Incentives for tax fraud tipsters may get even tinier

March 4, 2013, 7:51 PM UTC

FORTUNE — Hoping to win millions of dollars from the Internal Revenue Service for exposing tax fraud? It’s going to get even tougher — and some powerful people in Washington are not amused.

In January, Sen. Charles Grassley, the 79-year-old Iowa Republican, chastised acting IRS commissioner Steven Miller over his recent proposal to restrict the agency’s whistleblower program, already an object of criticism since its creation in 2006. The proposed curbs, Grassley wrote in a letter to Miller, showed one thing: that the IRS and its boss, the Treasury Department, “view whistleblowers with hostility.”

What exactly is at issue? The current whistleblower rules say a tipster can collect a reward of 15%-30% of proceeds brought in as a direct result of a tip. The dirt has to involve tax evasion of at least $2 million or tax fraud by an individual making at least $200,000 a year.

Miller’s proposed restrictions will likely shrink payouts. Among the curbs: making it nearly impossible for whistleblowers to share in rewards stemming from a company’s inflation of losses, and excluding from rewards any money brought in from so-called Fbar fines. These draconian fines, levied on offshore tax evaders, are often dozens and even hundreds of times the amount of actual back-tax an evader must pay.

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But here’s the rub in this unusual political fight: Even in its current structure, very few whistleblower claims get paid, thanks to bureaucratic foot-dragging at the IRS, according to lawyers representing whistleblowers. Despite receiving more than 1,960 claims since 2006, the IRS made its first payment only in 2011. In total, it has paid only three claims. The biggest: $104 million to convicted felon Bradley Birkenfeld, the former UBS AG private banker who kick-started the investigation of Swiss banks. Tens of thousands of other claims that the IRS did not put into a prior, far less lucrative rewards system put in place before 2006 have languished; those that did result in rewards produced much smaller bounties for their tipsters.

Still, that’s not stopping Grassley, the ranking member on the Senate Judiciary Committee and author of the original bounty regulations. And the senior senator, who criticizes the program for its opacity and “suspension” of hundreds of claims, is not alone in his ire.

A grassroots campaign started by the National Whistleblower Center, an advocacy group, saw more than 670 barb-laden letters from lawyers and ordinary citizens, an unusually high number, flood Miller’s desk over the past two months.

One acid-tongued writer who signed himself “Anonymous” wrote that he was trying to decide whether the best metaphor for the IRS’s whistleblower program ”would be Dickens’ Bleak House or Kafka’s The Trial. While the program surely has elements of both … the closest analogy would be to a more modern classic, Seinfeld, because for claimants and their counsel, it has devolved into a program that is really about nothing.”

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The arrows at the IRS come amid rising populist frustration over billions of dollars of corporate tax avoidance and a crackdown on offshore tax evasion through Swiss and other foreign banks. By the IRS’s own estimate, the difference between what U.S. taxpayers should have paid and what they actually paid, stands at $345 billion — each year.

Even though it has received plenty of tips, only a few are detailed and good, of course. But “the big advantage that taxpayers have over the government is that they possess the facts,” wrote lawyer Jeffrey Neiman in a recent letter to Miller. Neiman, a former prosecutor who was involved in the Birkenfeld case, put it bluntly: “Bad facts and smoking guns are often needles in haystacks impossible to uncover with ordinary audit techniques.”

Thomas Pliske, a former IRS trial lawyer now representing dozens of whistleblowers, tells a hall-of-mirrors story. In 2009, two clients submitted a reward-claim based on their detailed allegations of fraud at an unnamed consulting firm. The whistleblowers, former employees, had the goods on $150 million in bogus-refund schemes. The IRS disagreed, and in 2011 it rejected the claim. Months later, Pliske sued the IRS in Tax Court over the rejection. Last November, he effectively lost the case — even as the IRS stated in court papers weeks before the ruling that it was opening an independent investigation into the consulting firm, based on the clients’ insider information.

Pliske’s story then turns even more surreal. On Feb. 4, he learned that the IRS was reopening his clients’ claim — nearly four years after it was made. The agency now even wants to wire one of the whistleblowers.

The flip-flopping, Pliske said democratically, “has been a waste of the court’s time.” An IRS spokesman declined to comment.

It’s a battle being fought inside the walls of the IRS as well. At one end is the Whistleblower Office, lead by Steven Whitlock, who once ran the agency’s Professional Responsibility unit; at the other end is the Chief Counsel’s office, headed by William Wilkens, a former tax lawyer who once represented the Swiss Bankers Association at blue-chip law firm WilmerHale. Some proud officials outside Whitlock’s office don’t like the idea of “outsourcing examination” — a basic IRS function — to anybody, let alone to rank-and-file citizens. As one tax lawyer remembers an IRS official telling him recently: “You can lead a horse to water, but you can’t make the IRS do its job.”