Taxability of Whistleblower Payment

O’Donnell v. Allegheny Cty. N. Tax Collection Comm., 2020 WL 7413634 (Pa. Cmwlth. 2020) (unreported), allocatur granted Apr. 27, 2021, appeal docket 16 EAP 2021

In this case, the Pennsylvania Supreme Court will consider whether whistleblower award payments are taxable as earned income in Pennsylvania.

This case arises from Edward J. O’Donnell’s (Taxpayer) appeal from the trial court’s order entering judgment in favor of the Allegheny County Tax Collection Committee, the Borough of Fox Chapel, and the Fox Chapel Area School District (collectively, the Taxing Authority) in the amount of $437,194.92 based on a qui tam lawsuit settlement payment O’Donnell received in conjunction with his participation in a whistleblower action prosecuted by the federal government. O’Donnell argued that the qui tam lawsuit settlement payment he received was not taxable for the purposes of the Borough’s and School District’s Earned Income Tax (EIT). Commonwealth Court summarized the parties’ specific arguments as follows:

The Taxing Authority asserts that, in its published guidance on the matter, the Department lists “whistleblower payments” as miscellaneous compensation which is taxable for purposes of the PIT. Taxing Authority’s Br. at 20 (citing the Department’s Personal Income Tax Guide11 (Personal Income Tax Guide); R.R. at 503a). The Taxing Authority further notes that, “if a particular item of income is not explicitly listed in the definition of, or does not fit neatly within, any class of income, the relevant inquiry is ‘whether the payment is a substitute for income that would have been included in one of the eight classes of income subject to [PA PIT].’ [Department’s Personal Income Tax Letter Ruling] Pa. [Letter][Ruling]PIT-6-007[, June 15, 2006;]” Taxing Authority’s Br. at 20 (emphasis added). The Taxing Authority acknowledges qui tam payments are not explicitly listed in the statutory definition of compensation. However, it argues that the Trial Court properly held qui tam payments constitute compensation to Taxpayer because he was acting as an agent of the Federal Government, performing services on its behalf. Taxing Authority’s Br. at 20.

The Taxing Authority argues that the FCA requires the whistleblower to bring an action in the name of the government and that an individual cannot initiate legal action on behalf of another without the existence of an agency relationship. Taxing Authority’s Br. at 22. Citing the Black’s Law Dictionary definition of “agent,” the Taxing Authority argues that an agent is “one who is authorized to act for or in place of another; a representative. Black’s Law Dictionary, (7th [ed.] 1999).” Taxing Authority’s Br. at 21. Further, Taxing Authority, citing Basile v. H&R Block, Inc., 761 A.2d 1115, 1120 (Pa. 2000) (internal citations omitted), notes that the three basic elements of agency in Pennsylvania are “ ‘(1) the manifestation by the principal that the agent shall act for him, (2) the agent’s acceptance of the undertaking, and (3) the understanding of the parties that the principal is to be in control of the undertaking.’ ” Taxing Authority’s Br. at 21.

Citing the FCA, Taxing Authority states that, “[i]n a qui tam action, the whistleblower … brings a civil action on [his] own behalf ‘and for the United States Government.’ 31 U.S.C. § 3730(b)(1).” Taxing Authority’s Br. at 22. The Federal Government is the principal in the relationship because “[it] is given the authority to dismiss the action, settle the action, or substantially limit the relator’s prosecution of the case, all without the assent of the [whistleblower].” Taxing Authority’s Br. at 22 (citing 31 U.S.C. § 3730(c)(2)).

The Taxing Authority further asserts that Taxpayer provided services to the Federal Government via the qui tam action and that “the [f]ederal [c]ourts, in holding that qui tam payments are taxable for [f]ederal [i]ncome [t]ax purposes, have established that qui tam relators provide services to the government. See United States ex rel. Kelly v. Boeing Co., 9 F.3d 743 (9th Cir. 1993).” Taxing Authority’s Br. at 25.

The Taxing Authority states:

The [whistleblower’s] “concrete, private interest” in the outcome of the suit is the “bounty” he will receive if the suit is successful. [Vt.] Agency of Natural [Res.] v. United States ex rel. Stevens, 529 U.S. 765 (2000).

Accordingly, the [f]ederal [c]ourts have held that qui tam payments are both “rewards” and “bounties.” Black’s Law Dictionary defines a “reward” as “payment given in return for services (such as recovering property).” Black’s Law Dictionary (9th ed. 2009). Similarly, “bounty” is defined as a “payment given to induce someone to take action or perform a service.” Id.

Taxing Authority’s Br. at 25-26.

