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Whistleblower must pay tax on reward; attorney fees are miscellaneous deductions.

January 22, 2010

A Lockheed Martin analyst blew the whistle on alleged procurement fraud by his employer on government contracts. The company ended up settling in 2003 with a $37.9 million payment to the government. The whistleblower received an $8.75 million cut as a "qui tam" payment (I think that means "plaid hat" in Scottish). 40% of the $8.75 million went to the whistleblower's lawyers.

A Chicago tam-o-shanter, Creative Commons Flickr image courtesy TheeErin.

While the whistleblower got lawyers involved, he apparently was too thrifty to pay a tax advisor to help him with that small unusual income item, as the Tax Court explains:

On October 26, 2004, [late, even for an extended return - ed.] petitioner filed a Form 1040, U.S. Individual Income Tax Return, for his 2003 taxable year (return). Petitioner prepared the return without consulting a tax professional. Petitioner included the $5.25 million net proceeds of the qui tam payment on line 21 of his return as other income. However, the return omitted the $5.25 million net proceeds of the qui tam payment from the calculation of taxable income on line 40. The return showed a resulting taxable income of $793. Petitioner attached to the return Form 8275, Disclosure Statement, in which he argued that the $3.5 million attorney's fee payment had been held not to be taxable income by the U.S. Court of Appeals for the Eleventh Circuit. On the Form 8275, petitioner failed to include a citation of an opinion of the Eleventh Circuit, or of any Court of Appeals, standing for that proposition. Additionally, petitioner failed to identify on the Form 8275 any authority for excluding from his taxable income the $5.25 million net proceeds of the qui tam payment.

Nothing good happened from this point on in the whistleblower's tax life. The Tax Court yesterday ruled:

- The entire $8.75 million was includible in his taxable income.
- The $3.5 million lawyer fee was only deductible as a miscellaneous itemized deduction, which means not a deduction at all in computing alternative minimum tax.
- He was subject to accuracy-related penalties of $608,800 and late filing penalties of $151,955.50.

How much does that leave our whistleblower? He had $5.25 million after the attorney fees. The IRS assessed $3,044,000 in tax. After tax, penalties, and lawyer fees, $1,445,245 is left -- not counting the fees for the lawyers he used in Tax Court. Now $1.4 million is better than a poke in the eye, but at the very least he could have saved himself $750,000+ in penalties had he been advised better.

The Moral? If you are going to get a windfall, get the tax people involved early, not after you've filed a late and botched return.

Cite: Campbell, 134 TC No. 3

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I am about to receive a 100,000 dollar reward for info i provided in a murder case can it be taxed

Bonnie, yes it can.

Are there any expenses incurred in a windfall settlement case that would be considered tax deductible, or are they always miscellaneous expenses?

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