The Fruit Of The Tree

 

I have a friend who is pressing an employment lawsuit.

It is not pretty: falsified records, deleted files, retaliatory firings. The legal process itself is glacial: may we live long enough to see the end. They enter discovery soon. I suspect the employer/defendant will then seek to settle rather than risk any further public disclosure.

I suppose I am my friend’s tax advisor.

The taxation of litigation is not what it used to be.

Let’s travel back to 2005. The Supreme Court was hearing two cases involving income recognition and legal contingency fees.

ISSUE: You sue for $100 grand. If you win, the attorney takes 30 percent. Are you taxed on $100 grand or on $70 grand?

The Appeals courts had split, which is how the Supreme Court got involved.

We will restrict ourselves to one case: Banks v Commissioner. Banks had brought an employment lawsuit. Before going to trial, he settled for $464,000 and paid a contingency fee of $150 grand. The Sixth Circuit reasoned there was no extant income when the contingency was created, making the agreement more akin to a division of property (the claim) than a division of spoils (the settlement). Banks did not have a sufficiently uninterrupted claim to require reporting of the entire amount ($464,000).

The Supreme Court took a different tack and saw anticipatory assignment of income. This is a classic tax doctrine; one I learned in school as “fruit of the tree.” The concept is that income (the fruit) should be taxed to the person earning or generating it (the tree). An example would be my working all week but having my paycheck go to my child. I earned the paycheck and cannot avoid taxation by redirecting its payment.

This result could have been disastrous to Banks, requiring him to pay taxes on $150 grand which he did not receive. Pause to consider that his attorney was also reporting the same $150 grand in income, so the contingency fee was being taxed twice. Unless there was a safety valve somewhere, this was not taxation – it was confiscation.

But Banks fortunately had a safety valve: itemized deductions. Take a look at this itemized deduction schedule (Schedule A) for 2015: 

             

Go to the bottom where you see “Miscellaneous Deductions.”

You know what was a miscellaneous deduction? Yes, contingency fees paid an attorney on a legal judgement or settlement.

Was it a perfect answer? No. The deduction came after Adjusted Gross Income (AGI), so a tax attribute based on AGI would be unfortunately skewed. It was an itemized deduction, and the taxpayer may not have been itemizing except for the contingency fee. And it was a “miscellaneous” itemized deduction, meaning that the taxpayer had to subtract 2% of AGI off-the-top before getting to the deductible amount.

Still, it was something and much better than nothing.

Then the tax law changed with the 2017 Tax Cut and Jobs Act (TCJA).

One of the things that the TCJA did was to eliminate almost all miscellaneous itemized deductions, beginning in 2018.

Those contingency fees were no longer deductible.

Congress argued that it was simplifying the tax Code by reducing the number of taxpayers who were itemizing. While this result did happen, Congress also eliminated the economic handcuff to the Banks case: a deduction somewhere on a tax return to offset that severe 100% income recognition.

COMMENT: Let’s clarify this issue by separating legal fees between business and nonbusiness lawsuits. Business legal fees are still deductible. Nonbusiness legal fees (think employment lawsuits) are generally nondeductible. There still exists a narrow deduction for selected nonbusiness litigation (such as certain discrimination and whistleblower claims), but for the vast majority of nonbusiness litigation there simply is no deduction for legal fees.

Let’s look at the Eiler case.

James and Kathryn Eiler sued LexisNexis, Equifax, Experian and Trans Union for inaccurate, incomplete or otherwise injurious information on their credit reports. The parties settled for $64,750, of which $4,700 went to the Eilers.

COMMENT: The comment writes itself, I would say.

The IRS came in, eyes gleaming and jaws slavering, with a Notice of Deficiency totaling over $11 grand.

The Eilers were in a tough spot. Under Banks the IRS was correct, and there remained only a few ways to deduct related nonbusiness legal fees. The Eilers started thinking: we brought action under the Fair Credit Reporting Act (FCRA), which is kinda-sorta like the Equal Credit Opportunity Act (ECOA), which has explicit discrimination protections. If the FCRA is like the ECOA, and if “unlawful discrimination” includes “enforcement of civil rights,” and if the moon hits your eye like a big pizza pie …

The Eilers wanted a deduction because of civil rights discrimination.

To be accurate, the Eilers just wanted a deduction. They were being creative on how to get there.

And the Tax Court shot them down.

They received $4,700 and owed over $11 grand.

My thoughts?

I question whether the Supreme Court would decide Banks the same way given today’s tax Code. When a line of reasoning (assignment of income rather than co-ownership of a claim) leads to absurd results (such as double taxation of the same “fruit”), a sober and responsible person would conclude that the reasoning is flawed.

And there you have the taxation of nonbusiness litigation since 2018.

Our case this time was Eiler v Commissioner, 167 T.C. No. 3, Docket No. 16903-22, 7/14/2026.