Taxpayer argues that his qui tam recovery was not payment for services rendered to the government because such payments “are meant as a financial incentive for a private person to bring a lawsuit for the prosecution of claims relating to fraudulent activity.” Taxpayer’s Br. at 27. Further, he was entitled to a share of the settlement proceeds because of the lawsuit he initiated against the Institution. Taxpayer asserts that “this is consistent with the reporting of the qui tam payment as ‘other income’ on a federal [f]orm 1099-MISC, as opposed to ‘nonemployee compensation’ on the [f]orm.” Id. Taxpayer argues that Internal Revenue Service (IRS) guidance makes it clear that “nonemployee compensation” includes awards for services performed as a nonemployee and other forms of compensation for services performed by an individual who is not an employee, “while ‘other income’ encompasses income not reportable in one of the other boxes on the … 1099, including awards that are not for services performed.” Taxpayer’s Br. at 27-28. Accordingly, Taxpayer contends that, if a payment from the Federal Government is not taxable as compensation for federal income tax purposes, it cannot be taxable as compensation for PA PIT purposes or for purposes of the local EIT. Taxpayer’s Br. at 28. Although contending the Trial Court did not address whether he was an employee of the Federal Government, Taxpayer asserts that, for PA PIT purposes, an “employee” means “an individual from whose wages an employer is required under the Internal Revenue Code to withhold [f]ederal income tax. 72 P.S. § 7301(g).” Taxpayer’s Br. at 26. Taxpayer argues that he does not fall within this definition and that “the lawsuit settlement payment he received was not reported as wages paid to an employee (regular or casual) on a federal Form W-2.” Taxpayer’s Brief at 26.

In addition, Taxpayer argues that the Federal Government’s decision to intervene and become a co-plaintiff in the qui tam action did not convert him into an agent of the Federal Government. Taxpayer asserts there was no fiduciary relationship between himself and the Federal Government. He contends that he had no power conferred upon him by the Federal Government, and he had no authority to act on behalf of the Federal Government with respect to the qui tam action “or to bind the Federal Government with his actions.” Taxpayer’s Br. at 25-26. Taxpayer asserts that “[t]he Trial Court overlooked section 3730(c)(1) of the FCA which specifically provides that ‘[i]f the Government proceeds with the action, it shall have the primary responsibility for prosecuting the action, and shall not be bound by an act of the person bringing the action.’ 31 U.S.C. § 3730(c)(1) (emphasis added). R.[R.] at 173a (Jt. Stip., Exhibit A).” Taxpayer’s Br. at 25. Citing United States ex rel. Taxpayers Against Fraud v. General Electric Company, 41 F.3d 1032, 1041 (6th Cir. 1994), Taxpayer notes “a whistleblower is not vested with any governmental power.” Taxpayer’s Br. at 25-26.

In addition to its arguments that Taxpayer was an agent of the Federal Government and received a qui tam payment as remuneration for his services, the Taxing Authority asserts that Taxpayer’s qui tam payment was an incentive payment/reward made for the purpose of inducing performance and that, “by allowing relators to share in a percentage of a qui tam recovery, the FCA rewards relators for their whistleblowing activity and participation in prosecuting the case.” Taxing Authority’s Br. at 31. Taxing Authority adds that the FCA incentivizes whistleblowing and that “the greater the effort and level of participation in the case by the relator, the greater the possible share of any award or settlement. See 31 U.S.C. § 3730(d)(1).” Id. The Taxing Authority maintains that “[t]he [f]ederal [c]ourts have supported this position, describing qui tam payments as ‘a financial incentive for a private person to provide information and prosecute claims related to fraudulent activity.’ Campbell v. Commissioner [of Internal Revenue], 658 F.3d 1255, 1258 (11th Cir. 2011).” Id. The Taxing Authority notes that “a qui tam payment is includable in gross income for [f]ederal income taxes because it is equivalent to a reward. Campbell, 658 F.3d at 1258-59. See also Patrick v. Commissioner [of Internal Revenue], 142 T.C. No. 5 (2014) (‘a qui tam award is a reward for the relator’s efforts in obtaining repayment to the Government’).” Id. The Taxing Authority adds that “rewards are explicitly listed as compensation in [the Department’s Regulations at] 61 Pa. Code § 101.6(a).” Id.

Alternatively, the Taxing Authority argues that Taxpayer’s qui tam recovery is the equivalent of an award for damages, asserting that “Pennsylvania regulations provide that damages from a settlement agreement are taxable unless ‘pain and suffering, emotional distress or other like noneconomic element was, or would have been, a significant evidentiary factor in determining the amount of the taxpayer’s damage.’ 61 Pa. Code § 101.6(c)(1).” Taxing Authority’s Br. at 31-32. The Taxing Authority acknowledges that “ ‘damages from personal injury or sickness are excludable from Pennsylvania [c]ompensation,’ ” but argues that Taxpayer’s qui tam payment did not stem from personal injury or sickness. Taxing Authority’s Br. at 31-32 (citing R.R. at 503a, i.e.Personal Income Tax Guide, which states that “[d]amages or settlement for lost wages other than personal injury” are included in “Miscellaneous Compensation,” (i.e., “nonemployee compensation from sources other than a federal Form W-2 or 1099-MISC”)).

