[author: Adam Koelsch]

Recently, in O’Donnell v. Allegheny County North Tax Collection Committee, et al., No. 8 WAP 2021 (Dec. 27, 2021), the Pennsylvania Supreme Court held that whistleblower payments constituted compensation subject to local earned income taxes.

In 2014, the taxpayer had filed an action alleging that his employer violated the federal False Claims Act (“FCA”). After a “whistleblower,” such as the taxpayer, files an action under the FCA (known as a “qui tam action”), the government choses whether to pursue the claim, let the whistleblower pursue the claim, or seek dismissal of the claim. Despite this control by the government, the FCA provides the whistleblower with “an interest in the lawsuit,” specifically, an entitlement to part of any settlement the government obtains in the action. Thus, the whistleblower’s monetary incentive drives the initiation of the lawsuit. Here, the taxpayer received an award equal to 16% of the settlement, amounting to $34,560,000, later the same year.

Later, in 2017, the tax collector for the School District and the Borough in which the taxpayer resided discovered that the taxpayer had not filed a local earned income tax return for 2014, and assessed him approximately $437,000 in tax, interest, penalties, and costs based on the award.

The School District and the Borough derive their authority to impose an earned income tax on their residents, such as the taxpayer, from the Local Tax Enabling Act (“LTEA”). The LTEA defines “earned income” as “[t]he compensation as required to be reported to or as determined by the [Pennsylvania Department of Revenue] under section 303 of the . . . Tax Reform Code of 1971, and rules and regulations promulgated under that section.”

Section 303 defines “compensation” for state Personal Income Tax purposes, in relevant part, as: “All salaries, wages, commissions, bonuses and incentive payments whether based on profits or otherwise, fees, tips, and similar remuneration received for services rendered whether directed or though and agent and whether in cash or in property . . . ” 72 P.S. § 7303(a)(1)(i).

In addition, the Department’s regulations provide, in relevant part:

Compensation includes items of remuneration received, directly or through an agent, in cash or in property, based on payroll periods or piecework, for services rendered as an employee or casual employee, agent or officer of an individual, partnership, business or nonprofit corporation, or government agency. These items include salaries, wages, commissions, bonuses, stock options, incentive payments, fees, tips, dismissal, termination or severance payments, early retirement incentive payments and other additional compensation contingent upon retirement, including payments in excess of the scheduled or customary salaries provided for those who are not terminating service, rewards, vacation and holiday pay, paid leaves of absence, payments for unused vacation or sick leave, tax assumed by the employer, or casual employer signing bonuses, amounts received under employee benefit plans and deferred compensation arrangements, and other remuneration received for services rendered.

61 Pa. Code 101.6(a) (emphasis added).

The question for the Supreme Court was whether the qui tam award was taxable in Pennsylvania as “compensation” under Section 303. Qui tam awards are not explicitly listed in the statutory definition of “compensation.” Therefore, the Court was required to determine whether the award fell within any of the other enumerated categories of compensation in the statute, which necessitated an analysis of qui tam actions and their purpose. The Court noted that the FCA aims to prevent fraud upon the government by incentivizing private citizens to act “‘for the person and for the United States Government’ against the entity perpetrating the fraud.” Thus, the Court concluded that qui tam awards fit within the listed category of “incentive payments.” In a footnote to its decision, the Court also concluded that the award met the definition of compensation for “similar remuneration for services rendered,” as remuneration for the taxpayer’s services in providing useful information to the federal government about his employer’s fraud and for initiating the qui tam action.

Relying on the Department’s regulation — which states that compensation must be for “for services rendered as an employee or casual employee, agent or officer” — the Commonwealth Court had previously held that the taxpayer was required to be (but was not) an employee or agent of the federal government for the qui tam award to be taxable. But the Supreme Court disagreed, holding that there is nothing in the plain language of the statutory definition of “compensation” suggesting that an employment nexus is a prerequisite for a payment to constitute compensation. In fact, according to the Supreme Court, there are several categories of compensation mentioned in the statute that are routinely provided outside of an employment relationship, such as commissions, fees, and tips. Moreover, contrary to the Commonwealth Court’s view, the Supreme Court concluded that the regulation does not limit the definition of compensation to require an employment relationship, but rather provides a non-exhaustive, illustrative list of common items that the Department believes qualify as compensation. In any event, the Supreme Court noted that a regulation cannot conflict with a statute and the statute here clearly did not require the existence of an employment relationship.

The Supreme Court further held — contrary to a dissenting opinion — that, although a whistleblower possesses a private interest in a qui tam action, the qui tam award nevertheless satisfies the statutory requirement that a compensation is for “services rendered,” because a whistleblower renders a service to the government as its representative in bringing the action.

This result is unsurprising, because, as the Supreme Court ultimately noted, the federal government and almost all other states tax qui tam awards. That said, Pennsylvania’s personal income tax is unique in that it taxes eight enumerated classes of income, rather than simply taxing all federal taxable income. Consequently, there is some additional room for interpretation when determining what is subject to tax in Pennsylvania.