Z Street Decision Will Force IRS To Disclose How It Reviews – And Delays - Tax-Exempt Applications

I am reading things that make me wonder what is going on at the IRS. It repetitively appears that the agency – or at least influential partisan players – think that the job of the IRS is to take sides in political issues.

I am looking at Z Street v Shulman. It is a Court decision from the District of Columbia. There are some interesting points in here, embalmed in yawn-inducing legalese.

Let’s talk about this case.

Z Street is a non-profit corporation. It comes out of Pennsylvania, was organized in 2009 and immediately applied for tax-exempt status. Its purpose is to educate the public about Zionism; about facts on the formation of the Jewish state; and about Israel’s right to refuse to negotiate with terrorists.

We know about that the IRS instituted a policy of 501(c)(4) suppression prior to the 2012 presidential election. The 501(c)(4)s are a different animal from a (c)(3), the “traditional” charity. A (c)(4) may engage in an unlimited amount of lobbying, as long as it stays within the issues for which it was organized. If someone felt strongly about blue M&Ms, for example, I suppose that someone could organize a (c)(4) and lobby nonstop – as long as they stayed within the issues concerning blue M&Ms. A (c)(4) can also engage in some partisan political activity, as long as it does not become its primary activity. There is a price however for this freedom to till so close to political soil: deductions to a (c)(4) are not deductible.

Contrast that to a (c)(3), contributions to which are tax-deductible. As a trade-off, there are severe restrictions on lobbying activities of a (c)(3).

Anyway, Z Street applies for (c)(3) status. It wants that tax-deductible status, understandably. It is possible that – in the future – it will spin-off a (c)(4). 

Here are some quick dates:

·       12/29/09 - applies for exempt status with IRS

·       5/15/10 – IRS send a letter requesting additional information

·       6/7/10 – Z Street provides additional information to the IRS

·       7/10/10 – Z Street’s attorney tracks down the IRS person (Dianne Gentry) handling the file.  Agent Gentry tells the attorney that she has two reservations:

o   Z Street is engaged in “advocacy” activities that are not permitted under Section 501(c)(3)

o   The IRS has special procedures for applications from organizations whose activities relate to Israel, and whose positions with respect to Israel contradict the current policies of the U.S. government. She further stated, “these cases are being sent to a special unit in the D.C. office to determine whether the organization’s activities contradict the Administration’s public policies."

I am stunned.

I immediately pick up on the issue of a (c)(3) and advocacy. I expected that issue, and frankly, I wonder why Z Street didn’t organize a (c)(4) instead.

But “special procedures” and the “Administration’s” current policies? My tax-exempt application is to be judged on whether the Administration “likes” me and whether I say “politically correct” things? Good grief, bring on Kristallnacht.

Z Street brought a lawsuit. They alleged that the IRS maintains a special policy when it comes to Israel and to (c)(3)s whose stance does not agree with the Obama Administration, and that such applications are subject to special procedures not applied to other organizations. 

What does Z Street want?

·       A declaration that policy is unconstitutional, and

·       An injunction forcing the IRS to disclose the policy and barring the IRS from employing the same.

The IRS stalled this thing almost long enough to put your kid through college. I am disturbed that the IRS core argument seems to be “we can do whatever we want.” Here are their arguments:

(1)  The Anti-Injunction Act

The AIA was first enacted in 1867, and states that ”no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person, whether or not such person is the person against whom such tax is assessed.”

The IRS argued that the AIA barred the Court from granting injunctive relief.

(2)  Code Section 7428

Code Section 7428 already provides remedy for organizations that seek to challenge IRS determination of their (c)(3) status.

(3)  The IRS also argued that the case should be dismissed on “sovereign immunity” grounds.

The Court goes to work:

(1)  The D.C. Circuit had already decided a case (Cohen) rejecting  that the AIA’s “assessment and collection” language bars any and all lawsuits that might ultimately impact revenue to the Treasury. It has to be so, otherwise one could pass virtually any law and render it unreachable by calling it a “tax.”

(2)  By its terms, Section 7428 applies when there is controversy concerning qualification of an organization as a (c)(3). The only available remedy under Section 7428 is a “declaration with respect to … initial qualification or continuing qualification.”

The Courts points out that Z Street is not asking the Court for (c)(3) qualification. Rather it is asking the Court to force the IRS to follow a “constitutionally valid process” – nothing more and nothing less.

(3)  The Administrative Procedure Act expressly waived sovereign immunity for lawsuits such as this. The APA waives sovereign immunity for suits for nonmonetary damages that allege wrongful action by an agency or its officers or employees.

The Court points out the obvious: that is exactly what Z Street is doing.

Judge Ketanji Brown Jackson observed:

Defendant struggles mightily to transform a lawsuit that clearly challenges the constitutionality of the process that the IRS allegedly employs when it determines the tax-exempt status of certain organizations into a dispute over tax liability as a means of attempting to thwart this action’s advancement.”

