This article originally was published by Law360 on July 1, 2019.

One of the more recent and aggressive shifts in state tax administration has been the rise of the state False Claims Act, or FCA, tax lawsuit. The scourge of the tax community, these lawsuits represent a shift from the disciplined examination by state tax authorities to a free-for-all attack by anyone with a theory on an alleged unfulfilled tax obligation.

While taxpayers[1] and practitioners fight to defend against FCA actions, crucial distinctions from traditional tax administration give taxpayers a significant advantage to defeat an FCA lawsuit. This article examines two key advantages taxpayers have to defeat an FCA claim — (1) the burden of proof, and (2) the requirement to prove the taxpayer’s mental intent.

First, FCA actions shift the burden of proof from the traditional tax enforcement matter to the taxpayer’s advantage. In traditional tax enforcement proceedings, the taxpayer has the burden to prove that state tax authority’s presumptively correct assessment is erroneous to succeed. However, in an FCA action, the party bringing the action (or relator) has the burden to prove every element of an FCA violation to succeed.

The burden of proof is significant because a taxpayer will defeat an FCA action if the relator fails to prove any of the required elements for an FCA violation. This shifted burden of proof gives taxpayers the advantage of playing defense against an FCA claim.

Second, FCA laws require the relator to prove the taxpayer’s mental intent to succeed in its claim.[2] In traditional tax enforcement proceedings, the taxpayer’s mental intent is irrelevant because the tax imposition is strict liability. However, in an FCA action, the relator must prove that the taxpayer acted with “knowing” mental intent to engage in conduct that violated a state tax law obligation.

The relator must prove that the taxpayer knew or should have known of its tax obligation when it engaged in conduct that violated the tax law. The FCA’s mental intent requirement therefore gives taxpayers a unique and strong advantage to defending against an FCA claim.

The confluence of these two critical distinctions gives taxpayers a unique and significant advantage to defeat a tax FCA lawsuit.

FCA Basics

While states entrust traditional tax administration to state tax authorities, some state legislatures have extended their FCA statutes to allow private citizens to bring a tax FCA claim.

States have largely enacted their FCA laws to mirror the federal FCA, which bars tax claims (e.g., California, Massachusetts, North Carolina, Virginia). However, some states bar FCA actions only for income tax matters, which permits FCA actions for other taxes (e.g., Illinois, Indiana, Rhode Island), and New York expressly permits tax FCA claims.

The FCA laws are commonly referred to as “whistleblower laws” because of the direct financial appeal to private citizens to “blow the whistle” to expose otherwise undiscovered proof of improper tax filings. FCA laws encourage whistleblowing by permitting relators to collect anywhere from 10% to 30% of the proceeds of a successful FCA claim.[3]

States further encourage whistleblowers to bring these actions by promising protection against employer retaliation, if applicable. While a relator may initiate an FCA action, the state is authorized to intervene in or dismiss an FCA action. If the state chooses to intervene, the state attorney general commandeers the prosecution of the tax FCA action and the whistleblower retains a financial reward interest in any successful FCA claim.[4] If the state attorney general does not prosecute or dismiss the tax FCA action, the relator is permitted to continue to prosecute the case on the state’s behalf.[5]

Generally, in a state tax FCA action, the plaintiff — whether the relator or the state — must prove that the taxpayer (1) had a tax obligation (direct or indirect); and (2) acted with knowledge, reckless disregard or deliberate ignorance of the law when it either (a) submitted a false record to the state material to that tax obligation, or (b) concealed or avoided its obligation to pay the tax to the state.[6] Therefore, the relator or the state must prove out the substantive tax obligation and that the taxpayer acted with the requisite mental intent to violate the FCA law.

Flipping the Burden in an FCA Action

Contrasting the burden of proof in traditional tax administration with an FCA action highlights a significant advantage taxpayers have to defeat an FCA tax claim. Taxpayers in traditional tax administration challenge an assessment that is presumed to be correct, while taxpayers defend against an FCA claim that the relator must prove by a preponderance of the evidence. The shifted burden of proof therefore profoundly impacts the tax litigation.

