Craig Patrick v. CIR , 799 F.3d 885 ( 2015 )

In the
United States Court of Appeals
For the Seventh Circuit
____________________
No. 14-2190
CRAIG PATRICK and
MICHELE PATRICK,
Petitioners-Appellants,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellee.
____________________
Appeal from the United States Tax Court.
No. 16387-12 — Diane L. Kroupa, Judge.
____________________
ARGUED JANUARY 7, 2015 — DECIDED AUGUST 26, 2015
____________________
Before RIPPLE, WILLIAMS, and SYKES, Circuit Judges.
WILLIAMS, Circuit Judge. This case concerns the proper tax
treatment of nearly $7 million that the government paid
Craig Patrick for uncovering a Medicaid fraud scheme
where the government paid in excess of $75 million in phony
billings. Patrick and an associate filed a qui tam suit under
the False Claims Act against Kyphon, Inc. alleging that the
company induced hospitals to file claims for Medicare reim-
2 No. 14-2190
bursement “for unnecessary inpatient hospital stays.” The
United States intervened and settled the case. For his role in
initiating the suit Patrick received a relator’s share of the
government’s recovery, totaling $5.9 million. Patrick also re-
ceived $900,000 from the settlement of related qui tam actions
against hospitals that overbilled Medicare.
Patrick and his wife, Michele, filed joint tax returns for
2008 and 2009 reporting his share of the qui tam recoveries as
capital gains. The Commissioner of Internal Revenue issued
deficiency notices, notifying the Patricks that the relator’s
shares must be reported as ordinary income. The Tax Court
upheld that determination. We agree with the Commissioner
and the Tax Court that the relator’s share of a qui tam recov-
ery is not the result of a “gain from the sale or exchange of a
capital asset.” Rather, Patrick’s relator’s shares are a reward
for filing the suit against Kyphon and the hospitals and must
be treated as ordinary income.
I. BACKGROUND
Craig Patrick worked as a reimbursement manager for
Kyphon, a company that designs, manufactures, and sells
medical equipment to treat spinal conditions. The company
developed a procedure called a “kyphoplasty” that could be
performed on an outpatient basis. But Kyphon feared that
medical providers would be reluctant to purchase the
equipment if they could not bill for an overnight hospital
stay. As a result, Kyphon marketed its treatment as an inpa-
tient procedure that required the patient to stay overnight,
thereby allowing providers to collect larger reimbursements
from Medicare for the unnecessary hospital stays.
No. 14-2190 3
In 2005, Patrick and a former Kyphon salesperson jointly
filed a qui tam action under the False Claims Act, 31 U.S.C.
§§ 3729–33, alleging that Kyphon had defrauded the gov-
ernment. The False Claims Act imposes liability on any per-
son who presents to the United States “a false or fraudulent
claim for payment or approval,” see id. § 3729(a)(1)(A), and
permits a private person—called a “relator”—to bring suit
on behalf of the government, see id. § 3730(b)(1). The relator
must serve the government with a copy of the complaint and
supporting evidence so that the government may decide
whether to intervene in the suit. See id. § 3730(b)(2), (4). If the
government intervenes and wins the suit using primarily
non-public information provided by the relator, the relator is
entitled to receive between fifteen and twenty-five percent of
the recovery. See id. § 3730(d)(1).
After reviewing Patrick’s qui tam suit against Kyphon,
the government exercised its option to intervene and
reached a settlement with Kyphon that required the compa-
ny to pay it over $75 million. Because the government had
obtained the recovery based primarily on non-public infor-
mation provided by Patrick and his co-relator, they received
a portion of the recovery, with Patrick taking home more
than $5.9 million.
After the settlement, Patrick and his co-relator filed simi-
lar suits under the False Claims Act against hospitals that
had billed Medicare for the kyphoplasty procedure as an in-
patient treatment. The hospitals settled those suits, and Pat-
rick received almost $900,000 for his involvement as a rela-
tor.
When tax season arrived, Patrick and his wife jointly
filed a 2008 return that reported Patrick’s share of the set-
4 No. 14-2190
tlement with Kyphon as a capital gain. The couple also filed
a 2009 tax return that reported the money Patrick received
from the hospital settlements as capital gains.
The Commissioner sent the couple deficiency notices for
both tax years. The notices explained that Patrick’s qui tam
recoveries were “other income rather than a capital gain,”
and thus, were taxable at the higher rate applicable to ordi-
nary income. Using that higher tax rate, the Commissioner
determined that the Patricks owed an additional $716,883 for
2008 and $94,714 for 2009.
The Patricks petitioned the Tax Court for redetermina-
tion of the tax deficiencies. But the court concluded that the
qui tam recoveries were properly characterized as ordinary
income, not capital gains. This appeal followed.
II. ANALYSIS
Resolution of the appeal requires this court to decide
whether a relator’s share is a “gain from the sale or exchange
of a capital asset,” 26 U.S.C. § 1222(1), (3) (defining “capital
gain”), or a reward intended to compensate the relator for
his work in bringing the qui tam suit. If the relator’s share
constitutes a payment for services, the Patricks must claim
the award as ordinary income. See Canal-Randolph Corp. v.
United States, 568 F.2d 28, 32 (7th Cir. 1977); Bouchard v.
