Millions Received from Qui Tam Award Is Ordinary Income.
(Parker Tax Publishing March 9, 2014)

A taxpayer's qui tam award for bringing to light systematic fraud against the government is ordinary income and not capital gain. Patrick v. Comm'r, 142 T.C. No. 5 (2/24/14).

Craig Patrick was the reimbursement manager for Kyphon, Inc., a company that designed, manufactured, and marketed minimally invasive equipment to treat certain spinal conditions. The equipment allowed for treatment by outpatient procedure. Kyphon feared that medical providers would avoid purchasing the equipment because performing the procedure on an outpatient basis would no longer generate revenue from overnight hospital stays. Therefore, Kyphon instructed its sales representatives to market the procedure as an inpatient procedure. Certain medical providers that purchased the equipment had patients admitted when undergoing the treatment and billed this expense to the government under Medicare.

Criag and another Kyphon employee, Charles Bates, believed that Kyphon's practices violated federal law. Craig and Charles agreed to file a qui tam complaint and to split any relator's award. Craig collected various documents he had helped create during his employment that demonstrated Kyphon's practices. Criag also kept some internal Kyphon documents and external marketing material. Craig and Charles filed a qui tam complaint alleging Kyphon had defrauded the government. Kyphon eventually settled the matter for $75 million. The government intervened after Kyphon agreed to the settlement. Craig and Charles then filed additional qui tam complaints against various medical providers. Those entities also entered into cash settlements to resolve the complaints.

OBSERVATION: The phrase "qui tam" is short for a Latin phrase meaning one "who pursues this action on our Lord the King's behalf as well as his own." Congress has enacted multiple qui tam provisions, including the False Claims Act (FCA). The FCA imposes civil liability on any person who knowingly presents a false or fraudulent claim for payment or approval and authorizes a person, referred to as the relator, to file under seal a complaint seeking reimbursement on the government's behalf. The relator must serve on the government the complaint and all supporting information the relator possesses before the action may proceed. The government may intervene and prosecute the matter, may request dismissal, or settle the action with the court's approval.

Craig received a relator's share of almost $6 million in 2008 and $850,000 in 2009. The government issued to Craig Forms 1099-MISC, Miscellaneous Income, for the years at issue reflecting those amounts. On their joint individual Form 1040s for 2008 and 2009, Craig and his wife reported the awards (less attorney's fees) as capital gains. The IRS rejected that treatment and issued a deficiency notice. According to the IRS, the income should've been characterized as other income and not capital gain. The Patricks argued that Craig sold information to the government in exchange for a share of any recovery. The IRS, on the other hand, argued that the relator income was similar to a reward and did not satisfy the requirements for capital gains treatment.

The Tax Court held that the information Craig provided to the government was not his property and therefore was not a capital asset. Thus, the income Craig received from the qui tam award was not the result of a sale or exchange of a capital asset and was instead taxable as ordinary income.

The court rejected the Patricks' argument that a relator sells his information to the government, instead agreeing with the IRS that the relator has a statutory obligation to provide all supporting information to the government and this does not constitute a sale or exchange.

The court rejected the couple's assertion that the sale or exchange requirement is met because the qui tam complaint establishes the relator's contractual right to a share of the recovery. Absent a legislature's clear indication to contractually bind the government, the court stated, a law does not create private contractual rights. The government does not purchase information from a relator under the FCA, the court noted, but instead permits the person to advance a claim on behalf of the government. The award is a reward for doing so and no contractual right exists.

The court also rejected the Patricks' contention that the right to future income that vested when Craig filed the qui tam complaints was a capital asset and dismissed their alternative argument that the documents and information provided to the government were capital assets.

Citing numerous cases, the court said that the right to future payments of ordinary income is not a capital asset. A qui tam award, the court observed, is a reward for the relator's efforts in obtaining repayment to the government and is includible in a taxpayer's gross income. The court also rejected the Patricks' argument that Craig had a property interest in the information and documents he disclosed to the government, saying that the documents and information are not a capital asset because Craig did not have a legal right to exclude others from the use and enjoyment of that property.

For a discussion of the taxation of qui tam awards under the FCA, see Parker Tax ¶74,140. (Staff Contributor Parker Tax Publishing)

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