I have a
friend who was considering employment litigation earlier this year. His job has
sufficient visibility that it attracts people – some unpleasant and others unhinged. Couple that with a
political-correctness-terrified employer and you have a combustible mix.
The taxation
of litigation damages leaves room for improvement. Certain types of litigation –
say personal injury or employment – are commonly done on a contingency basis.
This means that the attorney does not receive fees unless the case is
successful or settled. A common contingency fee is one-third. A rational tax
system would recognize that the litigant received 67 cents on the dollar and assess
tax accordingly. Our system does not do
that.
Our tax Code
wants to tax the litigant on the full proceeds, although one-third or more went
to the attorney. The Code does allow one to deduct that one-third as a
miscellaneous itemized deduction. It sounds great but many – if not most –
times it amounts to nothing. Why?
·
Miscellaneous
itemized deductions are deductible only to the extent that they exceed 2% of
your adjusted gross income (AGI). Swell that AGI to unrepresentative levels -
say by the receipt of damages – and that 2% can amount to a high hurdle.
·
Even
that result can be overridden by the alternative minimum tax (AMT). The AMT
does not allow miscellaneous deductions at all. Forget about deducting that contingency
fee if you are an AMT taxpayer, which you likely will be.
·
Then
you have states, such as Ohio, which do not allow itemized deductions. The
damages are sitting in your AGI, though. It stinks to be you.
How did we
get to this place?
We know that
the tax Code allows one to deduct business expenses against related business
income. There may be restrictions – entertainment expenses, for example, or
limitations on depreciation – but overall the concept holds. The result of this
accounting exercise enters one’s tax return as net profit or loss.
But not
always.
For example,
I am in the trade or business of being an employee of my accounting firm. My
salary enters my individual tax return as gross income. What if I have business
expenses relating to the practice? The IRS
allows me to deduct those, but not directly against my salary. The IRS instead wants
me first to itemize and then claim my accounting-practice expenses therein as a
miscellaneous deduction. Miscellaneous deductions are the redheaded stepchild of
itemized deductions. They are never deductible in full, and depending on one’s situation,
they may not be deductible at all.
Extrapolate this
discussion to the recipient of a legal settlement and you have the issue I have
with accounting-practice expenses – but greatly magnified, as the dollars are likely
more substantive.
So I was
pleased to review the case of Bagley v
United States.
Richard
Bagley had an MBA and a M.S. in accounting. He worked for TRW Inc, and from
1987 to 1992, he was the Chief Financial Manager for their space and technology
group. TRW did a lot of work for the government, meaning they had to follow
certain accounting procedures when requesting payment from the government. Remember
that Bagley was in charge of the accounting, and you have a good idea of where
the story is going.
Bagley
became aware of bad accounting. He nonetheless signed certifications to the
government, mostly because he needed the job. He did the good soldier thing and
reported his concerns to his superiors. TRW in turn notified him that he was
going to be laid off because of a corporate reorganization, rising tides, Punxsutawney
Phil not seeing his shadow and the Chicago Cubs missing the World Series.
He was laid
off in 1993.
In 1994 he
brought a wrongful termination lawsuit against TRW. He lost that lawsuit.
In that same
year, he filed a False Claims Act (FCA) on behalf of the United States against
TRW.
There is a peculiarity
about a FCA lawsuit that we should discuss. Although Bagley brought the FCA
lawsuit, the action was technically brought by the United States against TRW for
fraud. Bagley stood-in as an agent for the United States, and his status was that
of “relator.”
Bagley took
this matter seriously.
During the 1994 to 2003 time period, Bagley exclusively
worked on his FSA prosecution activity, and was not otherwise employed.”
He
maintained a contemporaneous log of hours he worked on the litigation. He
attended meetings with his attorney and government counsel. He spent a lot of
time looking through TRW documents. He stayed involved because the attorneys
… weren’t accountants and hadn’t spent 25 years working with
TRW and didn’t have an in-depth understanding of TRW’s accounting system or the
people or the products or anything about the company which was necessary to understand how the frauds
occurred and where the evidence was.”
He logged approximately
5,963 hours working on the FCA. He put in those hours
… in order to successfully prosecute the claims so that [he]
would receive an award.”
In 2003 TRW
paid the government, which in turn paid Bagley $27,244,000. He in turn paid his
attorney $8,990,520. TRW also paid Bagley’s attorneys $9,407,295 and issued the
Form 1099 to Bagley.
NOTE: This is standard treatment. The payment to the attorney
is imputed to the litigant.
He filed his
2003 Form 1040. There was some complexity on how to handle the attorney fees paid
directly by TRW, so he amended the return. He went the usual route of deducting
the attorney fees as a miscellaneous deduction. He amended a second time, this
time showing the relator litigation as Schedule C self-employment income. He
was now deducting the attorney fees directly – and fully - against the litigation
proceeds.
The IRS
bounced the seconded amended return.
There really
was only one issue: did Bagley’s litigation activity rise to the level of Bagley
being self-employed?
The Court went
through the analysis:
·
Pursuing
the activity in a business-like manner
·
Expertise
·
Time
and effort expended
·
Success
in carrying on similar activities
·
History
of income and losses with respect to the activity
·
Financial
status while pursuing the activity
·
Elements
of personal pleasure or recreation
·
Regularity
and continuity
The IRS
argued along different lines. They reminded the Court of the origin and
character of the activity giving rise to the FCA claim. Bagley’s claim was that
of an informant, according to the IRS, not that of a relator prosecuting the
case. According to them, it was Bagley’s status as an informant, not his
activities as a relator – that drive the tax consequence.
The Court
decided that an action under the FCA was different from a tort action, as the
“gravamen” of a FCA action was fraud against the government. The relator stands
in the shoes of the government in order to prosecute the claim. This consequently
was not a personal claim that Bagley had undertaken. He had no personal stake
in the damages sought – all of which, by definition, were suffered by the
government.
The Court decided
that Bagley did have a trade or business, and that the second amended return
was correct. The government was to refund him approximately $3,874,000 plus
interest for his 2003 tax year.
Note the tax
year involved: 2003. This case was decided just this summer. Sometimes these
matters take a while to resolve, but this was an especially slow boat on a lazy river.
OBSERVATION: The facts are too unique for this case to
provide much precedence, but I am pleased that Bagley won. Frankly, a minor
change to the tax law would make this case obsolete and remove the tax
nightmare from future litigation settlements. Simply allowing the litigant to
recognize the net damages as income would solve this matter. It would also reflect
the equity of the transaction. Do not hold your breath, though.