Court Rejects Novel Arguments and Holds Qui Tam Award Is Taxable Income

(Parker Tax Publishing February 2019)

A district court held that a taxpayer who filed a qui tam action under the False Claims Act (FCA), and was awarded a portion of the settlement payment the United States received, was required to include the award in income under Code Sec. 61(a). The court rejected the taxpayer's argument that her claim was nontaxable as a partial assignment of the government's claim for damages and instead held that the qui tam award was a taxable bounty or a reward received for uncovering a fraud. Barnes v. U.S., 2019 PTC 20 (N.D. Tex. 2019).

Sharon Barnes filed a qui tam action in a district court under the False Claims Act (FCA) in 2012. In that case, the United States sought to recover damages and penalties under the FCA arising from an aerospace company misrepresenting itself as a woman-owned small business in order to obtain government contracts.

The government intervened in the qui tam action in 2015. Shortly thereafter, the case was settled and the company agreed to make a settlement payment to the United States of approximately $20 million. Barnes agreed to a relator award of approximately $3.6 million, or 18 percent of the total settlement payment. The agreement provided that it did not in any manner affect any claims the government may have against Barnes under the Internal Revenue Code.

On her 2015 Form 1040, Barnes reported the $3.6 million relator award on Schedule C, Profit or Loss from Business. She paid tax of approximately $914,000 and then sought a refund on the basis that settlement proceeds from a qui tam action are not taxable income. The IRS disallowed all but around $67,000 of the claimed refund. It recharacterized the award from net business income/profits on Schedule C to Form 1040, line 21, "Other Income," which resulted in a refund of the self-employment taxes Barnes paid. Barnes subsequently sued in a district court.

Barnes moved for summary judgment, arguing that a qui tam recovery is either not subject to tax or taxable as capital gains rather than as ordinary income. Barnes contended that, under the origin of the claim doctrine, (1) taxability is determined by the origin and nature of the claim to which the recovery relates, (2) assignment does not change the character of proceeds for tax purposes, (3) under Vermont Agency of Nat. Resources v. U.S. ex rel. Stevens, 529 U.S. 765 (2000), by filing an action under the FCA, Barnes effected a partial assignment of the government's claim for damages, and (4) the United States does not pay taxes. Therefore, Barnes argued, the partial assignment of the government's claim to her did not alter the nontaxable character of the original claim because any recovery retains its nontaxable character, whether or not the recipient of the damages is the injured party. Further, taxing the award violated the terms of the FCA by effectively increasing the government's share of the recovery beyond the statutory cap, according to Barnes.

The IRS responded with its own summary judgment motion, arguing that qui tam payments are taxable even under the origin of the claim doctrine. The IRS contended that such awards are compensation for personal services and are really a bounty or a fee. In the IRS's view, the FCA effects a partial assignment of the claim to the relator only for the limited purpose of conferring standing. The IRS also rejected Barnes's argument that she should be treated as a coequal with the government, and argued that a relator acts as an instrumentality of the government and therefore, the claim belongs to the government as the injured party.

The district court granted summary judgment for the IRS, holding that qui tam awards are gross income under Code Sec. 61(a). The court noted qui tam awards are not excluded from income under the Internal Revenue Code and that no decisions in the Fifth Circuit (to which the case was appealable) addressed whether they are includable in gross income. However, the court noted that at least four circuit courts have held that qui tam payments are includable in gross income.

The court found that a qui tam award is a bounty or a reward that the relator receives for uncovering a fraud and bringing the suit, making it subject to tax under Code Sec. 61(a). The court found that when the qui tam provisions of the FCA were enacted in 1863 to combat fraud by Civil War defense contractors, private citizens were authorized as relators to sue on the government's behalf and, as a bounty, share in any recovery. The court also noted that under the FCA, the percentage of the qui tam award depends on the extent to which the person substantially contributes to the prosecution of the action, as well as on the significance of the information and the role of the person bringing the action in advancing the case to litigation.

The district court found that the Supreme Court, the Fifth Circuit and the majority of circuit courts treat the relator's award as a bounty or fee. In the court's view, Barnes's argument improperly characterized the relator's award and expanded the scope of the Supreme Court's holding in Vermont Agency. The court explained that Vermont Agency evaluated a relator's standing under the FCA and concluded that, in that context, the FCA could be regarded as effecting a partial assignment of the government's damages claim. The court found that the Supreme Court's decision never altered what a relator's award is - a bounty. Finally, the court found that taxing the relator's award would not contravene the statutory caps in the FCA because the language in the FCA limits the relator's award, not the government's proceeds.

For a discussion of qui tam payments under the FCA, see Parker Tax ¶74,140.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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