August 2012

The Ninth Circuit decided a taxation case of first impression involving whether a qui tam or whistleblower recovery provides a taxable capital gain from a sale of property, or ordinary taxable income. The District Court in Los Angeles, and the Ninth Circuit both agreed with the IRS that the higher rate of taxation from ordinary income applied.

James Alderson, a former hospital chief financial officer, received $27 million by blowing the whistle on his former employer’s accounting fraud. The Ninth Circuit summarized the underlying facts as follows:

“In 1993, James Alderson filed a qui tam action under the False Claims Act (“FCA”) alleging Medicare fraud by Quorum Health Group, Inc. (“Quorum”), a hospital management company, and several related entities including the Hospital Corporation of America, Inc. (“HCA”). The United States intervened in 1998. The United States settled its FCA claims against HCA for $631 million in 2003. …

Alderson was the Chief Financial Officer for North Valley Hospital in Whitefish, Montana, in 1990. That year, Quorum, an affiliate of HCA, began managing the hospital. Quorum asked Alderson to prepare two sets of books, one for the hospital’s financial auditors and one to serve as the basis for the hospital’s Medicare cost reports. Alderson refused to prepare separate books. Quorum fired him in September 1990. In May 1991, Alderson filed a wrongful termination suit. During discovery, Alderson deposed several Quorum officials and obtained sample Medicare cost reports. The depositions and documents suggested widespread accounting fraud.”

The Ninth Circuit noted that the qui tam action involved considerably more effort from Aldersen than selling an asset. Indeed, Aldersen spent years prosecuting the case, analyzing documents produced in the litigation, and attempting to get the government to intervene in his suit. The Ninth Circuit explained its rational pertaining to the generation of ordinary income (vs. the sale of a capital asset) as follows:

“First, Alderson did not receive his right to a relator’s share in return for an ‘underlying investment of capital’. … Uncovering accounting fraud, receiving documents during discovery, and interpreting those documents are not activities that constitute an investment of capital. Appellants point out that Alderson incurred expenses in acquiring the documents and information that he provided to the government. However, the fact that Alderson incurred expenses is not determinative, for taxpayers routinely incur expenses in the production of ordinary income.

Second, the increase in value between 1993 and 2003 did not “reflect an accretion in value over cost to [the] underlying asset.” The increase in value of Alderson’s relator’s share—of his “underlying asset”—was not the sort of “accretion in value” that characterizes a capital gain. Alderson was not an investor who bought and held an asset that increased in value during the holding period. Rather, Alderson worked intensively after 1993 to increase the likelihood that his qui tam suit would be successful…”

Although not directly addressed in the case, the Court’s rationale in Aldersen should probably provide precedent to the increasingly common situation for plaintiff-side purchase or finance of claims.

Most tax practitioners agree that the ruling is not unexpected, but the case nevertheless provides guidance on a topic where no case authority previously existed.

Fulcrum Inquiry is an accounting firm that provides  whistleblower reporting solutions for corporations and non-profit organizations.