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FAVORITISM FOR IRS ALUM ON EXAM?

August 12, 2004

The Tax Analysts article on alleged favoritism and cronyism involving a former high-level IRS executive now with a national accounting firm leaves us troubled, and perhaps a tad jealous. It would certainly be nice if, when faced with a hopeless tax case, we could get a "no change" report forced through without so much as a real audit, just by sheer force of our personality. If a whistleblower's story is true, there exist forceful personalities with such powers.

Remy Welling, a 22-year IRS veteran, is the whistleblower. Her story, in short:

She was asked by her manager, Ron Yokoo, to close an examination of Micrel Inc. sight unseen. When she balked, she was pressured to sign off. She contacted the Senate Finance Committee, which declined to get involved, as did the General Accounting Office. The Treasury Inspector General, which is the inspection arm that oversees IRS administration, eventually sided with her supervisors and then began investigating Ms. Welling for disclosing taxpayer information to the FBI. Ms. Welling's attempts to get help from the SEC and the Senate Permanent Subcommittee on Investigations failed.

Now Ms. Welling is likely to lose her job, even though it looks like the IRS may have had a slam-dunk case worth around $50 million, because she allegedly violated taxpayer confidentiality rules in her contacts with other agencies.

Ms. Welling says the IRS was so eager to close the case because of the influence of a former IRS official. Her manager, Mr. Yokoo,

   ... told her that it would be futile to challenge
   the closing agreement because the Micrel
   case was being handled on Micrel’s behalf 
   by Jim Casimir — a former IRS national 
   director of Appeals who left the IRS in 2000 
   to head PricewaterhouseCoopers’ IRS tax 
   dispute resolution practice in Los Angeles — 
   and that he ‘‘would stop at nothing’’ to seal the 
   ISO deal.

THE TAX ISSUE

It appears that Micrel was in real tax trouble. The company had an "Incentive Stock Option," or "ISO," plan. These options enable employees to defer taxable income from the exercise of stock options until they sell their stock. (ISOs also have major AMT problems, but that's another story). Further, the sale of ISO stock is treated as capital gain. By contrast, employees exercising non-ISO options recognize ordinary income at the time they exercise the options.

ISOs have to meet a long list of rules - one of which is the requirement that the exercise price cannot be less than the fair value of the option stock at the date the option is granted (Sec. 422(b)(4)). The Micrel plan apparently ran afoul of this rule because option prices would be "reset" to the lowest stock price for the month in which the option was granted. Tax Analysts reports that Micrel eventually sued its prior accounting firm for approving this aspect of their ISO plan. Micrel then hired Mr. Casimir's firm to help deal with the tax fallout.

CONFIDENTIALITY - PROTECTING TAXPAYERS OR BREEDING INSIDER DEALS?

The tax law over time developed elaborate safeguards to protect taxpayer confidentiality. At one time tax returns were actually considered "public records," but only open to inspection under presidential order. The confidentiality rules are now much stricter -- preventing your neighborhood stalker from reviewing your deductions, but also providing cover for potential insider dealing and corruption.

Lawsuits by organizations such as Tax Analysts have forced the IRS to release documents such as private letter rulings. These disclosures help prevent the development of "secret law" available only to those with connections. Still, as long as returns themselves are confidential, the possibility exists for insider dealing at the examination level.

How big of a problem is it? If Ms. Welling is correct, it is a big problem:

   [Ms. Welling] accused some firms like PwC and 
   former IRS officials of leading an organized 
   effort to undermine legitimate IRS collections.

   ‘‘All they have to do is step into the room 
   and we leave,’’ she said. ‘‘They hire all the 
   old IRS executives. They bully us around. 
   They’re like the old Arthur Andersen.’’

It's not clear whether the problem is that bad. In our experience, IRS agents aren't easily intimidated. Still, the former IRS executives don't get hired by national accounting firms merely to reward their years of public service. There is at least an impression that they still have strings to pull. While the IRS has rules to prevent abuses, rules are never perfect. The only real cure for such abuse is transparency - that is, making returns and examination results public.

Such a cure might be worse than the disease. It's hard to make a case that it's worth exposing individual finances to public view to eliminate IRS abuses. The argument for confidentiality in returns for public companies like Micrel is less compelling, considering the extensive disclosures they already make under SEC rules. The tax returns of public companies would certainly make popular reading for their non-public competitors.

In any case, we aren't aware of any push to loosen the confidentiality rules. Unless that changes, we can expect controversies over insider influence at the IRS to erupt every few years.

UPDATE: Micrel has issued a press release on The New York Times coverage of this story. We discuss the Micrel response here.

UPDATE II: Remy Welling responds to Tax Update posts.

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