How the Tax Code Rewards Fraudsters and Punishes Whistleblowers
Corporate defense counsel and their allies such as the U.S. Chamber of Commerce have unfairly maligned whistleblowers as “living the dream” and receiving a “windfall” from their awards. This characterization could not be further from the truth. Not only do whistleblowers face enormous risk–often for relatively little reward–but the tax code benefits fraudsters over whistleblowers at every turn. In fact, last year, the tax deductions available to defendants as a result of committing fraud likely exceeded the entire amount awarded to whistleblowers.
The tax code doubly rewards fraudsters. Under section 162(f) of the Internal Revenue Code, a taxpayer may deduct from its taxable income any amounts that “constitute restitution … for damage or harm which was or may be caused by the violation of any law or the potential violation of any law,” or that are “involved in the investigation or inquiry” of a violation of law.1
That means companies and individuals that settle False Claims Act (FCA) suits can deduct from their tax liability the portion of the settlement earmarked for “restitution,” as well as any attorney fees and other expenses they incur in defending against the FCA claims. So, while whistleblowers and their attorneys must pay taxes on everything they earn, defendants who have defrauded the government can write off a substantial portion of the bills they pay.
The Department of Justice’s FCA settlement statistics from 2021 provide real-world insight into how these double standards work. DOJ recovered $2.625 billion in FCA cases last year, excluding the bankruptcy settlements involving Purdue Pharma and its owners, which involved a unique procedural posture. Of this sum, the DOJ paid about $238 million in awards to whistleblowers, known as “relators” in FCA cases. But these figures don’t tell the whole story.
Turning first to the amount recovered from defendants, any amount earmarked for “restitution” is tax-deductible. Although the percentage of each settlement allocated to restitution varies, it rarely drops below 50 percent. Of the 15 highest-value civil FCA settlements in 2020 and 2021 for which data are available, the average restitution percentage was 58.45 percent. Applying this figure to the total recoveries in 2021, we can estimate that approximately $1.53 billion of the $2.6 billion paid by defendants was considered restitution. At the corporate tax rate of 21 percent,2 this would have resulted in a tax savings of more than $322.2 million for these defendants, exceeding the entirety of the $238 million awarded to whistleblowers.
And this figure likely underestimates the tax write-offs available to fraudsters, as it does not include write-offs for the attorney fees and other costs these defendants incurred in defending against the government’s allegations. With high-profile defense firms often charging well over $1,000 per hour,3 these expenses—and tax write-offs—can add up quickly. In addition, well-heeled defendants may end up avoiding many of these expenses altogether. Large corporations often have insurance policies that cover defense costs, judgments, and settlements for damages.
Several recent court cases have held that these policies apply to FCA cases, even where some or all of the settlement is considered restitution.4 As a result, many defendants have been able to further offset the costs of defending against and settling allegations of fraud.
Whistleblowers face a much less favorable financial outlook. They cannot write off the amounts they receive as whistleblower awards. Federal and state income taxes are likely to consume at least one-third of these payments. After deducting taxes and attorney contingency fees, whistleblower take-home pay in 2021 was likely around $95.2 million.5 This means that fraudsters likely earned a tax break worth more than three times the net amount whistleblowers earned from federal FCA suits. No wonder many corporate defendants see the penalties for committing fraud as merely the cost of doing business.
Fortunately, these results are not preordained. Aggressive prosecutors in recent years have crafted settlement agreements that prevent defendants from taking advantage of tax breaks to offset their liability. For instance, the members of the Sackler Family agreed not to seek a tax deduction for any of the $225 million they paid as part of the Purdue Pharma settlement. And the U.S. Attorney’s Offices for the Northern District of New York and the Eastern District of Washington recently entered into a settlement whereby the owner of one of the corporate defendants paid a $100,000 civil penalty and agreed not to seek indemnification for the amount, including through any insurance policy.
Classifying the payment as a penalty, rather than restitution, means the defendant cannot benefit from a tax write-off. These tactics could be replicated in other cases to make sure that fraudsters are held fully to account for their wrongdoing.
Written by Noah Rich of Baron & Budd. Edited by Kate Scanlan of Keller Grover LLP. Fact checked by Julia-Jeane Lighten of Taxpayers Against Fraud.
1. 26 U.S.C. § 162(f)(2)(A)(i)(I)-(II).
2. Non-corporate individual defendants likely would face even higher tax rates—and reap greater tax deductions.
3. See, e.g., Objection of the United States Trustee to Debtor’s Application for Retention of Hogan Lovells Us LLP as Special Counsel ¶ 23, In re: LTL Mgmt. LLC, No. 21-30589-MBK (Bankr. N.J. May 20, 2022), ECF No. 2324.
4. See Astellas US Holding, Inc. v. Starr Indem. & Liab. Co., 566 F. Supp. 3d 879, 908 (N.D. Ill. 2021) (settlement payment “is insurable as a Loss” because “it is a payment for the Government’s damages,” rather than disgorgement of profits). See also Guaranteed Rate, Inc. v. ACE Am. Ins. Co., No. CVN20C04268MMJCCLD, 2021 WL 3662269 (Del. Super. Ct. Aug. 18, 2021) (insurer must advance defense costs in responding to government investigation); Call One Inc. v. Berkley Ins. Co., No. 21-CV-00466, 2022 WL 580802, at *5 (N.D. Ill. Feb. 25, 2022) (claims under Illinois FCA not uninsurable as a matter of law); Affinity Living Grp., LLC v. StarStone Specialty Ins. Co., 959 F.3d 634, 642-43 (4th Cir. 2020) (holding that healthcare fraud case was related to “medical incident” such that insurance policy applied).
5. According to scholarship on the subject, contingency fees in qui tam cases are “often set at 40%.” David Freeman Engstrom, Harnessing the Private Attorney General: Evidence from Qui Tam Litigation, 112 Colum. L. Rev. 1244, 1282 (2013). This estimate also includes a 33% reduction for federal and state income taxes.