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    Thanks but More Tax Due: Whistleblower’s Reward is Ordinary Income

    Joe Forward

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    Aug. 28, 2015 – The U.S. Government paid Craig Patrick almost $7 million for uncovering a Medicare fraud scheme involving $75 million in false billings. Recently, a federal appeals court ruled that Patrick can’t claim the award as a capital gain.

    Patrick and his wife filed a joint tax returns reporting the qui tam recoveries as a capital gain rather than ordinary income, which is taxed at a higher rate. Patrick challenged the IRS’s deficiency notice. A tax court ruled the recovery is ordinary income.

    And in Patrick v. Commissioner of Internal Revenue, No. 14-2190 (Aug. 26, 2015), a three-judge panel for the U.S. Court of Appeals for the Seventh Circuit affirmed, agreeing that Patrick owes the government an additional $812,000 in taxes.

    Patrick uncovered the scheme while working as a reimbursement manager for Kyphon, which designed and sold medical equipment to treat spinal conditions. The company was later purchased for $3.9 billion by Medtronic, headquartered in Minneapolis.

    Kyphon had developed a procedure known as “kyphoplasty” to repair injured vertebra. Using Kyphon’s equipment, the surgical procedure could be performed on an outpatient basis. But Kyphon marketed it as an inpatient procedure, which would allow medical providers who used it to bill the government more for Medicare reimbursements.

    In 2005, Patrick and another employee filed a qui tam action under the federal False Claims Act, which allows “whistleblowers” or “relators” to obtain a percentage of any recovery obtained by the U.S. Government for fraudulent billings.

    Kyphon settled with the government for $75 million, and paid Patrick more than $5.9 million (about 8 percent of the settlement). Patrick received an additional $900,000 for similar suits against hospitals that used the procedure and billed Medicare.

    Patrick argued these recoveries were capital gains, gains from the sale or exchange of a capital asset. The Seventh Circuit Court of Appeals noted that it has never addressed the question, but concluded that qui tam recoveries are taxed as ordinary income.

    “Treating a relator’s reward as a capital gain would contravene the long-recognized rule that a ‘capital gain’ generally involves a ‘realization of appreciation in value accrued over a substantial period of time’ of an initial investment of capital,” the judge wrote.

    “[Patrick] expended time and effort to discover and document Kyphon’s fraud, and that work was not an investment of capital.” The panel analogized the situation to one involving an attorney who takes a percentage of recoveries on contingency:

    “The attorney’s interest in future compensation for legal work, and Patrick’s interest in a future award for his investigative work, both constitute an interest in future payment for services,” wrote Judge Ann Claire Williams for the three-judge panel. “And compensation for services qualifies as ordinary income, not a capital gain.”