Is Vanguard hiding behind low-cost structure to evade taxes?

When he left the grueling, white-knuckle New York corporate legal world to work as a lawyer for the Vanguard Group Inc. in Malvern, Pa., David Danon expected that the substantial pay cut he took would be worth it in the long run.

“I wanted less stress in my life,” Mr. Danon, 54, of Wayne, Pa., told InvestmentNews in his first interview with a financial publication since filing a whistle-blower lawsuit against Vanguard in May 2013.

In his suit, Mr. Danon accuses the top U.S. mutual fund company of using its status as a low-cost investment manager to consistently avoid hundreds of millions in tax liabilities.

“Vanguard has operated as an illegal tax shelter for nearly 40 years,” according to the complaint. It adds that Vanguard has been the leader in low-cost mutual funds because its funds receive the services of their corporate arm at below-market-rate prices. “The only purpose of ‘at-cost’ prices is to avoid federal and state income taxes.”

Vanguard, which Mr. Danon says fired him last summer after he filed a then-sealed whistle-blower complaint, vehemently denies the claims.

The lawsuit, which was first reported Friday afternoon by InvestmentNews, was filed on May 8, 2013 in the Supreme Court of New York State. It was only recently unsealed.

The complaint estimates the company owes about $1 billion in federal and New York state taxes.

The case raises novel questions about the unique legal status of Vanguard’s hallmark corporate structure and its cost-conscious mantra, typified by the firm’s plain-spoken founder, John C. Bogle, an advocate of long-term, buy-and-hold-oriented investing.

“Our secret is simple: We offer our funds ‘at cost,’” according to the firm’s marketing materials. “We can do this because we’re the only company in the industry that’s client owned. We’re owned by our funds and our funds are owned by the people who invest in them, people like you. We don’t generate profits for private owners or stockholders. We return profits to you as cost savings.”

The firm declined to make executives available, but in a statement spokesman David R. Hoffman said “the issues presented in the complaint are far too complex to get a full and proper hearing in the news media.”

The complaint, which runs 40 pages, argues the fund manager enjoys illegal special benefits by not charging market rates for its services and said that the firm has filed false statements with New York, for whom it works as a manager of 529 college-savings plans, saying it had paid taxes. But in fact the firm filed no tax returns between 2004 and 2011, according to the complaint.

Mr. Danon’s lawyer, Brian Mahany, of Mahany & Ertl in Milwaukee, also said the fund company keeps a $1.5 billion “contingency reserve,” collected from shareholders, on which it failed to pay taxes.

He said the New York State Attorney General’s office declined to prosecute the case itself. The AG’s office did not respond to a request for comment.

“There are big questions being asked here,” said Daniel P. Wiener, a New York-based investment adviser who recommends Vanguard products and publishes The Independent Adviser for Vanguard Investors, a newsletter. “If there is an issue here then you’re talking about a seismic disruption in the fund industry. It could really change the complexion of the industry.”

Within his first year at the firm, in 2008, Mr. Danon said he discovered inconsistencies between tax law and how the company approached its compliance obligations. After initially focusing on the taxation of funds, he was reassigned to corporate issues. On several occasions he said he disagreed with superiors about the legality of their take on its tax liabilities, and he said he was told by a superior that doing so had harmed his career.

In December 2012, the firm gave him a negative performance evaluation. “You invested heavily this year in researching technical issues and lightly in helping clients and colleagues achieve practical results,” it read, according to Mr. Danon.

Mr. Danon is not working and fears he may be unemployable as a corporate tax lawyer.

Under New York state law, Mr. Danon would be entitled to between 25% and 30% of money recovered in a settlement or at the end of a successful lawsuit. His complaint estimates the New York is owed at least $20 million.