Traditional tax administration involves a state tax authority’s careful examination of taxpayer’s records to determine whether the taxpayer complied with the tax law. The state tax authority may assess additional tax, if appropriate. Because the state tax authority issued an assessment based on its examination of the taxpayer’s books and records, an assessment is afforded a presumption of correctness.[7]

This presumption of correctness means that the department of revenue satisfied its prima facie requirement to establish the basis for an assessment. As a result, the taxpayer has the burden of proof to overturn a tax assessment.

In FCA matters, the legislature placed the burden of proof on the relator to demonstrate an FCA violation based on the extraordinary nature of deputizing private citizens to enforce the tax law. As a result, an FCA violation allegation does not carry a presumption of correctness.  Rather, the relator bringing an FCA claim must prove all the requisite elements of an FCA violation.

In fact, the FCA laws in Illinois and New York require the relator to prove by a preponderance of the evidence each and every required element of an FCA violation.[8] Unlike the state tax authority that establishes the basis for a tax assessment on audit, the relator must establish at trial the entire basis for the allegation that tax is due. Further, the relator has the added burden of proving out the taxpayer’s mental intent. As such, the shifted burden of proof provides a critical distinction to the taxpayer’s advantage for contesting an FCA allegation.

For example, relators have filed numerous Illinois FCA cases against taxpayers alleging the failure to collect sales or use tax based on an attributional nexus theory. Relators alleged that the state could impose its taxing jurisdiction on remote sellers based on the attributional nexus theory.

In such a case, the relator has the burden to prove that (1) the taxpayer had an obligation under the tax law to collect and remit tax, and (2) the taxpayer “knowingly” disregarded its obligation to collect and remit such tax. As a result, the relator’s burden to prove the tax obligation required proof that the taxpayer had a tax collection and remittance obligation (or nexus) under Illinois tax law that would not offend U.S. commerce clause nexus principles.[9]

While proving attributional nexus is an arduous factual task, the additional requirement to prove that the taxpayer acted with a “knowing” mental intent significantly increases the relator’s difficulty in proving a FCA violation. Specifically, the relator had the burden to prove that the taxpayer “knew or should have known” about its tax obligation when it did not comply with the obligation. Proving a taxpayer’s mental intent is an extremely difficult task (discussed further below).

Contrasting the attributional nexus FCA claim with traditional tax administration further highlights the burden of proof’s significance. If the state tax authority alleges that the taxpayer has an obligation to collect and remit tax under an attributional nexus theory, it will issue a tax assessment that receives the presumption of correctness, which establishes the prima facie proof of additional tax due.

The taxpayer has the burden to prove that the state tax authority’s assessment is erroneous by proving the factual basis for the assessment does not establish that it had nexus. Furthermore, the taxpayer’s mental intent is not relevant to challenging a state tax authority’s assessment because the taxpayer’s mental intent is not relevant to the tax obligation.

As a result, the taxpayer can only prove the state’s assessment is erroneous with proof that the taxpayer did not have nexus based on Illinois tax law or the constitutional limitations on state taxation. This requires the taxpayer to disprove the state tax authority’s finding of a sufficient nexus — proving a negative (no nexus) is very difficult.

Therefore, while a taxpayer carries the burden to overcome the presumption of correctness in traditional tax administration, the taxpayer will defeat an FCA claim by demonstrating the relator failed to prove by a preponderance of the evidence any of the requisite elements of the FCA allegation. The taxpayer has an advantage to defeat an FCA action because the burden is on the relator.

The Mental Intent Card

The FCA requirement to prove the taxpayer’s mental intent is a key factor distinguishing FCA actions from traditional tax litigation that benefits taxpayers. The relator must prove that the taxpayer possessed the necessary mental intent to commit an FCA violation. Proving the taxpayer’s mental intent is a very difficult proposition.

In traditional tax litigation, the taxpayer’s mental intent is irrelevant in determining whether tax is due because a taxpayer is liable for the tax imposed regardless of the taxpayer’s mental intent. The taxpayer is liable for the tax regardless of whether the taxpayer knew or should have known of the tax obligation. Therefore, the taxpayer’s mental intent is not a defense in traditional tax litigation.

