Are Whistleblower Awards Taxable Income?

Individuals who receive a whistleblower award will find that the payment is subject to federal income tax. The Internal Revenue Service (IRS) considers these awards to be gross income, a broad category that encompasses earnings from various sources. This tax treatment applies to awards from numerous federal programs, including those administered by the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), the IRS, and those under the False Claims Act. The initial amount reported by the government agency paying the award represents the full, pre-tax figure, meaning the entire sum is considered income before any allowable expenses are subtracted.

Tax Characterization of Whistleblower Awards

For tax purposes, a whistleblower award is classified as ordinary income. This characterization means the award is taxed at the same rates as wages, salaries, and other forms of compensation. It is not treated as a capital gain, which results from the sale of an asset like stocks or real estate and is often taxed at lower rates. The inclusion of the award in ordinary income subjects it to the taxpayer’s marginal tax rate, which is the rate applied to their highest layer of income.

The federal income tax system uses a progressive structure with several tax brackets. As a person’s income rises, it moves into higher brackets, and the income within each bracket is taxed at a different rate. For example, a portion of income falls into the 10% bracket, the next portion into the 12% bracket, and so on. A large whistleblower award can push a portion of a taxpayer’s income into the highest brackets, resulting in a tax obligation on that award money.

This treatment is rooted in the Internal Revenue Code’s broad definition of gross income, which includes all income from whatever source derived unless specifically excluded by law. A key legal principle affirms that a litigant’s gross income from a recovery includes the entire amount, even the portion paid directly to their attorneys.

Allowable Deductions for Whistleblowers

A key consideration for any whistleblower is the ability to deduct the legal fees associated with these cases. These fees, often paid on a contingency basis, can represent a large percentage of the total award. Federal tax law provides a mechanism for deducting these costs through what is known as an “above-the-line” deduction for attorney’s fees and other legal costs incurred in connection with the whistleblower action.

An above-the-line deduction directly reduces a taxpayer’s Adjusted Gross Income (AGI). AGI is a figure on a tax return calculated before itemized or standard deductions are taken. By lowering AGI, this deduction can help a taxpayer qualify for other tax benefits that have AGI-based limitations. This deduction is available to all qualifying taxpayers, regardless of whether they choose to itemize their deductions or take the standard deduction.

The creation of the above-the-line deduction ensures that whistleblowers are taxed on the net amount they ultimately receive after legal expenses, not on the gross award. This applies to awards under the False Claims Act, as well as those from the SEC and CFTC whistleblower programs. For awards from the IRS, this deduction is available for mandatory awards in cases where the amount in dispute exceeds $2 million. However, for smaller, discretionary IRS awards, this above-the-line deduction is not permitted, meaning whistleblowers are taxed on the gross amount of their award.

Federal Tax Reporting Process

The process of reporting a whistleblower award for federal tax purposes begins with receiving an informational document from the paying government agency. This document is typically a Form 1099-MISC, Miscellaneous Information, or a Form 1099-NEC, Nonemployee Compensation. The form will report the total gross amount of the award, which is the full amount before any deductions for attorney’s fees or other costs.

When filing their federal income tax return, the whistleblower must report this entire gross amount as income. This figure is entered on Schedule 1 of Form 1040, which is used for “Additional Income and Adjustments to Income.” This ensures that the income reported to the IRS by the paying agency matches what the taxpayer reports on their return, avoiding automated notices.

On the same Schedule 1, the taxpayer will then claim the deduction for their legal fees in the “Adjustments to Income” section. The tax form provides a specific line for this purpose. This process correctly reports the gross award and the offsetting deduction for legal costs.

State Income Tax Implications

The tax treatment of a whistleblower award at the state level is dependent on federal tax law. Most states that impose a personal income tax use the federal Adjusted Gross Income (AGI) as the starting point for calculating state taxable income. Because the above-the-line deduction for attorney’s fees reduces federal AGI, the net amount of the whistleblower award is already factored into the initial figure used for state tax purposes.

This means that the portion of the award remaining after legal fees will be subject to state income tax in states that have one. The specific tax rate applied will vary based on the state’s own tax bracket structure and rules. Since the deduction for legal fees is handled at the federal level, it flows through automatically to the state return.

While the reliance on federal AGI is a commonality, there can be state-specific adjustments or different rules. A whistleblower should review the income tax laws for their state of residence or consult with a tax professional. For those residing in a state with no personal income tax, the award would not be subject to any state-level income tax, though the federal obligation remains.