Whistleblowers Can Face Tax Problems

Whistleblower claims are brought under a variety of federal and state statutes and are usually handled for contingent fees. On big recoveries, a legal fee of 40 percent—or any other customary contingent fee—can be a lot of money. That means the tax treatment of the gross recovery and the legal fees can be a very big issue.
Most plaintiffs and whistleblowers assume that the most that could be taxable to them by the Internal Revenue Service (or by their state) is their net recovery. Lawyers often receive the gross amount, deduct their fees, and remit only the balance to the plaintiff or whistleblower. Their net take-home pay after legal fees and costs is not the only money the IRS sees, however.
For many plaintiffs and whistleblowers, the first inkling that the gross recovery may be their income is the arrival of Forms 1099 in January. The statute under which the claim is made can impact taxes materially. The oldest whistleblower statute is the federal False Claims Act, dating back to the Civil War. See 31 U.S.C. §§ 3729–3733. However, there are state versions of this law, IRS whistleblower claims, and SEC whistleblower claims. The latter emanate from section 922 of the Dodd-Frank Act, Pub. L. No. 111-203, 124 Stat. 1377 (July 21, 2010).
To say that not all whistleblower claims are created equal when it comes to taxes would be an understatement. Not all claims qualify to have legal fees deductible “above the line,” which means essentially off the top, so the whistleblower does not pay any tax on the legal fees. Otherwise, you must claim a miscellaneous itemized deduction, which is subject to a number of limits.
If you obtain a huge recovery and must pay 40 percent or more to your lawyer, you will care very much about what type of deduction you receive for those fees.
Contingent Fees and Gross Income
Clients often have a hard time understanding this rule. They might ask, “How can I be taxed on something I never received?” Generally, amounts paid to a plaintiff’s attorney as legal fees are gross income to the plaintiff, even if paid directly to the plaintiff’s attorney by the defendant. See Comm’r v. Banks, 543 U.S. 426 (2005). For tax purposes, the plaintiff is considered to receive the gross award, including any portion that goes to pay legal fees and costs.
The IRS rules for Form 1099 reporting bear this out. Under current Form 1099 reporting regulations, a defendant or other payor that issues a payment to a plaintiff and a lawyer must issue two Forms 1099. The lawyer should receive one Form 1099 for 100 percent of the money actually paid to the attorney. The client should receive one, too, also for 100 percent. The client, however, will invariably receive a Form 1099-MISC that reports 100 percent of the money. When you receive a Form 1099, you must put the full amount on your tax return. Not every Form 1099 is correct, is ordinary income, or is necessarily income at all.
Plaintiffs receive Forms 1099 in many other contexts, which they must explain. For example, plaintiffs who are seriously injured, and who should receive compensatory lawsuit proceeds tax-free for their physical injuries, may still receive a Form 1099. In those cases, they can report the amount on their tax return and explain why the Form 1099 was erroneous.
Plaintiffs and whistleblowers do not have this argument because they are required to report the gross payment as their income. The question is how the plaintiff or whistleblower deducts the legal fees and costs. Successful whistleblowers may not mind paying tax on their net recoveries, but paying taxes on money their lawyers receive has long been controversial.
In 2005’s Comm’r v. Banks, the U.S. Supreme Court resolved a bitter split in the circuit courts about the tax treatment of attorney’s fees. The court held—in general at least—that the plaintiff has 100 percent of the income and must somehow deduct the legal fees. That somehow is important.
In 2004, just months before the Supreme Court decided Banks, Congress added an above-the-line deduction for attorney’s fees, but only for certain types of cases. The above-the-line deduction applies to any claims under the federal False Claims Act, the National Labor Relations Act, the Fair Labor Standards Act, the Employee Polygraph Protection Act of 1988, and the Worker Adjustment and Retraining Notification Act as well as claims under certain provisions of the Civil Rights Act of 1991, the Congressional Accountability Act of 1995, the Age Discrimination in Employment Act of 1967, the Rehabilitation Act of 1973, the Employee Retirement Income Act of 1974, the Education Amendments of 1972, the Family and Medical Leave Act of 1993, the Civil Rights Act of 1964, the Fair Housing Act, the Americans with Disabilities Act of 1990, chapter 43 of title 38 of the United