Source: http://www.jameshoyer.com/whistleblower-award-held-to-be-ordinary-income/
Timestamp: 2019-04-21 06:05:43+00:00

Document:
In our experience, whistleblowers by and large do not do it for the money. Rather they bring the case in order to right a wrong inflicted upon their government and fellow taxpayers. That said, whistleblowers are financially incentivized to bring their cases.
Section 3730(d)(1) of the False Claims Act (“FCA”), 31 U.S.C. §§3729-33 provides that a qui tam relator, or “whistleblower”, shall receive an award of at least 15% of the proceeds of an FCA action, depending on the extent to which the relator substantially contributed to the prosecution of the action.
One question surrounding these whistleblower awards is whether the money is taxed as ordinary income or some other form of compensation like capital gains or lottery winnings?
The Seventh Circuit Court of Appeals, which handles federal appeals from Illinois, Indiana, and Wisconsin, recently addressed this question in a matter of first impression.
In the case of Patrick v. Comm’r, No. 14-2190, (7th Cir. Aug. 26, 2015), the whistleblower filed a qui tam action under the FCA, in which the government intervened. The defendant eventually settled with the government for over $75 million, and the qui tam relator received a whistleblower award of more than $5.9 million.
On his tax return, which he filed jointly with his wife, the relator reported the whistleblower award as a capital gain. The IRS, however, asserted that the whistleblower award was not a capital gain, and was thus subject to ordinary income rates. Consequently, the IRS assessed additional taxes. The relator petitioned the Tax Court, which ultimately sustained the IRS’s position and held that whistleblower awards are properly characterized as ordinary income. See 142 T.C. 124 (Feb. 24, 2014).
On appeal, the sole issue before the Seventh Circuit was the proper characterization of the whistleblower award — was it a capital gain or ordinary income.
A gain is a capital gain if it results from the sale or exchange of a capital asset. See I.R.C. § 1222(3). But, if the payment is a whistleblower award designed to “compensate the relator for his work in bringing the qui tam suit,” then it should be properly treated as a payment for services, i.e., ordinary income.
The Court noted that other “[c]ourts have consistently described a relator’s share as a ‘bounty’ or ‘reward’ for the efforts a relator puts forth to gather evidence and file a qui tam suit.” See Vt. Agency of Natural Res. v. United States ex rel. Stevens, 529 U.S. 765, 772 (2000); Roberts v. Accenture, LLP, 707 F. 3d 1011, 1016 (8th Cir. 2013) (using the language “finder’s fee”); Riley v. St. Luke’s Episcopal Hosp., 252 F.3d 749, 752 (5th Cir. 2001) (using the term “reward”).
Based on those cases and others, the Court concluded that “a relator’s award is a payment for services performed, and therefore, that the award must be claimed as ordinary income.” This is in accord with the only other circuit case to date on the issue, Alderson v. United States, 686 F.3d 791 (9th Cir. 2012), which held similarly that the whistleblower award is ordinary income to the qui tam relator.
To treat the money as a capital gain would “contravene the long-recognized rule that a ‘capital gain’ generally involves a ‘realization of appreciation in value accrued over a substantial period of time’ of an initial investment of capital,” the court noted. Moreover, the qui tam relator “made no initial investment in some asset.” Rather, he expended time and effort in discovering and documenting the alleged fraud, which was not an investment of capital.
The Court also examined the statutory language. Section 1221 defines a capital gain as resulting from the sale or exchange of a capital asset.
The term capital asset, defined in § 1221, is property held by the taxpayer (with listed exceptions). The term property, the Court explained, normally connotes the ability to exclude others from using it.
The qui tam relator advanced two arguments to meet the capital asset requirement. First, the “property” was the information that he acquired, which he argued he had a right to stop others from using. The Court disagreed, noting that, although the qui tam relator did compile documents, the information contained in those documents was available to other employees.
Second, he argued that the right to share in the recovery constituted a capital asset. The Court disagreed, noting that the award was simply in exchange for his efforts in collecting documents and filing the qui tam suit.
In conclusion, the Seventh Circuit affirmed the Tax Court and held that a whistleblower award from a qui tam settlement is ordinary income.

References: v. 
 § 1222
 v. 
 v. 
 v. 
 v. 
 § 1221