Comm’r, 229 F.2d 703, 704 (7th Cir. 1956). This court has nev-
er addressed the question of how a relator’s share of a recov-
ery must be characterized under the Internal Revenue Code.
The only other circuit to resolve the issue concluded that a
relator’s share is ordinary income because it operates as a
bounty for the relator’s work in filing the qui tam suit,
No. 14-2190 5
see Alderson v. United States, 686 F.3d 791 (9th Cir. 2012), and
we agree.
Courts have consistently described a relator’s share as a
“bounty” or “reward” for the efforts a relator puts forth to
gather evidence and file a qui tam suit. See Vt. Agency of Natu-
ral Res. v. United States ex rel. Stevens, 529 U.S. 765, 772 (2000)
(stating that relator’s “bounty is simply the fee he receives
out of the United States’ recovery for filing and/or prosecuting
a successful action on behalf of the Government.”) (emphasis
in original); U.S. ex rel. Chovanec v. Apria Healthcare Grp. Inc.,
606 F.3d 361, 364 (7th Cir. 2010) (explaining that relator’s
award compensates for relator’s “services” and “work to un-
cover fraud”); Roberts v. Accenture, LLP, 707 F.3d 1011, 1016
(8th Cir. 2013) (referring to relator’s share as “finder’s fee”);
Alderson, 686 F.3d at 795; Riley v. St. Luke’s Episcopal Hosp.,
252 F.3d 749, 752 (5th Cir. 2001) (describing relator’s share as
“reward”). This line of cases suggests that a relator’s award
is a payment for services performed, and therefore, that the
award must be claimed as ordinary income. See Canal-
Randolph Corp., 568 F.2d at 32; Bouchard, 229 F.2d at 704.
Treating a relator’s reward as a capital gain would con-
travene the long-recognized rule that a “capital gain” gener-
ally involves a “realization of appreciation in value accrued
over a substantial period of time” of an initial investment of
capital. Comm’r v. Gillette Motor Transp., Inc., 364 U.S. 130,
134–35 (1960); see also Alderson, 686 F.3d at 797. But here Pat-
rick made no initial investment in some asset. Instead, he
expended time and effort to discover and document Ky-
phon’s fraud, and that work was not an investment of capi-
tal. See Alderson, 686 F.3d at 797. Further, there was no “real-
ization of appreciation in value” of an underlying invest-
6 No. 14-2190
ment that “accrued over a substantial period of time.” Gil-
lette Motor Transp., Inc., 364 U.S. at 134. Patrick had an inter-
est in a portion of the government’s recovery, but that inter-
est did not grow in value over time. It did not even vest until
the government received its recovery. See Vt. Agency of Natu-
ral Res., 529 U.S. at 772.
When we turn to the Internal Revenue Code’s definition
of “capital gain”—a “gain from the sale or exchange of a
capital asset,” 26 U.S.C. § 1222(1), (3)—we reinforce our con-
clusion that a relator’s award does not qualify for that status.
The Internal Revenue Code defines a “capital asset” as
“property held by a taxpayer,” 26 U.S.C. § 1221, and courts
agree that an item is property only if the owner has the right
to exclude others from using it, see Kaiser Aetna v. United
States, 444 U.S. 165, 179–80 (1979); Minn. Mining & Mfg. Co. v.
Pribyl, 259 F.3d 587, 609 (7th Cir. 2001). The Patricks offer
two ways to regard them as having invested a “capital asset”
or “property,” but neither is persuasive.
First, they maintain that Patrick’s “property” was the in-
formation that he gathered at Kyphon and, they contend, he
had a right to stop others from using it. We do not see it that
way. True, Patrick compiled documents that he transferred
to the government. But the information contained in those
documents—information about Kyphon’s fraudulent prac-
tices—was available to many other Kyphon employees who
could have used the knowledge to file their own qui tam suit.
The Patricks reply by comparing the information to a trade
secret, which may have multiple owners. But even if the in-
formation Patrick gathered was secret in the sense that it
was nonpublic information, he had no right to stop anyone
No. 14-2190 7
else from using it, and, thus, the information and documents
cannot be his “property.” See Kaiser Aenta, 444 U.S. at 179–80.
Second, the Patricks contend that Patrick’s right to a
share of the recovery constitutes a “capital asset,” but this
argument fares no better. Patrick’s award was a payment for
his efforts to collect documents and file the qui tam suit.
See Vt. Agency of Natural Res., 529 U.S. at 772; Apria Healthcare
Grp. Inc., 606 F.3d at 364. The Commissioner aptly analogizes
this situation to an attorney’s interest in payment under a
contingency fee arrangement. The attorney’s interest in fu-
ture 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. And compensation
for services qualifies as ordinary income, not a capital gain.
See Canal-Randolph Corp., 568 F.2d at 32; Bouchard, 229
F.2d at 704. Because the Patricks have not demonstrated that
Patrick possessed a capital asset, his relator’s share from the
qui tam suit cannot constitute a “capital gain.” See 26 U.S.C.
§ 1222(1), (3) (defining “capital gain” as a “gain from the sale
or exchange of a capital asset”).
III. CONCLUSION
For all the foregoing reasons, the decision of the Tax
Court is AFFIRMED.