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Should Whistleblower Awards be taxed?

Dodd-Frank and the Ethics of Taxing Whistleblower Awards

Section 922 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), amended the Securities Exchange Act of 1934 by, among other things, adding Section 21F, entitled “Securities Whistleblower Incentives and Protection.” Section 21F directs the Commission to make monetary awards to eligible individuals who voluntarily provide original information that leads to successful Commission enforcement actions resulting in the imposition of monetary sanctions over $1 million, and certain successful related actions.  Awards are required to be made in the amount of 10% to 30% of the monetary sanctions collected. 

On August 21, 2012, a whistleblower who had helped the Commission stop an ongoing multi-million dollar fraud received an award of 30 percent -- the maximum percentage payout allowed by law -- of the amount collected in the Commission’s enforcement action against the perpetrators of the scheme.  The award recipient in this matter submitted a tip concerning the fraud and then provided documents and other significant information that allowed the Commission’s investigation to move at an accelerated pace and ultimately led to the filing of an emergency action in federal court to prevent the defendants from doing harm to additional victims and further dissipating investor funds.  The whistleblower’s assistance led to the court ordering more than $1 million in sanctions, of which approximately $150,000 had been collected by the end of 2012. The whistleblower has been paid about $50,000 to date. 

Some believe the whistleblower provision incentivizes whistleblowing and raises ethical questions about a provision that might lead opportunists to obtain confidential information about a company’s actions and then turn it in to the SEC if wrongdoing is suspected. I have blogged about this issue before and pointed out that while this is a concern, so is the need to cut down and, ideally, eliminate instances of fraudulent behavior and fraudulent reporting by businesses.

Lost among the debate about the appropriateness of whistleblowing is the generally unknown reality that whistleblowing awards are taxable. Not only that but, as Gary J. Aguirre, former SEC Senior Counsel, points out, whistle-blowers pay income tax on their entire award, including the portion paid to their attorney under a contingent fee agreement. This is in addition to the income tax their attorneys pay on the same fee.

To compensate for the tax paid, the IRS permits the amount paid to the attorney to be treated as an itemized deduction. However, it would be deductible only as a miscellaneous expense and then only in excess of two percent of taxable income.

An example is if we assume a whistle-blower receives a $600,000 award from the SEC pursuant to the Dodd-Frank Act and pays $150,000 as the contingent fee and then the whistle-blower is taxed on $600,000. Assuming a 30 percent combined federal and state tax rate, the whistle-blower pays $180,000 in taxes and nets $270,000 [($600,000- ($150,000 + $180,000)], or 45 percent of the award.

The taxability of whistle-blower awards falls under general tax rules in IRC section 61. It states that all income is taxable from whatever source derived, unless exempted by another section of the Code. The matter is quite complicated so contacting an attorney is the best way to go if you receive such an award. 

My biggest complaint is that the portion of the award that is paid out as a contingent fee is taxed twice: once to the awardee and once to the attorney receiving the fee. I’ve never been a fan of double-taxation, and this is a good example of the unfairness of that practice.

It seems to me the remedy is to reduce the taxable amount of the award by the contingent fee paid to the attorney and tax the balance. Whistleblowers should not be taxed on amounts they really don’t receive (the net amount). I realize the government needs money, but this is not the way to go about it.

Blog posted by Steven Mintz, aka Ethics Sage, on April 17, 2013