False Claims Act tax twister: Are relator’s attorney fees deductible?

by Kurt Schulzke

Yes and no. Internal Revenue Code § 62(a)(20) is the authority on the federal income tax treatment of fees paid by whistleblowers to their attorneys, in federal FCA and federal-law based whistleblower retaliation cases.  IRC § 62(a)(20) says that such attorney fees, if paid after October 22, 2004 with respect to any judgment or settlement occurring after that date, are treated as a for-AGI adjustment on the relator’s tax return.

For-AGI adjustments are in essence deductions against gross income, subtracted in computing AGI. This for-AGI adjustment is limited to the amount includible in the relator’s gross income for the tax year on account of the judgment or settlement. IRC Section 62(a)(20) allows this for-AGI “adjustment” by defining AGI as gross income minus the following:

… attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination (as defined in subsection (e) ) or a claim of a violation of subchapter III of chapter 37 of title 31, United States Code or a claim made under section 1862(b)(3)(A) of the Social Security Act (42 U.S.C. 1395y(b)(3)(A)). The preceding sentence shall not apply to any deduction in excess of the amount includible in the taxpayer’s gross income for the taxable year on account of a judgment or settlement (whether by suit or agreement and whether as lump sum or periodic payments) resulting from such claim.

Campbell v. Comm., 134 TC 20 n.7 (2010), applies this provision. In Campbell, the taxpayer filed two FCA actions against Lockheed Martin in 1995. The court stated:

. . . During September 2003, the United States, Lockheed Martin, and petitioner settled both suits. Lockheed Martin agreed to pay the United States $37.9 million.

As part of the settlement, petitioner received a qui tam payment of $8.75 million ($8.75 million qui tam payment) for his role as “relator”. The U.S. Department of Justice filed and sent petitioner a Form 1099-MISC, Miscellaneous Income, reporting the $8.75 million qui tam payment in 2003. The $8.75 million qui tam payment was wired to petitioner’s attorneys. Petitioner’s attorneys subtracted from the $8.75 million qui tam payment a fee of 40 percent of the proceeds, or $3.5 million ($3.5 million attorney’s fee payment) and then sent petitioner a check for the remaining $5.25 million ($5.25 million net proceeds of the qui tam payment).

Later, in 2004, the taxpayer omitted the $5.25 million from his 2003 net taxable income but disclosed the omission on Form 8275 filed with his Form 1040. Not surprisingly, the IRS reached out to Campbell with a deficiency assessment, of $1,846,108.63, for the “math error” in his tax return. The Tax Court ruled in favor of the IRS. Why?

As stated above, the IRC § 62(a)(20) adjustment is applicable only to fees and costs paid after October 22, 2004, with respect to any judgment or settlement occurring after that date.  Campbell’s settlement occurred in September 2003, well before October 22, 2004. For this reason, for federal tax purposes, Campbell was obligated to treat the associated attorney fees as a miscellaneous itemized deductions, subject to the 2% of AGI floor and not deductible in computing alternative minimum tax (AMT).

Retaliation claims, which qui tam attorneys often call “(h) claims,” are more complicated from a federal income tax standpoint. Generally speaking,* in cases not subject to Section 62(a)(20) — such as non-federal False Claims Act cases (but see below regarding state or local retaliation claims) — relator’s attorney fees are treated as miscellaneous itemized deductions subject to the 2% AGI floor/AMT limitation/overall limit on itemized deducts.  See Comm. v. Banks, John W. II, 95 AFTR 2d 2005-659, 160 L Ed 2d 859, 2005-1 USTC ¶50155 (2005).

However, attorney fees for non-federal-law-based retaliation claims (brought under, for example, the New York False Claims Act) get the favored for-AGI adjustment treatment because IRC Section 62(e)(18)** defines “unlawful discrimination” for IRC Section 62(a)(20) purposes “an act that is unlawful” under

(18) Any provision of Federal, State, or local law, or common law claims permitted under Federal, State, or local law

(i) providing for the enforcement of civil rights, or
(ii) regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.

As is so often the case, the Internal Revenue Code is a basket of contradictions.  Why would Congress treat attorney fees for litigating state & local retaliation claims as for-AGI deductions while relegating the fees for state FCA claims to miscellaneous itemized status?  Question for another day.

* For a professional whistleblower (think Harry Markopolos), all whistleblower attorney fees are for-AGI business deductions.

**Attorneys who litigate ANY kind of relatiation or discrimination cases should read 26 U.S.C. Sec. 62(e) in its entirety.  The list of covered unlawful acts is long.

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