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Ninth Circuit Rules Relator's Share is Ordinary Income


August 23, 2012

In U.S. v. Alderson, 686 F.3d 791 (9th Cir. July 18, 2012), a case of first impression, the Ninth Circuit Court of Appeals found that a relator's share should be treated as ordinary income for tax purposes rather than as capital gain.  Given the lack of authority for both the qui tam relator and the Government's positions, the Ninth Circuit analyzed the correct treatment of relator's share based on the text of the Internal Revenue Code.  Under the Internal Revenue Code, a capital gain is a gain from the sale or exchange of a capital asset.  Using this analysis, the Ninth Circuit found that (1) the information provided to the Government by a relator was not a "sale or exchange" and (2) that neither the information provided to the Government nor the relator's share itself constituted a capital asset.  Finally, the Ninth Circuit also found that the increase in value of the relator's share did not amount to a capital gain from when the relator filed the qui tam action in 1993 to when the case was settled in 2003.

Background 

In 1993, James Alderson, the former CFO of North Valley Hospital in Montana, filed a  qui tam suit under the False Claims Act against Quorum Health Group (Quorum) as well as other entities including the Hospital Corporation of America (HCA).  After litigating the cases on his own for five years, the United States intervened in 1998 and settled the case against HCA for $631 million and the case against Quorum for $85.7 million.  After accounting for attorney's fees and expenses, Alderson received $27.1 million as his share of the HCA settlement.  Prior to receiving the settlement, Alderson transferred 40% of his interest of the potential share to a family partnership he established.  He then gave his two children 49% interests in the partnership, his wife a 1% interest, and retained a 1% interest for himself.  In 2003, Alderson and his wife filed a joint tax return for both the 60% relator's share Alderson retained as well as the 2% interests they kept in the family partnership as ordinary income.  Additionally, both Alderson's son and his wife, and Alderson's daughter and her husband, filed tax returns for their 49% interests in the partnership as ordinary income.

In 2007, all three couples filed amended returns for tax year 2003, in which they re-characterized their portion of the relator's share as capital gain.  Such a re-characterization would reduce their tax liability significantly - Alderson and his wife sought a refund of $3.2 million and his son and daughter sought refunds of just over $1 million each.  After the IRS denied their refund requests in 2008, all three couples filed suit in district court for refunds.  The district court denied the requests, finding the relator's share was ordinary income.  The three couples ("Appellants") then filed for appeal to the Ninth Circuit. 

As a matter of first impression, the Ninth Circuit analyzed whether the relator's share under the FCA would constitute a "capital gain," which is defined in the Internal Revenue Code as a "gain from the sale or exchange of a capital asset."  26 U.S.C. § 1222(1),(3).  To make this determination, the Ninth Circuit considered whether the relator's share would satisfy the requirements of both "sale or exchange" and "capital asset."

Sale or Exchange

Noting that capital gains treatment only applies to gains from sales or exchanges, the Ninth Circuit addressed Appellant's arguments that Alderson's exchanging documents, information, and know-how to the government in exchange for a relator's share, was a sale or exchange.  The Ninth Circuit rejected this argument, finding that Alderson did not "sell" or "exchange" the information that he provided to the Government in his qui tam suit.  The Court noted that if Alderson had offered to sell the information he had to the Government they would almost certainly reject this offer.  Rather, the Ninth Circuit found that Alderson provided the information to the Government as a precondition for pursuing his qui tam suit, as required by the statute. 

Further, Alderson did more than simply "hand information over to the Government" in exchange for payment.  Instead, he performed numerous and extensive acts to persuade the Government to intervene in the case, such as reviewing the thousands of documents the Government had obtained through subpoenas and preparing a spreadsheet based on his analysis of these documents.  Thus, the Ninth Circuit found that Alderson's actions could not constitute a "sale or exchange" for purposes of capital gains treatment.

Capital Asset

The Ninth Circuit next addressed Appellant's arguments that Alderson's relator's share constituted a "capital asset."  Specifically, Appellants argued (1) that the information supplied by Alderson to the Government was a capital asset and (2) that the relator's share itself was a capital asset.  The Ninth Circuit rejected both arguments. 

First, the Ninth Circuit found that the information supplied by Alderson to the Government was not a capital asset as it was not his "property" as required by 26 U.S.C. § 1221(a).  The Ninth Circuit recognized that general principles of property law require the owner to have a legal right to exclude others from use and enjoyment of that property.  In this case, the Ninth Circuit found that Alderson had no legal right to exclude others from the information he obtained through discovery and subsequently provided to the Government.  Rather, the information was known to other officials in the company and Alderson had no right to prevent those officials from providing it to others.  Although the FCA required Alderson to file his complaint and accompanying evidence under seal to allow the Government to investigate the case, this requirement did not alter the fact that Alderson could not prevent others who knew of the information from revealing it.  Thus, because the information Alderson provided to the Government was not his "property," it could not be considered a capital asset. 

Next, the Ninth Circuit rejected Appellants' argument that the relator's share itself was a capital asset and that the increase in value of the relator's share between 1993 (when Alderson filed the case) and 2003 (when he actually received it) was a capital gain.  The Ninth Circuit recognized that a relator's share could constitute property for some purposes such as for assignment to others.  However, the Ninth Circuit rejected the notion that because a relator's share could be property for some purposes, that it could be a capital asset.  Notwithstanding the Appellant's argument, the Ninth Circuit found that neither of the factors used to identify capital assets applied to the relator's share. 

First, Alderson did not receive his right to a realtor's share in return for an underlying investment of capital.  The Ninth Circuit found that Alderson's uncovering of HCA's fraud and receiving documents revealing the fraud during discovery were not activities that constitute an "investment of capital".  Although Alderson incurred expenses in furtherance of his acquisition of the documents he provided to the Government, taxpayers routinely incur expenses in the production of ordinary income.  Next, the Ninth Circuit found that the increase in value of the realtor's share between 1993 and 2003 did not reflect an "accretion in value over cost to the underlying asset."  Alderson was not an investor who bought and held an asset that increased in value, but rather a relator who worked "intensively" to increase the likelihood that his qui tam suit would be successful. 

Finally, the Ninth Circuit rejected Appellants argument that the increase in value of the relator's share between 1993 and 2003 itself was a capital gain under 26 U.S.C. § 1234A.  That provision allows gain from property constituting a "capital asset" to be treated as capital gain.  Because the Ninth Circuit already rejected the notion that the relator's share was a capital asset, it found that the increase in value of the relator's share from 1993 to 2003 was not a capital gain.

Conclusion

This decision has important tax implications for successful qui tam whistleblowers.  Following this decision, successful qui tam relators must be careful to pay taxes on their relator's share as ordinary income rather than as a capital gain.