Vanguard denies wrongdoing. The company, based in Malvern, said Danon's complaint "is without merit" and promises to "vigorously defend" against it in court.
Vanguard traces its client-owned structure to its founding in 1975. Government regulators have had almost 40 years to complain, if there were a problem.
Still, corporate tax lawyers and mutual fund industry observers contacted by The Inquirer say that Danon is basing his arguments on well-known provisions of federal tax law - and that his insider analysis, if upheld by courts and adopted by the IRS, could provoke changes, and perhaps reduce Vanguard's cost advantage in the marketplace.
By making funds and their investors its ultimate owners and squeezing profits out of operations, founder John C. Bogle made Vanguard "similar to a credit union or a traditional mutual insurance company," Vanguard says on its website and marketing materials.
But unlike mutual insurers and credit unions, which operate under well-established federal laws, no law gives Vanguard the right to operate on a tax-free basis, Danon argued in his lawsuit and in interviews with The Inquirer.
Danon contends Vanguard Group has "illegally" reduced its federal and state tax liabilities in two ways:
By charging its funds below-market prices for investment advisory and other services - functions provided by Vanguard Group. The suit says that violates Section 482 of the U.S. tax code: The law requires payments for services between related companies to be sold at market prices, not discounted or inflated levels, so companies are not tempted to use such payments to shift or reduce reported income - and taxes.
By piling up a "contingency reserve" of cash payments from Vanguard mutual funds, without paying taxes on it. The reserve has topped $1.5 billion, Danon claims in his suit, citing confidential documents he gave federal and state agencies under whistle-blower statutes.
Vanguard has declined to address Danon's specific allegations. "The issues presented in the complaint are far too complex to get a full and proper hearing in the news media," according to a statement Monday by Vanguard spokesman David Hoffman.
"Vanguard has operated under its unique structure for nearly 40 years," Hoffman added. He said the company follows the laws and rules of the Securities and Exchange Commission, the IRS, and the U.S. Department of Labor.
The suit was unsealed after the New York state attorney general declined to prosecute the case, freeing Danon and his lawyer to pursue a civil action. If the court finds for Danon, he could collect a cut of Vanguard's back taxes.
Is Danon right?
How do Danon's arguments hold up?
When the IRS reviews payments between two related companies, "they want a profit margin," said Robert Willens, a New York tax lawyer who advises hedge funds and other investors on corporate tax issues and who teaches corporate tax at Columbia University.
Vanguard's structure may be "unusual" for mutual funds, Willens said, but such arrangements are common, for example, with real estate investment trusts (REITs), which pay related management companies for services.
There is a temptation, Willens said, to set the fees the funds pay their management affiliates so they show only "very small amounts of taxable income." It's a tax lawyer's job to warn the company it needs to pay its affiliate about the same as it would pay an outside firm to do the same job, Willens explained.
Similarly, cash that piles up in "contingency reserves" starts to look like tax avoidance, Willens added.
What if an IRS audit finds Vanguard should be charging its funds more? "They probably will require that Vanguard adjust the formula and charge a higher fee to reflect the cost of providing the services, and a profit," Willens said. If that happens, Vanguard could appeal.
"As an investor in Vanguard funds, I'm thinking, 'What? They don't charge enough fees? Right on!'" said Stanley Kull, a former secretary-treasurer of the Philadelphia Bar Association's tax section and a partner at Saul Ewing L.L.P. "It doesn't sound to me like a case of fraud or evasion."
But he agreed Vanguard could indeed face issues similar to the real estate fund operators. "The REIT example is a very good one," Kull said. If REITs pay market-level fees, Vanguard may have to show why it deserves different treatment, he added.
"The law does let you provide mundane and run-of-the-mill services at cost or close to cost. It does not let you do that with services that require a big skill set, like we imagine investment management to be," says Lee Sheppard, a lawyer and contributing editor at Tax Notes, a prominent Washington tax journal.
"The issue is not that the funds need to pay more to the investment adviser," it's that Vanguard Group, by not charging market rates, is not recording the income and paying proper taxes, says David Shakow, a former Treasury Department tax lawyer and University of Pennsylvania law professor who is helping Danon with his case.
What's the worst that could happen to Vanguard investors?
"This assault on Vanguard's 'at cost' operating principle, if successfully challenged, has seismic implication for the mutual fund industry and could possibly put competitors on a more level playing field with Vanguard," said Daniel P. Wiener, in a note to clients of his Independent Adviser for Vanguard Investors newsletter.
Even if that happens, Vanguard, with its size and focus, will likely remain "one of the low-cost leaders in the industry," Wiener added. But ruling against the firm and its longtime structure "would be a huge hit to the firm's reputation as an investor advocate and ethical leader."