Slip op. at 14-19 (emphasis in original; footnotes omitted).

Commonwealth Court reversed the trial court and held that Taxpayer’s qui tam recovery is taxable for EIT purposes, reasoning that:

There is no question that EIT in Pennsylvania is tied to the definition of compensation for purposes of the PA PIT. There is also no question that there is no specific reference to a qui tam recovery in Pennsylvania’s Tax Code. Thus, the determination of whether such a recovery is taxable for EIT purposes comes down to whether said recovery fits, or arguably fits, into one of the kinds of compensation contemplated in the Tax Code. As Taxpayer notes: “[t]he Department’s regulations provide that ‘compensation’ is defined as ‘items of remuneration received … for services rendered as an employee or casual employee, agent or officer …. These items include salaries, wages, commissions, bonuses, stock options … rewards, vacation and holiday pay … and other remuneration received for services rendered.’ 61 Pa. Code § 101.6(a) (emphasis added).” Taxpayer’s Br. at p. 23. In order for Taxpayer’s proceeds from the qui tam settlement to be compensation, they would have to have been for services rendered, which, in turn, would mean that Taxpayer was employed by the Federal Government or served as its agent. Taxpayer was neither.

Slip op. at 21 (emphasis in original). Commonwealth Court further rejected the Taxing Authority’s argument that the qui tam proceeds were taxable under Pennsylvania law as an award, concluding that:

While it is true that the qui tam recovery was the result of his initiation of a lawsuit, the proceeds were not a recovery for any damages sustained by Taxpayer. In other words, the proceeds were not part of an effort to make Taxpayer whole. Further, the Taxing Authority relies on the Department’s guidance, and New Jersey law, rather than the Tax Code or the Department’s regulations, in its attempt to suggest damages should be considered compensation for purposes of the EIT. We find this attempt unavailing, especially in light of the differences between Pennsylvania’s and New Jersey’s tax laws.

It may be more plausible that the qui tam recovery was a reward for Taxpayer’s efforts. However, here again, we stress, through reiteration, that Pennsylvania’s tax laws “are to be construed most strictly against the government and most favorably to the taxpayer, and a citizen cannot be subjected to a special burden without clear warrant of law.” In re Husband’s Estate, 175 A. at 506. Further, there was no guarantee that Taxpayer’s efforts would result in any financial recovery whatsoever. Unlike a reward for providing information about criminal activity or for recovering an individual’s lost pet, for example, where a fund may be established and announced as an incentive for a particular outcome, there was no certainty, here, that Taxpayer would receive any payment for his efforts.

The FCA is not a new law. It was “adopted in 1863 as a ‘way of combating the fraud suffered by the Union Army when it received deliveries of defective or non[-]existing military supplies.’ After reviewing evidence of massive procurement fraud, Congress believed that military contractors, aided and abetted by civil servants were robbing the Treasury in a way that could undermine the war effort.” Accordingly, our General Assembly has had ample time to consider, and to address, specifically if it so desired, the proceeds from qui tam recoveries in the Commonwealth’s tax laws. In the absence of same, there is no “clear warrant of law,” and, thus, Taxpayer, here, should not be burdened with taxation, in the form of EIT, on the proceeds of his qui tam recovery. In re Husband’s Estate, 175 A. at 506. It seems incongruous that, on the one hand, we would encourage individuals to ferret out government waste, and, on the other hand, we would punish them by taxing the proceeds for doing so.

Slip op. at 23-24.

While Judge Ceisler agreed with the majority that O’Donnell was neither an agent nor an employee of the federal government for the purposes of the qui tam payment, she dissented as to the taxability of the qui tam payment. Specifically, Judge Ceisler would hold that O’Donnell’s qui tam settlement payment constituted a taxable “incentive payment,” reasoning that:

Here, O’Donnell initiated the qui tam action against a financial institution, with the understanding that he could benefit financially if the suit was successful, and then actively assisted the federal government once it took over the suit’s prosecution. The settlement payment O’Donnell received as a result was ultimately the prospective incentive for his decision to initiate this qui tam action in the first place.

Slip op. at EC-3.

The Pennsylvania Supreme Court granted allocatur limited to the following issues:

(1) Is a qui tam whistleblower payment received for initiating and substantially contributing to a lawsuit brought under the False Claims Act taxable under the Local Tax Enabling Act and Tax Reform Code of 1971?

(2) Did the Commonwealth Court err by applying a more restrictive regulatory definition of compensation thereby making the taxability of remuneration contingent on a recipient’s employment status which is not required by the statutory definition?

(3) Did the Commonwealth Court err when it applied an employer/employee standard to analyze the existence of an agency/principal relationship?

For more information, contact Kevin McKeon or Dennis Whitaker.