Conversely, the FCA law requires the relator to prove by a preponderance of the evidence that the taxpayer “knowingly” violated a tax obligation.[10] Specifically, the relator must prove that the taxpayer had actual knowledge or acted with “reckless disregard” in violating the tax law. Reckless disregard requires the relator to prove that the taxpayer knew (or should have known) that the law imposed a tax obligation and deliberately acted contrary to the law. Taxpayers have defeated FCA claims by rebutting the allegation of a “knowing” violation of the tax law.

Several key facts and considerations can aid taxpayers in rebutting an allegation that they acted with the requisite mental intent for FCA purposes. First, taxpayers can rebut the allegation of knowing intent by demonstrating their own due diligence in determining whether they owe any tax. Through testimony and contemporaneous documentation, the taxpayer can prove that they determined they did not owe tax or have a tax collection obligation.

Taxpayers can demonstrate that they engaged in due diligence to research the issue and review the rules, and that they understood them to support their tax position.[11] A taxpayer that can demonstrate that it was their subjective understanding that they did not owe tax or have a tax collection obligation will defeat an FCA claim. Tax professionals know that uncertainty is rampant in the application of archaic tax laws to the modern economy.

Such uncertainty leads to many differences of opinion between tax professionals and state tax authorities. To the extent that the taxpayer has a reasonable difference of opinion regarding the tax obligation, the FCA law should not apply because the purpose of the FCA “is not to penalize frank differences of opinion or innocent errors made despite the exercise of reasonable care.”[12]

Therefore, states’ FCA laws do not apply to the extent that taxpayers rely in good faith on reasonable interpretations of the law.[13]

In addition, taxpayers can assert an expert advice defense to rebut an allegation of “knowing” mental intent. Taxpayers’ consultation with tax professionals and reliance on expert advice can dispositively rebut an allegation that a taxpayer acted knowingly or with a reckless disregard. Taxpayer’s have defeated FCA claims in Illinois courts with the expert advice defense.

Where taxpayers sought out and relied on advice, courts have determined that FCA liability cannot attach because the relator cannot prove a knowing violation in those instances.[14]

In instances where the taxpayer has relied on the expert advice defense, taxpayers can disprove liability by demonstrating they acted in good faith and (1) sought advice from a competent advisor to determine the lawfulness of the possible future conduct; (2) fully and accurately reported to the advisor all material facts known to the defendant; and (3) acted strictly in accordance with the advisor’s advice.[15] Reliance on such advice supports the affirmative defense even where the advice was wrong.[16] Therefore, the expert advice defense is a powerful weapon to defeat an FCA claim.

Further, reliance on the results of prior examinations by governing agencies or other third parties can aid taxpayers in disproving FCA liability. Courts have found that taxpayers have successfully disproved FCA liability, and particularly that they could not have engaged in a knowing violation of the law, when the state’s tax authority has audited the taxpayer for that tax and not assessed additional tax.[17]

At times, another state’s audit may aid taxpayers in disproving liability where the underlying determination of whether tax was due is one that would apply across all states, such as those based on U.S. constitutional analyses.[18] Reliance on professional advice has been found to include reliance on the results of independent financial statement audits, where taxpayers’ independent auditors have not indicated any risks associated with the taxpayers’ position.[19] Therefore, taxpayers can prove they lacked the requisite mental intent to commit an FCA violation.

The mental intent requirement is a powerful tool for taxpayers to defend against FCA liability, one which is not available in traditional tax litigation.

Conclusion

While FCA tax litigation continues to be a nightmare for taxpayers, understanding two key distinguishing factors — the burden of proof and the mental intent requirement — provides significant advantages for taxpayers defending against FCA actions. These unique and significant advantages are not available in traditional tax administration.


[1] Taxpayer refers both to taxpayers reporting and paying direct taxes, such as income/franchise taxes, as well as persons or entities determined or alleged to be “vendors” that would be required to collect and remit sales and use tax.

[2] The mental intent requirement is often referred to as “scienter” or “mens rea.”

[3] See 740 ILCS 175/4(d) N.Y. State Fin. L. §190(6) . The amount awarded to the relator depends on a variety of factors, including whether the matter is one based on a prior disclosure and whether the state proceeds with the action.

[4] N.Y. State Fin. Law § 190(2)(c); 740 ILCS 175/5(c) .

