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).
Last week, in Fresenius Medical Care Holdings, Inc. v. United States, No. 13-2144, __ F. 3d __ (1st Cir. Aug. 13, 2014), the Court of Appeals for the First Circuit affirmed a district court opinion that had allowed a defendant in an FCA action to deduct for federal income tax purposes amounts in excess of both single damages and relator payments. This affirmance is of considerable import because, in a well-reasoned opinion, the First Circuit expressly rejected the government’s “Catch-22” argument that the ability of a taxpayer to deduct at least a portion of this excess was precluded by the absence of an agreement between the parties.
For some time, the law had been relatively clear that, for federal income tax purposes, a taxpayer could deduct amounts in excess of single damages to the extent that the taxpayer could prove the excess represented compensatory rather than punitive damages. See, e.g., Cook County v. United States ex rel. Chandler, 538 U.S. 119, 130-31 (2003). However, the Internal Revenue Service has traditionally taken the position that, at least apart from amounts paid the relator, a taxpayer cannot carry its burden of proof as to the compensatory nature of any part of the excess absent agreement with the government on this point. This was a Catch-22 argument because, in settling FCA cases, the Department of Justice procedures generally proscribe any agreement as to the deductibility of amounts paid.
The First Circuit would have none of the government’s argument. Stating that, in tax matters, “[s]ubstance matters,” the court refused to give the government “a whip hand of unprecedented ferocity” that would enable it to “always defeat deductibility by the simple expedient of refusing to agree . . . to the tax characterization of a payment.” The Court then held that, so long as a taxpayer like the one before it had proven that a portion of the excess was compensatory, that portion was deductible.
While important and helpful, the First Circuit opinion is not a panacea. First, a Ninth Circuit opinion distinguished by the court, Talley Industries Inc. v. Commissioner, 116 F.3d 382 (9th Cir. 1997), arguably is to the contrary – a point the First Circuit expressly conceded. Second, the First Circuit’s opinion reiterates that the burden lies with the taxpayer to establish the compensatory nature of the excess. Third, the First Circuit said that one argument by the government – that reductions to the government’s original compensatory and punitive claims in a settlement should be done proportionally rather than first to punitive claims – had a “patina of plausibility.” (The court did not need to contend with this argument in the case before it because the government had raised it too late in the proceedings.)
Thus, while the First Circuit’s decision in Fresenius is very good news, careful planning and analysis are still necessary to maximize the deductibility of FCA payments for federal income tax purposes.
Sidley lawyers Kristin Graham Koehler and Brian Morrissey have authored an article as a part of the Washington Legal Foundation’s Counsel’s Advisory series, entitled “Court Ruling Provides Blueprint for Deducting False Claims Act Damages.” The article examines the recent ruling in Fresenius Medical Care Holdings, Inc. v. United States, No. 08-12118, 2013 WL 1946216 (D. Mass. May 9, 2013), a potentially path-marking decision by the U.S. District Court for the District of Massachusetts. The decision allowed a defendant in an FCA suit to present evidence that damages it paid under the Act were tax-deductible compensatory payments to the Government, despite the fact that the Department of Justice, consistent with its customary practice, refused to agree to the tax characterization of the damages payment. The ruling establishes an important precedent for individual and corporate FCA defendants seeking to determine the likely tax treatment of potential damages awards.
The article is available for download on the Washington Legal Foundation’s website: http://www.wlf.org/publishing/publication_detail.asp?id=2390.
Posted by HL Rogers and Loui Itoh
Although the federal FCA specifically exempts tax fraud, New York is one of over 30 states and four municipalities that have enacted separate FCA laws. These state FCA laws generally follow the federal FCA but vary in certain specifics. For instance, New York’s state FCA law specifically exempted tax fraud, similar to the federal FCA, when it was passed in 2007. However, it was expanded in 2010 by amendments that allowed, among other things, whistleblower claims related to tax fraud. This expanded provision had not been successfully used until this month when New York announced its first FCA tax recovery. The settlement marks the first time that an FCA has been used to penalize tax fraud. Critics and experts will be watching closely to see if this recent recovery will lead to a new national trend.
On March 5, 2013, New York Attorney General Eric T. Schneiderman announced that tailor Mohanbhai “Mohan” Ramchandani and his business corporation, Mohan’s Custom Tailors, Inc., pled guilty to a ten-year tax evasion scheme and agreed to pay a $5.5 million civil settlement for claims filed under New York State’s False Claims Act. The civil claims were first raised by a whistleblower who offered insider information and will receive a $1.1 million award under the New York FCA’s relator award provisions.