In legalese, this is like being punched in the face.

The Court decided that the Z Street’s lawsuit could proceed. After the IRS files its response, the case will go to discovery. The IRS will have to pony up what it has been doing with tax-exempt applications these last few years. Anticipate that Z Street attorneys will seek depositions from other groups similarly treated by the IRS.  

Good.

If proven, this type of behavior by the IRS is thuggish and needs to be punished. People need to lose their jobs, if not their freedom for a while. Perhaps we could build a Lois Lerner wing at a prison somewhere. Perhaps somewhere near the District of Columbia so these people would not have to travel far.

Why do I say this? Our taxation system relies – to an overwhelming extent – on voluntary compliance. The function of the IRS is to administer and collect taxes and process records of the same. Whatever our political stance, we can have common ground on the assessment and collection of tax. We can all hate the IRS equally.

If we disagree on tax law, however, we take that disagreement into the legislative arena. Allow elected representatives to hash it out. At least the representatives have to run for reelection occasionally, so there is some chance for an accounting of their decisions and actions. This is greatly preferable – and healthier for our system of governance – than partisan berserkers bending whatever lever of government they can access to impose their dogma du jour.

Remember: there will be a future White House with very different attitudes and values than the present one. If this behavior goes unpunished, those now in power will then be out of power, and it will be their views and causes that will be handed to the tender mercies of the partisan berserkers then in power.

Don’t come crying then.

“ROB”-ing a 401(k) Plan

A CPA acquaintance from New Jersey came into town and spent a couple of days at the office. Why? Well, maybe he wanted to get away from New Jersey. Actually, he wanted to take a look at some of the policies and procedures we utilize. He only recently purchased his own practice.

He said something that surprised me, and which I thought we could discuss this week. He funded his accounting practice by using his 401(k) funds. This technique is sometimes referred to as “rollover for business startup.” The acronym is “ROBS.” Catchy, eh?

What do I think about ROBS? Frankly, I am a bit uncomfortable with them. There is the issue of concentrating your retirement monies in a venture also intended to provide current income. Should it fail both income and retirement monies vanish. I am financially conservative, as you can guess.

The second issue is technical: there are a number of ways this structure can run afoul of some very technical requirements. You have tax law, you have ERISA, you have … well, you have enough to cause concern.

Let’s give this CPA acquaintance a name. We will call him “Garry,” mostly because his name actually is Garry. Here is what Garry did:

(1)    Garry created a corporation. The corporation had no assets, no employees, no business operations, no shareholders. Accountants call this a “shell” corporation.

(2)    The corporation adopted a retirement plan. The plan allowed for participants to invest the entirety of their account in employer stock.

(3)    Garry became an employee of the corporation.

(4)    Garry rolled-over his 401(k) (or a portion thereof) to the newly-created retirement plan.

(5)    Garry had the plan purchase the employer stock.

(6)    The corporation now had cash, which …

(7)    The corporation used to purchase an accounting practice.

What can possibly go wrong? Here are several areas:

(1)    You need a solid valuation for the 401(k) purchase of the employer stock. I would not want to go into the IRS with only a rough calculation on the back of an envelope. The trustee of the plan has fiduciary responsibility. Granted Garry is both the fiduciary and beneficiary, but he still has responsibilities as trustee.

(2)    The workforce has to be able to participate in the plan.

a.       This is a qualified plan. There are nondiscrimination requirements, same as any other qualified plan.

b.      This is not a problem for a one-man shop. What will Garry do when he hires, however?

                                                               i.      Here is what he better do: amend the plan to prohibit further investment in employer stock. Future employees will not be allowed to invest in Garry’s accounting firm stock.

(3)    There is a fiduciary standard for investment diversification.

a.       You can see the problem.

                                                               i.      Maybe Garry can open a second accounting office. You know, diversify.

(4)    Garry is paying for all this. Some brokers will charge over $5,000 to set up a ROBS.

a.       Oh, there are also ongoing annual charges. The plan will have an annual Form 5500 filing requirement, for example.

b.      There may also be periodic valuations, requiring Garry to pay a valuation expert.

                                                               i.      Why? Because Garry has a difficult-to-value asset in a qualified plan. Difficult-to-value does not mean Garry gets a free pass on valuing the asset. It does mean that it is going to cost him.

(5)    These transactions have caught the attention of the IRS. This does not mean that his transaction will be audited, challenged or voided, but it does mean that he has walked into a spotlight.

a.       Garry had to gauge his IRS risk-tolerance as well as his financial diversification risk-tolerance.

Are ROBS considered “out there” tax-wise? Actually, no. There are tens of thousands of these structures and their businesses up and running. Garry is in good company. And while the IRS has scowled, that doesn’t mean that ROBS are not viable under the tax code and ERISA. It does mean that Garry should be careful, though. Professional advice is imperative.