Seventh Circuit Holds Relator’s Share Is Taxable As Ordinary Income Rather Than Capital Gain

Late last month, in Patrick v. Commissioner, No. 14-2190,  _ F. 3d __ (7th Cir. Aug. 26, 2015), the Court of Appeals for the Seventh Circuit unanimously affirmed a United States Tax Court opinion as to the characterization of a qui tam award received by a relator.  The Seventh Circuit held, as had the Tax Court, that the award constituted ordinary income rather than capital gain and thus was subject to tax at the highest individual rate rather than the preferential (lower) capital gain rate.   Previously, this characterization issue had only been addressed by one other federal circuit, the Ninth, in Alderson v. United States, 686 F.3d 791 (9th Cir. 2012).

The characterization of the award turned on whether the award should be viewed as compensation for services, in which case it would be ordinary income, or gain from the sale or exchange of a capital asset, in which case it would be capital gain.  The Seventh Circuit, with little difficulty determined, as had the Ninth Circuit, that courts had consistently described a relator’s share as a “bounty” or “reward” for work done by the relator to gather evidence and file the qui tam action and thus that the award must be treated as “for services.”  The Seventh Circuit also noted that treating the relator’s reward as capital gain would be inconsistent with the “long-recognized rule” that capital gain involves the realization of appreciation accrued over time.  The relator’s arguments to the contrary were dismissed in two short paragraphs.

Given the ease with which the Seventh Circuit affirmed the Tax Court, the presence of a similar holding by the Ninth Circuit, and the soundness of their reasoning, relators even in the remaining circuits are unlikely to sustain the position that an award should be entitled to preferential capital gain tax treatment.