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Should Whistle-blower Awards Be Taxed by the IRS?

The Act of Whistle-blowing: Ethical Issues Examined

Are you thinking about becoming a whistle-blower under a federal law such as the Dodd-Frank Financial Reform Act or the Commodity Futures Trading Commission (CFTC)? You best first understand that any amount you receive is treated as ordinary taxable income by the IRS. Even the amount you pay as a contingent fee to an attorney is taxable. You can only get a deduction for that amount as a miscellaneous itemized deduction subject to the 2% floor.

Let’s assume that 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. The whistle-blower is taxed on the full $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.

Notwithstanding the exception described below, 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.

Attorney's fees can be deducted above the line to determine adjusted gross income only if the award is the result of a retaliation case, not a Dodd-Frank whistle-blower action. In these cases, the recipient only pays tax on the amount received net of attorney’s fees.

Also, a whistleblower under the Federal False Claims Act only pays taxes on the net recovery. The same is true for a whistleblower who receives an award from the IRS.

However, since no statutory exclusion applies to the attorney’s fees paid by a whistleblower who obtains an award from the SEC or CFTC under Dodd-Frank, he or she must go the itemized deduction route, which means the 2% floor and the 28% alternative minimum tax (AMT).

The classic case of taxability is Patrick v. IRS, 16387-12, U.S. Tax Court (Washington). In this case the court ruled that the whistleblower’s $6.8 million award must be taxed as ordinary income, rejecting arguments that the money should be recognized as capital gains and subject to a lower rate. Craig Patrick, a former reimbursement manager for California medical device-maker Kyphon Inc., helped win the recovery of tens of millions of dollars for the U.S. from an alleged Medicare fraud and his efforts “are to be applauded and were rewarded,” Judge Diane Kroupa wrote in her ruling. “Rewards, however, are treated as ordinary income” and “subject to tax as such.”

Patrick blew the whistle on allegedly fraudulent marketing. He argued that the transaction was akin to the sale of a trade secret. Kroupa ruled that under the False Claims Act, the government doesn’t purchase information. Instead “it permits the person to advance a claim on behalf of the government. The award is a reward for doing so. No contractual right exists.” Kroupa also rebuffed the Patricks’ argument that the information and documents Craig Patrick gave the government were his property and thus capital assets.

Patrick claimed in his whistleblower suit that Kyphon engaged in a years-long scheme to inflate Medicare bills by persuading hospitals to bill for a spinal procedure at inpatient rates rather than for less costly outpatient treatment.

The alleged fraud involved kyphoplasty, a treatment for compression fractures in which spinal gaps were filled with bone cement. Medtronic Inc. which acquired Kyphon in 2007, agreed to pay $75 million to settle the case in May 2008.

From an ethical perspective, I do not agree with the distinctions being made by the court with respect to the government purchasing information versus allowing the whistleblower to advance a claim on behalf of the government. Yes, a contractual right may not exist but how does it exist when retaliation is present? The rules seem to be applied indiscriminately.

On the other hand, it could be argued from a justice perspective that retaliation is a fair basis for differential treatment. Justice Theory holds that equals should be treated equally, while unequals should be treated unequally. Using that argument, those who have endured retaliation have been more harmed than whistleblowers who have not been retaliated against. However, the logic of this argument seems to imply it is better for the would-be whistleblower to wait to be retaliated against before blowing the whistle. It could save that party thousands in tax payments otherwise due to the IRS. However, it also exacerbates the negative effects on the investing public.

Clearly there are inconsistencies in the taxability of awards especially when we look at environmental whistleblowers. While many environmental whistleblowers report law-breaking simply because they believe it’s the right thing to do, financial incentives provide additional motivation for blowing the whistle.

Unfortunately, environmental whistleblower law is piecemeal, with inconsistent incentives and protections. While most laws have anti-retaliation provisions, many do not provide financial awards. In addition, cozy relationships between some enforcement agencies and industries can undermine whistleblowers’ efforts to ensure environmental regulation compliance.

There should be a full and transparent discussion about whistleblowing and the societal interest. The ultimate objective is to protect the public interest. The ethical question is whether whistleblowing is the best way to achieve that result. Assuming the answer is affirmative, then from an ethical perspective the entire issue should be examined including whether any distinctions should be made with regard to taxability. After all, it may be that awarding ethical action obscures the real purpose of the act of whistleblowing, which is to right a wrong.

Blog posted by Steven Mintz on July 14, 2016. Dr. Mintz is Professor Emeritus from Cal Poly San Luis Obispo. He also blogs at www.ethicssage.com.