Patrick v. Commissioner: Tax Court Holds That Whistleblower Award Is Ordinary Income

The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.

By David I. Kempler, Esq. and Elizabeth Carrott
Minnigh, Esq.

Buchanan Ingersoll & Rooney PC, Washington, D.C.

In Patrick v. Commissioner, 142 T.C. No. 5 (2014), the
Tax Court concluded that a whistleblower's award under the False
Claims Act (FCA) was ordinary income not capital gain because the
information and documents provided were not "sold" to the

Taxpayer served as a reimbursement manager for Kyphon, Inc.
(Kyphon), which designed, manufactured and marketed minimally
invasive medical equipment. The equipment allowed for treatment by
either inpatient or outpatient procedure. However, 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, so Kyphon
instructed its sales representatives to market the procedure as
inpatient. Certain medical providers that purchased the equipment
used it for inpatient procedures and billed this expense to the
federal government under Medicare.

The FCA imposes civil liability on any person who knowingly
presents a false or fraudulent claim to the federal government for
payment or approval. Under the qui tam, or
whistleblower, provisions of the FCA, an individual may sue in the
name of the federal government as a "relator" and then receive
between 15% and 25% of the government's recovery. Taxpayer and
another employee believed that Kyphon's practices violated federal
law, and together filed a qui tam complaint alleging Kyphon had
defrauded the federal government. Kyphon eventually settled the
complaint for $75 million. Taxpayer and the other employee then
filed additional qui tam complaints against various medical
providers, which providers also entered into cash settlements to
resolve the complaints.

As a result of these various settlements, Taxpayer received
$5,979,282 in 2008 and $856,123 in 2009. Taxpayer received Forms
1099-MISC, Miscellaneous Income, for the years at issue
reflecting those amounts. Taxpayer filed joint Forms 1040, U.S.
Individual Income Tax Return, with Wife for the years at issue,
reporting the awards (less attorney's fees) as capital gains. The
IRS determined deficiencies of $716,883 and $94,714 in federal
income tax for 2008 and 2009, respectively, on the grounds that the
qui tam award was ordinary income and not capital gains

As a general rule, under §1222, capital gains or losses are
realized upon the "sale or exchange" of a capital asset. Subject to
specified exceptions, under §1221(a), a capital asset includes any
"property held by the taxpayer." A general characteristic of
property is that an owner has the legal right to exclude others
from use and enjoyment of that thereof.1

The Tax Court first looked at whether Taxpayers received the qui
tam awards through a transaction considered to be a sale or
exchange. A sale is a transfer of property for a fixed price in
money or its equivalent;2 whereas an
exchange occurs when property is transferred in return for other
property.3 Taxpayer contended
that the sale or exchange requirement was met because the qui tam
complaint established the relator's contractual right to a share of
the recovery. However, the Tax Court disagreed, noting that absent
a clear Congressional indication to contractually bind the
government, a law does not create private contractual rights.4 Accordingly, the Tax
Court reasoned that the federal government does not purchase
information from a relator (i.e., whistleblower) under the FCA;
rather, it permits the person to advance a claim on behalf of the
federal government and provides a reward for doing so. This, the
Tax Court held that the sale or exchange requirement was not

The Tax Court then examined the capital asset requirement.
Taxpayer contended that the right to future income that vested when
he filed the qui tam complaints was a capital asset.  The Tax
Court, however, noted that the definition of capital asset under
§1221 is bound by the ordinary income doctrine.5 The Tax Court
reasoned that the qui tam award was in the nature of a reward and
as such, under Regs. §1.61-2(a)(1), must be included in a
taxpayer's gross income. The Tax Court then turned to Taxpayer's
alternate argument that the documents and information provided to
the federal government were capital assets. The Tax Court, however,
once again sided with the IRS, concluding that Taxpayer had no
property interest in the documents and information because he did
not have a legal right to exclude others from use and enjoyment of
that property.

Based on the foregoing, the Tax Court held that Taxpayer failed
to demonstrate that either requirement for capital gains treatment
was met and thus the qui tam awards received were ordinary income,
and subject to tax as such.

For the tax years at issue, the top tax rate for ordinary income
was 35%, compared with 15% for capital gains.  Accordingly,
the decision of the Tax Court dramatically reduced the amount of
the whistleblower award Taxpayers were able to retain. 
Although this higher taxation may be a disincentive to some
taxpayers, the decision of the Tax Court is in keeping with general
principles about what is rewarded with capital gain treatment.

For more information, in the Tax Management Portfolios, see
Maule, 501 T.M.
, Gross Income: Overview and Conceptual
Aspects,  and in Tax Practice Series, see ¶1620, Capital

  1 Freda v. Commissioner, T.C. Memo

  2 Commissioner v. Brown, 380 U.S. 563, 571

  3 Guest v. Commissioner, 77 T.C. 9, 24

  4 Tempel v. Commissioner, 136 T.C. 341,
348 (2011).

  5 Id.

Request Transfer Pricing Report