This rarely litigated question was presented to the Seventh Circuit in Patrick v. Commissioner of Internal Revenue, No. 14-2190, 2015 WL 5024985, — F.3d —- (Aug. 26, 2015). Previously, the First Circuit, in Fresenius Medical Care Holdings, Inc. v. United States, 763 F.3d 63, 71-72 (1st Cir. 2014), answered the related question of how an FCA defendant’s settlement payments should be treated for tax purposes, explaining that in the absence of a tax characterization agreement, the settlement can be deducted if the objective “economic realities” indicate that the settlement was intended to be compensatory. The Seventh Circuit recognized that its issue—how an FCA relator’s settlement proceeds should be treated for tax purposes— had not been addressed by that court; in fact, the Ninth Circuit is the only other circuit court to have looked at the issue. See Alderson v. United States, 686 F.3d 791 (9th Cir. 2012).
In Patrick, plaintiff had served as the relator in an FCA action against Kyphon, Inc., alleging that Kyphon had induced hospitals to file claims for Medicare reimbursement for unnecessary inpatient hospital stays. The government intervened and settled the case and the plaintiff received $5.9 million of the settlement proceeds. Plaintiff also received $900,000 from the settlement proceeds of a related FCA case against the hospitals. Subsequently, plaintiff reported his FCA settlement proceeds as capital gains in his tax returns. The Commissioner of Internal Revenue disagreed with plaintiff’s determination and informed him that the settlement proceeds must be reported as ordinary income. The Tax Court agreed with the Commissioner.
The Seventh Circuit affirmed, holding that FCA settlement proceeds are taxable as ordinary income. The Seventh Circuit explained that capital gains are the “gain from the sale or exchange of a capital asset,” and “generally involve a ‘realization of appreciation in value accrued over a substantial period of time’ of an investment of capital.” Patrick, 2015 WL 5024985, at *2-3 (quoting 26 U.S.C § 1222(1), (3) in former and Comm’r v. Gillette Motor Transp., Inc., 364 U.S. 130, 134-35 (1960) in latter). Conversely, FCA settlement proceeds are more akin to a “reward” or “bounty” and constitute a payment for services, and therefore, should be considered ordinary income. Id. at *2. Accordingly, the Seventh Circuit held that plaintiff owed an additional $811,597 under the higher tax rate for ordinary income.
Although the tax implications for a settlement are rarely at the forefront of FCA litigants’ concerns, their financial impact is significant. For FCA defendants, the best approach to ensure that your settlement payments are deductible is to include a tax characterization agreement in the settlement agreement itself. Without this agreement, there is a chance that FCA defendants will end up in further litigation with the government to determine the tax consequences of their FCA settlement. For FCA relators, the two circuit courts that have addressed the issue—the Seventh and the Ninth—have both held that settlement proceeds must be taxed as ordinary income. Given the absence of any case law holding to the contrary, it would be prudent for FCA relators to report settlement proceeds as ordinary income so as to avoid the costs and penalties resulting from incorrectly filing your tax returns.