When the IRS Taxes “Loans” as Income

When your uncle loans you $ 5,000 to help, is that taxable as income? Of course not, you have to pay it back. What about when the bank lends you $ 100,000? Again no. When you receive a loan, the money is not taxable because you have to pay it back. Can lawyers also borrow, like everyone else? Yes, and for this reason some lawyers and funders are concerned about Novoselsky v. Commissioner, Memo CT. 2020-68 (2020), where a lawyer was tax on loans. The case is full of tax lessons. David Novoselsky, a solo lawyer, raised $ 1.4 million through loan agreements he wrote himself. The IRS said these were not loans and instead were taxable as income. The Tax Court agreed with the IRS that the $ 1.4 million “loans” were income. Novoselsky was a handyman and entrepreneurial litigator. Thus, in 2009 and 2011, he signed “litigation support contracts” with eight doctors and lawyers around Chicago. They fell into three groups, each with a pre-existing interest in the litigation: (i) the physicians who were plaintiffs in the trials Novoselsky was preparing; (ii) physicians whose economic interests were aligned with those of the complainants; and (iii) the lawyers with whom Novoselsky had fee-sharing agreements.

Novoselsky documented them as loans. In some it has promised a high interest rate, and in others a multiple of the investment. All the loans were non-recourse. He did not report them as income on his 2009 and 2011 tax returns, since they were loans! During the audit, the IRS said these were not loans and Novoselsky omitted $ 1.4 million in gross income. When Novoselsky refused to extend the statute of limitations (standard rate in an audit), the IRS assessed the tax losses and penalties at over $ 600,000. Novoselsky went to the Tax Court, but proceedings were suspended when he declared bankruptcy in 2014, apparently for strategic reasons. Several years of acrimonious litigation ensued. Novoselsky, also acted as his own bankruptcy lawyer, and he came out of bankruptcy without discharge.

Returning to the Tax Court, he argued that non-recourse loans were the norm for litigation lenders, with a guarantee on the case or cases in question. Unfortunately, Novoselsky did not care about the security agreements. In their place, he put language in the litigation assistance agreements obliging him to pay the investor concerned “on the successful conclusion of this litigation”. If the litigation was unsuccessful, he would have no obligation to pay. It probably sounded like DIY common sense. But the Tax Court jumped on it, citing some of the many judgments finding that an obligation is not a debt for tax purposes if it depends on the occurrence of a future event.

This includes obligations that depend on the outcome of a dispute. The obligations under these litigation support agreements were contingent on the success of the prosecution, so they were not ready. The onus was then shifted to Novoselsky to provide further justification for excluding advances from income. He claimed they were gifts or deposits held “in trust” for investors, but the Tax Court did not buy either. The Tax Court said these litigation support agreements said they were “loans” but there was no promissory note, no payment schedule, no collateral and no payment. principal had never been done. Some have claimed interest or a fixed premium, but no interest or other amount has ever been paid. Advances were only payable on the future proceeds of litigation.

If the parties had behaved as if the transactions were authentic ready? Nope. Each investor had agreed that Novoselsky would have no obligation to pay unless the litigation was successful. The Tax Court then relied on Frierdich v. Commissioner, Frierdich v. Commissioner, TC memo. 1989-393, confirmed, 925 F.2d 180 (7th Cir. 1991). In Frierdich, a widow hired the taxpayer, a lawyer, to represent her as executor of her late husband’s estate. The widow knew the lawyer well, who had been her husband’s partner in various real estate businesses. The lawyer had also dealt with the widow in some cases.

They came to an unusual arrangement. The widow not only hired the lawyer to provide legal services, but also loaned him $ 100,000. The lawyer gave the widow a note bearing 8% interest, but there was no fixed deadline for repayment. Instead, principal and accrued interest were payable when the lawyer was due to pay his fees, which were “subject to [the] closure of the domain. The widow was allowed to deduct the loan balance from attorney’s fees. In Frierdich, the Tax Court reclassified the widow’s loan in advance of attorney fees. The lawyer’s obligation to pay under the note was not due until he was paid for the closing of the estate. The Tax Court concluded that both parties intended the reimbursement to be in the form of legal services. Novoselsky extended this analysis to include not only advances received from formal plaintiffs, but also those received from physicians and lawyers who were not parties but had an interest in the outcome of the litigation.

Novoselsky’s counterparties were clients, healthcare professionals whose interests aligned with those of its clients, or lawyers with fee-sharing agreements. The refund was not required at all Unless the litigation was successful, therefore, contingency determined whether an obligation arose in the first place. The Tax Court then concluded that the investor advances were in fact compensation for Novoselsky legal services.

Does this case endanger lawyers real litigation financing? Not really, because in a commercial litigation financing transaction, the funder should not have any pre-existing interest in the litigation. This should make it difficult for the IRS to argue that the funder’s advance is a disguised payment for the attorney’s legal services. As long as the loan documentation does not condition the borrower’s obligation at the end of the dispute, Novoselsky should not prevent loans from qualifying as loans or purchases for transactions structured in this way. Novoselsky reminds us, if one is needed, that plaintiffs and lawyers should generally not prepare fundraising documents themselves. They should not include terms suggesting that their obligation to repay a loan depends on the success of the litigation. They should limit donors appeal to a security interest in the proceeds of the dispute.

Of course, loans are not common in commercial litigation financing in the first place. Most are purchases, often prepaid term purchases. This further decreases the impact of Novoselsky. In the few loans that do arise, the business loan documentation usually includes a no-conditional payment obligation. Novoselsky also cautions lawyers not to borrow from clients or anyone else with an interest in the outcome of the case.

Otherwise, there is a risk that an advance from the lender will be reclassified as a down payment. If the lender is a professional funder with no prior interest in the lawsuit, the risk seems low. However, does Novoselsky warn lawyers that they may face a slightly higher tax risk than plaintiffs who find themselves in the same situation? Suppose an applicant sells part of their business under a good prepaid futures contract. It can be extremely difficult for the IRS to find a way to tax the initial money until the contract ends when the deal is closed. But let’s say that alone the contingency lawyer is the seller under the contract, and the plaintiff is not even involved in the transaction.

Let’s say the lawyer is entitled to 40% if the case brings in money, and he “sells” his right at half of that fee. Even though the Lawyer Funding Agreement is documented as a legitimate prepaid forward contract, it may be more tempting for the IRS to look for ways to attack the arrangement. The lawyer, unlike the plaintiff, always earns compensation income, so a successful challenge will hit the lawyer with ordinary income. And, of course, the IRS has a long history of prosecuting attorneys to lead by example.

Perhaps this is one of the reasons that many lawyer funding arrangements are structured with the applicant (s) also participating at some level. This is another reason why tax calendar issues for lawyers can be a bit more sensitive than for plaintiffs. Ultimately, however, the strange case of Novoselsky It sounds like a slam dunk to the IRS, and such an obvious loser to the handyman lawyer, it’s also a reminder to everyone: don’t try this at home.

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