Can Loopholes Blow the Whistle on Whistleblowers?

Can Loopholes Blow the Whistle on Whistleblowers?

Two court actions in Wisconsin, one of them now before the Seventh Circuit, open a rare window into corporate tax compliance. These actions raise questions about IRS competence in audits and reveal big holes in federal laws to encourage and protect whistleblowers.

In an unusual move the day before Thanksgiving, the Seventh Circuit on its own initiative appointed a lawyer to represent Michael DeGuelle, a tax compliance accountant who pleaded in pauperis. Earlier a federal district court judge in Milwaukee dismissed DeGuelle's case, a wrongful discharge lawsuit that included racketeering counts.

In court papers, DeGuelle detailed what he described as years of calculated tax cheating by S.C. Johnson & Son Inc., the maker of Drano, Raid bug spray, and Ziploc bags. Court papers describe how the company supposedly took advantage of egregious IRS mistakes in audits, including altering and destroying records to escape taxes it owed, covering up wrongdoing, and hiding the purchase of a tax shelter from Arthur Andersen that later became a listed transaction.

In its filings, the company insisted it did nothing wrong. It told me it welcomes having the case thoroughly reviewed by the circuit court.

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DeGuelle's wrongful discharge case details what he said were many efforts to correct errors and fraud in tax filings that shortchanged the federal government and Wisconsin many millions of tax dollars since 1997.

DeGuelle said that in 2001 he pushed to correct a multimillion-dollar IRS mistake that would benefit SC Johnson, only to be told by Daniel Wenzel, the company's top tax department lawyer, that at least for the time being no corrective action would be taken. The suit quotes Wenzel as saying, "This is why I go to church on Sundays."

In 2005, according to court papers, Wenzel instructed DeGuelle "to fraudulently alter an income statement by improperly netting numbers on the statement against an expense, instead of reporting the numbers individually" on Form 5471, consequence of which "may have been a fraudulent financial benefit" to the company of $3.7 million. DeGuelle said he was forced under duress to prepare the fraudulent form and that Wenzel later initialed it and mailed it to the IRS, actions that DeGuelle's court papers characterized as criminal.

Wenzel and others named in the suit were paid bonuses for the tax savings that, DeGuelle asserted, were in some cases fraudulent and in others improper under the company's integrity and honest-records policies.

These bonuses were central to DeGuelle's accusations under RICO. Federal District Judge Joseph P. Stadtmueller in Milwaukee dismissed those counts with prejudice, finding that the government was the only victim of any tax fraud and that under the RICO statute, only a "business or property" is defined as a victim, not the government.

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In addition to the multiple corporate tax fraud issues raised, the court actions have exposed large rifts between SC Johnson's stated policies and its actions. The way the family-owned company has responded to DeGuelle's accusations has marred, and may ruin, its carefully crafted image as a firm of sterling integrity. It boasts on its Web pages that integrity is in its DNA and that "the sincerity of our beliefs encourages us to act with integrity at all times."

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In defending itself, SC Johnson relied heavily on what it says was a "thorough investigation" by Kirkland & Ellis LLP that it characterized as absolving it. The company, in the state court case, stated that Kirkland & Ellis interviewed DeGuelle "to obtain all the information DeGuelle had to support the allegations he raised and to be sure they understood his allegations."

The company told state Judge Emily Mueller that Kirkland & Ellis concluded after its independent investigation that DeGuelle's "allegations that there was criminal and/or fraudulent conduct were not correct and that there was no criminal or fraudulent conduct as to any of the matters raised by DeGuelle."

There are problems with SC Johnson's representations to Judge Mueller. First, Kirkland & Ellis spoke to DeGuelle only by telephone, according to court papers and my interviews with DeGuelle. The telephone conversation lasted 15 minutes to perhaps an hour, according to DeGuelle, and he said the Kirkland & Ellis lawyers did not ask any probing questions or request any documentation.

Much more significantly, the Kirkland & Ellis memo did not declare that "there was no criminal or fraudulent conduct," as SC Johnson told Judge Mueller and as Beard told me.

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The case also suggests serious problems with IRS audits. State audits are not mentioned, but Wisconsin has drastically reduced its examinations of corporations, actions that some state tax auditors have characterized in interviews with me over the past few years as a subtle political gift to campaign donors.

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The accusation in this instance strikes me as significant enough that IRS Commissioner Douglas Shulman and the Treasury Inspector General for Tax Administration should conduct an inquiry and determine both whether to assign more diligent auditors to SC Johnson and whether broader training is necessary.

How the Seventh Circuit will rule is unclear from its order. This circuit seems to closely follow the Chicago School, which believes markets will sort themselves out with few to no government rules. Its chief judge, Frank Easterbrook, co-wrote a book stating that it was not important for securities markets to be covered by fraud statutes. The court's most famous judge, Richard A. Posner, has begun to question whether flaws may exist in the Chicago School theory as evidence mounts that not all people fit into the school's neat description of rational economic behavior that maximizes profits.

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View TaxAnalysts' David Cay Johnston's opinion in its entirety on TAX.com.

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