The Attorney General’s investigation concluded that since 2002, Mohan and his business had knowingly failed to pay at least $1.7 million in state and local sales taxes, and that Mohan himself owed at least $256,000 in state and local personal income taxes. Mohan confessed to these charges before the New York County Supreme Court, admitting that he and his business had knowingly failed to pay nearly $2 million in taxes. In addition to the civil settlement, Mohan faces up to three years in prison for the felony charges.
Although it specifically exempted tax fraud when it was passed in 2007, New York’s FCA was expanded in 2010 by amendments authored by Attorney General Schneiderman, who was then a state senator. Schneiderman called the newly expanded state FCA, a “False Claims Act on Steroids.” The revised FCA allows a whistleblower to bring a qui tam suit against an individual or business that makes more than $ 1 million net income and defrauds the state by more than $350,000 in taxes. The relator may keep up to 25 to 30 percent of the recovery, depending on whether the government joins the suit. The question remains whether this will become a national trend and another consistent tool in state governments’ arsenals to penalize tax fraud.
In 2011, Maxim Healthcare entered into a settlement agreement with DOJ under which it paid $121 million plus interest to resolve civil claims arising under the False Claims Act based on allegations that it had fraudulently billed Medicaid and the VA for services not provided or at inflated rates. The company also entered into a deferred prosecution agreement and nine individuals pled guilty to criminal charges related to the same conduct. On October 29, 2012, Maxim filed suit against DOJ under the federal FOIA to obtain the details of how the government apportioned its $121 civil settlement in order to allow Maxim accurately to claim the single damages “compensatory” portion of its settlement payment as a deduction, in accordance with applicable U.S. tax laws. When DOJ enters into FCA settlements it prepares a Civil Fraud Disposition Report, in which it describes how it has calculated single damages and penalties and how it has allocated the settlement funds. As companies that have entered into civil FCA settlements with DOJ know, DOJ routinely refuses to share the specific details of those calculations and allocations with defendants, making it difficult to determine the deductible portion of the settlement for income tax purposes.
Maxim’s complaint alleges that DOJ produced a copy of the Civil Fraud Disposition Report related to its settlement in response to Maxim’s FOIA request that was redacted of the information necessary to determine the amount attributed to compensatory damages, claiming that information was protected by the government’s attorney work product and pre-deliberative process privileges. Maxim argues that the Report was drafted two weeks after the settlement was finalized and is routinely shared with the IRS, preventing the application of the claimed privileges. In response to a separate FOIA request, DOJ produced a copy of a receipt detailing the financial breakdown of one of the 34 separate payments scheduled under the settlement agreement, which Maxim argues further undercuts the government’s privilege claims. If granted, Maxim’s request that DOJ be ordered to disclose the Civil Fraud Disposition Report would significantly assist defendants seeking to fully avail themselves of the tax benefits of future FCA settlements.
The case is pending in the U.S. District Court for the District of Columbia.
In what it characterized as an issue of first impression, the Ninth Circuit recently held that the relator’s share of a recovery under the FCA is taxable as ordinary income, rather than at lower capital gains rates. A copy of the decision in Alderson v. United States, No. 10-56007 (9th Circuit, July 18, 2012) can be found here. Although the Court’s ruling most directly affects relators, the taxability of the relator’s share is a factor that any relator considers in the settlement calculus, and is therefore an issue of interest to the defense bar as well.
Posted by Matthew D. Krueger and Gordon D. Todd
Last Thursday, New York intervened into a qui tam suit against Sprint under the State’s False Claims Act alleging underpayment of sales taxes. This marks the first such case since New York amended its False Claims Act specifically to allow whistleblowers to file state tax-fraud cases.
The complaint alleges that Sprint knowingly failed to collect and pay $100 million of sales taxes over the past seven years. According to the complaint, in 2005, Sprint began attributing a portion of subscribers’ monthly charges to interstate calls and did not pay New York sales taxes on that portion. The lawsuit also alleges that Sprint concealed its practice from state tax authorities. Under New York’s law, if liable, Sprint would have to pay three times the underpaid taxes—$300 million—plus penalties. The case will be closely watched as it tests the often-murky boundary between tax-management strategies that companies may lawfully pursue and false claims that give rise to hefty liability.
In contrast to New York’s law, the federal False Claims Act does not reach tax fraud. A provision of the Tax Code does, however, reward whistleblowers with 15 to 30 percent of proceeds that they lead the IRS to collect. 26 U.S.C. § 7623.