Every taxpayer should be aware of the real risk that its own employees could disclose the taxpayer’s confidential and privileged information to the Internal Revenue Service (IRS) for a whistleblower fee. Pursuant to Internal Revenue Code (Code) Section 7623, the IRS is permitted to pay a “whistleblower” who discloses information about a taxpayer who has violated the tax laws. The amount of the payment ranges from 15 to 30 percent of the recovery. We have previously reported about issues pertaining to whistleblowers.

While the flow of information is usually from the whistleblower to the IRS, there is also a risk that the IRS can disclose the taxpayer’s return information to the whistleblower. Code Section 6103(a) deems tax returns and return information as confidential and prohibits the disclosure absent an express statutory exception. Return information is broadly defined and includes the information received by the IRS, from any source, during the course of audit. There are several exceptions to this general rule. For example, Code Section 6103(n) authorizes that tax returns and return information may be shared with the IRS pursuant to a “tax administration contract.” The relevant regulations explain when the IRS may disclose information to a whistleblower and its representative.

A recent memo from the IRS’s Whistleblower Office provides the reasoning behind the IRS decision to enter into a whistleblower contract in order to share the taxpayer’s feeling empowered to share otherwise confidential protected information with whistleblowers.

In the memo, the IRS outlines the steps to be followed when deciding whether to enter into a whistleblower contract and permit the disclosure of confidential tax return information:

(1) The IRS should conduct interviews with the putative whistleblower; and

(2) The IRS should determine if disclosure would benefit tax administration and promote the effective resolution of the issues.

Factors to be considered when entering into a whistleblower contract:

(1) whether the issue involves transactions not recorded on the taxpayer’s books and records;

(2) whether the whistleblower has substantial relevant industry expertise; and

(3) issues involving substantial fact development where the whistleblower’s knowledge could be beneficial.

The IRS cautions that a whistleblower contract permits the IRS to only share information that the IRS deems necessary in connection with the proper or reasonable performance of the contract.

Practice Point: The memo outlines the very low bar that the IRS must reach to share the taxpayer’s returns and return information with a whistleblower. We advise our clients to take potential whistleblower actions very seriously and institute mechanisms to protect against disclosure. For example, a disgruntled tax department employee could file a whistleblower action citing garden-variety tax planning techniques as an impermissible tax-dodge, subjecting you to potential tax liability. Even if after the IRS investigation the taxpayer is cleared of all wrong doing, it has expended substantial time, money and resources for a matter that could likely have been avoided by instituting some simple safe-guards. If a taxpayer believes there may be a whistleblower, it should request any and all materials received by the IRS from third-parties. It should also inform the IRS that any materials provided by a whistleblower may contain privileged information and must be returned to the taxpayer.