trial on the merits but the DOR hadn't examined the shipping and handling tax issue, who would have the burden of proof -- the relator?

"And who's going to argue the tax law? A person who isn't an expert in it?" Dyckman asked. He continued: Even if there were a finding of fact that taxes were underpaid on the portion of shipping and handling charges, would there need to be an additional finding of fraud, or material misrepresentation, or whatever the standard will be for a false tax claim?

"How does that play out?" Dyckman asked. Maybe the court would determine there was probably money due but dismiss the false claims case because there wasn't material misrepresentation or fraud, he surmised, or maybe the court would allow some tax to be collected.

"It's an open question of law that we are potentially years away from getting to," Dyckman said. "But it kind of clouds everything."

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