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WHISTLEBLOWER DAMAGES SIMILAR TO IRA SETTLEMENTS?

February 05, 2007

Tax lawyer Kreig Mitchell has an interesting post today where he compares "restorative" payments to a whistleblower to payments made by employers and banks to individuals to restore losses from pension and IRA mismanagement.

The Federal Court of Appeals in Washington D.C. had ruled that Marrita Murphy's payments for restoring her reputation were a non-taxable "return of human capital." The ruling, since withdrawn, was roundly criticized. Mr. Mitchell says we critics may have been too hasty.

He notes that the IRS has ruled that payments into 401(k) plans to restore lost amounts are tax-free when made. The IRS has issued a letter ruling applying similar thinking to IRAs. Mr. Mitchell says:

The IRS has now, in Private Letter Ruling 200705031, applied this logic to IRA payments where a taxpayer received a “restorative payment” from a financial institution to restore losses resulting from the financial institution breaching its fiduciary duty to invest prudently. The IRS made this ruling even though the taxpayer held the “restorative payment” in a separate taxable account and the taxpayer missed the sixty day deadline for contributing the “restorative payment” to another IRA...

Is there really a difference between “restorative payments” and payments that are a “return of human capital?” If so then the rule is that payments to compensate a taxpayer for someone harming the taxpayer’s retirement account are tax free, yet payments to compensate a taxpayer for someone harming the taxpayer’s person are taxable?

There is one obvious difference between the "restorative payments." Their taxation is only deferred. When the restored amounts are drawn from the IRA or 401(k) plan, they will be fully taxed. In contrast, if whistleblower damages are tax-free on receipt, they are tax-free forever.

To me, the real problem with the Murphy decision was that it disregarded decades of established law, carelessly making dubious and far-reaching constitutional conclusions that weren't needed to rule on the case. Its conflicts with the Supreme Court's Glenshaw Glass decision matter a lot more than any inconsistency with PLR 200137065.

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