Taxpayers were again beaten back in an attempt to broadly define a “capital asset” and a “sale of a capital asset” in order to gain access to the preferential capital gain tax rates in the case of Patrick v. Commissioner, 142 TC No. 5, affirmed on appeal by the Seventh Circuit Court of Appeals, Case No. 14-2190.

In this case the taxpayers were looking to get capital gain treatment for an amount they received as a reward for, effectively, turning in the husband’s employer through a qui tam complaint filed under the False Claims Act.

The taxpayer had worked for an entity which, in the taxpayer’s view, had acted illegally to indirectly create excessive Medicare billings for the customers of its equipment.  The company had created equipment which, due to being minimally invasive, allowed certain medical procedures to be performed on an outpatient basis.  However being an outpatient procedure the company worried that some potential customers would refuse to purchase the equipment due to that effect.

Thus the company instructed its salesforce to market the procedure using the equipment as being an inpatient procedure.  Some providers, following this advice, billed such expenses to Medicare.

The taxpayer brought an action on behalf of the government under the False Claims Act (a qui tam procedure) making use of information the employee had.  Under the law a whistleblower taking this approach is awarded a portion of any resulting amount eventually received by the government.  The taxpayer received over $6 million in funds under this program.

On his tax return, the whistleblower claimed the payment represented a capital gain taxed at the lower capital gain rates.  The IRS and the Tax Court disagreed, arguing that such income failed to meet key requirements necessary to obtain capital gain treatment.

The taxpayers argued that they had sold information to the government in exchange for a share of the settlement, a transaction they viewed as being the sale of a capital asset. The Tax Court found both that there was no sale and that the taxpayer had no capital asset which could have been sold.

First, the Tax Court found that under the FCA the whistleblower was obligated to provide all supporting information to the government in order to be eligible to share in the award.  The taxpayer argued that the FCA created a contractual right (which would be a capital asset).  However, the Court found that the FCA created no contractual rights, but rather simply permits a person to advance a claim on behalf of the government and then receive a reward for doing so.

The Tax Court distinguished this situation from the sale of a trade secret, something the taxpayers argued the case was analogous to.  In the case of the sale of a trade secret the transferor transfer all substantial rights to the government—but the taxpayer transferred no rights to the government.

The taxpayer’s argument that the asset in question was a right to future income ran afoul of the ordinary income doctrine (a doctrine also used against attempting to get capital gain treatment for the proceeds from the sale of a winning lottery ticket).  Generally a capital asset does not include property that itself represents an item of income, nor any increase in the value of a capital asset that is itself attributable to income.

Finally the Tax Court agreed with the IRS that the information and documents themselves were not property of the taxpayer, since the taxpayer had no right to exclude others from the use of the items in question.  The taxpayer had an obligation under the FCA to disclose the information to the government and had no right to prevent either his employer or the medical service providers involved from using or disclosing the information.

So what the taxpayer had was simply ordinary income and it was to be taxed as such in the view of Tax Court.

The taxpayer attempted to get the decision reversed by appealing the case to the Seventh Circuit Court of Appeals.  The Seventh Circuit panel noted that it had never decided whether such an award represented the sale of a capital asset, but noted the Ninth Circuit had “concluded that a relator’s share is ordinary income because it operates as a bounty for the relator’s work in filing the qui tam suit, see Alderson v. United States, 686 F.3d 791 (9th Cir. 2012)…”

While the taxpayers may have been hoping for the Seventh Circuit to split with its sister circuit on the issue, they were to be disappointed.

The Court found that the qui tam award represents a payment for the services of the party in filing the suit, not the sale of an asset that would lead to capital gain.

The Seventh Circuit panel noted:

Treating a relator’s reward as a capital gain would contravene the long-recognized rule that a “capital gain” generally involves a “realization of appreciation in value accrued over a substantial period of time” of an initial investment of capital. Comm’r v. Gillette Motor Transp., Inc., 364 U.S. 130, 134-35 (1960); see also Alderson, 686 F.3d at 797. But here Patrick made no initial investment in some asset. Instead, he expended time and effort to discover and document Kyphon’s fraud, and that work was not an investment of capital. See Alderson, 686 F.3d at 797. Further, there was no “realization of appreciation in value” of an underlying investment that “accrued over a substantial period of time.” Gillette Motor Transp., Inc., 364 U.S. at 134. Patrick had an interest in a portion of the government’s recovery, but that interest did not grow in value over time. It did not even vest until the government received its recovery. See Vt. Agency of Natural Res., 529 U.S. at 772.

The Court then deals with the specific claim that there was the sale of an asset,  noting that “courts agree that an item is property only if the owner has the right to exclude others from using it, see Kaiser Aetna v. United States, 444 U.S. 165, 179-80 (1979); Minn. Mining & Mfg. Co. v. Pribyl, 259 F.3d 587, 609 (7th Cir. 2001).”

The taxpayer had raised two arguments claiming that what they had was property.  The taxpayers claimed the property sold was the information he had obtained while working for Krypton and that he therefore had a right to stop others from using it.  The Court found this unpersuasive, noting:

True, Patrick compiled documents that he transferred to the government. But the information contained in those documents—information about Kyphon’s fraudulent practices—was available to many other Kyphon employees who could have used the knowledge to file their own qui tam suit. The Patricks reply by comparing the information to a trade secret, which may have multiple owners. But even if the information Patrick gathered was secret in the sense that it was nonpublic information, he had no right to stop anyone else from using it, and, thus, the information and documents cannot be his “property.” See Kaiser Aenta, 444 U.S. at 179-80.

Then the Court turns to the claim that his right to a portion of the recovery should itself be a capital asset.

Patrick’s award was a payment for his efforts to collect documents and file the qui tam suit. See Vt. Agency of Natural Res., 529 U.S. at 772; Apria Healthcare Grp. Inc., 606 F.3d at 364. The Commissioner aptly analogizes this situation to an attorney’s interest in payment under a contingency fee arrangement. The attorney’s interest in future compensation for legal work, and Patrick’s interest in a future award for his investigative work, both constitute an interest in future payment for services. And compensation for services qualifies as ordinary income, not a capital gain. See Canal-Randolph Corp., 568 F.2d at 32; Bouchard, 229 F.2d at 704. Because the Patricks have not demonstrated that Patrick possessed a capital asset, his relator’s share from the qui tam suit cannot constitute a “capital gain.” See 26 U.S.C.§ 1222(1), (3) (defining “capital gain” as a “gain from the sale or exchange of a capital asset”).