Qui Tam Settlements and the Tax Benefit Rule

A qui tam claim involves a lawsuit where a private citizen helps the government prosecute fraud perpetrated against the government. These claims are often filed by employees or former employees who know of wrongdoing by an employer. These are often whistleblower claims. In exchange for helping to prosecute the claim, the private individuals are entitled to a portion of the government’s recovery.

Qui tam claims - and especially agreements to settle qui tam claims - raise a number of unique tax issues. One such issue is whether a taxpayer who pays to settle a qui tam claim can take advantage of the tax benefit rule. The IRS recently released a legal memorandum that addresses this issue.

The tax benefit rule allows a taxpayer to deduct or receive a tax credit for repaying income that the taxpayer paid tax on in a prior year. The idea is that the taxpayer who paid tax on income in a prior year and then had to repay the income, should be entitled to reduce their current year tax liability to offset the taxes that they paid in error in the prior year.

To qualify for the tax benefit rule, it must appear that the taxpayer had an unrestricted right to the payment in the year in which they received the payment. The courts have created a rule that says that taxpayers are not entitled to claim of right deductions or credits if the income was received on account of fraud or wrongdoing. The idea here is that the taxpayer who commits fraud knows or should know that it does not have an unrestricted right to the income.

A question arises where the taxpayer settles the claim without admitting or being found to have committed fraud - even though the taxpayer’s fraud is readily apparent. As the legal memorandum sets out, the IRS must scrutinize the settlement agreements and the intention of the parties to determine whether the settlement was for wrongdoing and whether there is sufficient nexus between the repayment and the income that was previously reported.

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