[5] N.Y. State Fin. Law § 190(2)(f); 740 ILCS 175/4(c)(3).

[6] 740 ILCS 175/3(a) ; see also N.Y. State Fin. Law § 189(1) . Notably, New York does not permit tax FCA actions in cases alleging the taxpayer knowingly concealed or knowingly or improperly avoided or decreased an obligation to pay money to the state. As such, the relator or state must always demonstrate that the taxpayer filed a false statement with the state that was material to the taxpayer’s tax obligation. See N.Y. State Fin. Law § 189(1).

[7] State tax assessments issued by the Illinois Department of Revenue, for example, are deemed prima facie correct. Jefferson Ice Co. v. Johnson, 139 Ill.App.3d 626, 630 (1985). The Department of Revenue need only establish its prima facie case to shift the burden of proof to the taxpayer to demonstrate that the notice is erroneous through clear and convincing evidence. Matter of McKee v Commr. of Taxation & Fin. , 2 A.D.3d 1077, 1078 (2003).

[8] N.Y. State Finance Law § 192(2) ; 740 ILCS 175/5(d).

[9] See, e.g., State of Ill. ex rel. Stephen B. Diamond, P.C. v. Lush Internet, Inc. , 2017 IL App (1st) 161601-U (2017).

[10] N.Y. State Fin. L. § 188(3) ; 740 ILCS 175/3(b)(1).

[11] State of Ill. ex rel. Stephen B. Diamond, P.C. v. Lush Internet, Inc., 2017 IL App (1st) 161601-U (2017).

[12] State ex rel. Schad Diamond and Shedden v. National Business Furniture, LLC , docket 12 L 84 (Ill. Cir. Ct. Oct. 23, 2014).

[13] People v. Sprint Nextel Corp. , 980 N.Y.S.2d 769 (N.Y. App. Div., 1st Dep’t 2014), aff’d 26 N.Y.3d 98 (2015).

[14] See People ex rel. Beeler, Schad & Diamond, P.C. v. Relax the Back , 2016 IL App (1st) 151580 (2016); State of Ill. ex rel. Stephen B. Diamond, P.C. v. Lush Internet, Inc., 2017 IL App (1st) 161601-U (2017). But see People ex rel. Schad, Diamond and Shedden, P.C. v. My Pillow, Inc., 2017 IL App (1st) 152668 (2017).  

[15] People ex rel. Schad, Diamond and Shedden, P.C. v. My Pillow, Inc. , 2017 IL App (1st) 152668 (2017).

[16] U.S. ex rel. Bidani v. Lewis , 264 F. Supp. 2d 612, see also People ex rel. Beeler, Schad & Diamond, P.C. v. Relax the Back, 2016 IL App (1st) 151580 (2016) (finding that, while reasonable minds would differ as to whether the defendant must collect tax on its catalog sales, the taxpayer lacked the requisite mental intent based on the taxpayer’s reliance on the review of independent professionals).

[17] See People ex rel. Beeler, Schad & Diamond, P.C. v. Relax the Back, 2016 IL App (1st) 151580 (2016); State of Ill. ex rel. Schad, Diamond & Shedden, P.C. v. National Business Furniture, LLC, 2016 IL App (1st) 150526 (2016); State of Ill. ex rel. Stephen B. Diamond, P.C. v. Lush Internet, Inc., 2017 IL App (1st) 161601-U (2017). While states may accept audit results to disprove mental intent, states may reject prior audits to apply the public disclosure bar and prohibit the action from proceeding altogether based on an alleged public disclosure. People ex rel. Lindblom v. Sears Brands, LLC, 2019 IL App(1st) 180588 (2019).

[18] See People ex rel. Beeler, Schad & Diamond, P.C. v. Relax the Back, 2016 IL App (1st) 151580 (2016); State of Ill. ex rel. Stephen B. Diamond, P.C. v. Lush Internet, Inc., 2017 IL App (1st) 161601-U (2017).

[19] See People ex rel. Beeler, Schad & Diamond, P.C. v. Relax the Back, 2016 IL App (1st) 151580 (2016); State of Ill. ex rel. Stephen B. Diamond, P.C. v. Lush Internet, Inc., 2017 IL App (1st) 161601-U (2017).