Paying Tax On Borrowed Money

I am looking at a Tax Court case where the IRS was chasing almost two-thirds of a million dollars. It involves an attorney and something called “litigation support agreements.”

There is a term you do not hear every day.

The taxpayer is a class-action lawyer.

You see, in a class action, the law firm sues on behalf of a group – or class - of affected parties. Perhaps numerous people were affected by a negligent act, for example, but there is not enough there for any one person to pursue litigation individually. Combine them, however, and you have something.

Or the lawsuit can be total malarkey and the law firm is seeking a payday, with little to no regard to the “class” it allegedly represents.

Ultimately, a class action is a tool that can be used for good or ill, and its fate depends upon the intent and will of its wielder.

Let get’s back to our taxpayer.

It takes money to pursue these cases. One has to bring in experts. There can be depositions, travel, cross-examinations. This takes money, and we already mentioned that a reason for class action is that no one person has enough reason – including money – to litigate on his/her own power.

Did you know there are people out there who will play bank with these cases? That is what “litigation support agreements” are. Yep, somebody loans money to the law firm, and – if the case hits – they get a very nice payoff on their loan. If the case fails, however, they get nothing. High risk: high reward. It’s like going to Vegas.

The taxpayer received over $1.4 million of these loans over a couple of years.

Then IRS came in.

Why?

I see two reasons, but I flat-out believe that one reason was key.

The taxpayer left the $1.4 million off his tax return as taxable income. The taxpayer thought he had a good reason for doing so: the $1.4 million represented loan monies, and it is long-standing tax doctrine that one (generally) cannot have income by borrowing money. Why? Because one has to pay it back, that is why. You are not going to get rich by borrowing money.

There are variations, though. It is also tax doctrine that one can have income when a lender forgives one’s debt. That is why banks issue Forms 1099-C (Cancellation of Debt) when they write-off someone’s credit card. How is it income? Because one is ahead by not having to pay it back.

Our taxpayer had different loan deals and agreements going, but here is representative language for one litigation support agreement:

… shall be a litigation support payment to [XXX] made on a nonrecourse basis and is used to pay for all time and expenses incurred by [XXX} in pursuant [sic] of this litigation. Said payment shall be repaid to …. at the successful conclusion of this litigation with annual interest to be paid as simple interest at the rate of …. as of the date of concluding this litigation.”

Let’s see: there is reference to repayment and an interest rate.

Good: sounds like a loan.

So where is the problem?

Let’s look at the term “nonrecourse.” In general, nonrecourse means that – if the loan fails – the lender can pursue any collateral or security under the loan. What the lender cannot do, however, is go after the borrower personally. Say I borrow a million dollars nonrecourse on a California house that subsequently declines in value to $300 grand. I can just mail the keys back to the lender and walk away without the lender able to chase me down. I am trying to divine what the broader consequence to society could possibly be if numerous people did this, but of course that is silly and could never happen.

Still, nonrecourse loans happen all the time. They should not be fatal, as I am technically still obligated on the loan - at least until the time I mail back the keys.

Let’s look at the next phrase: “successful conclusion of this litigation.”

When are you on the hook for this loan?

I would argue that you are on the hook upon “successful conclusion of this litigation.”

When are you not on the hook?

I would say any time prior to then.

The loan becomes a loan – not at the time of lending – but in the future upon occurrence of a distinguishable event.

The IRS was arguing that the taxpayer received $1.4 million for which he was not liable. He might be liable at a later time - perhaps when the universe begins to cool or the Browns win a Super Bowl – but not when that cash hit his hand.

Granted, chances are good that whoever lent $1.4 would pursue tort action if the taxpayer skipped town and sequestered on an island for a few years, but that would be a different legal action. Whoever put up the money might sue for fraud, nonperformance or malfeasance, but not because the taxpayer was liable for the debt. 

Let’s go back: what keeps one from having income when he/she borrows money?

Right: the obligation to pay it back.

So who did not have an obligation to pay it back?

The taxpayer, that’s who.

The IRS won the case. Still, what bothered me is why the IRS would go after this guy so aggressively. After all, give this arrangement a few years and it will resolve itself. The law firm receives money; the law firm spends money. When it is all said and done, the law firm will burn through all the money, leaving no “net money” for the IRS to tax.

So what fired up the IRS?

The taxpayer filed for bankruptcy.

Before burning through the money.

Meaning there was “net money” left.

He was depriving the IRS of its cut.

There is the overwhelming reason I see.

Our case this time was Novoselsky v Commisioner.