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.

Another Runaway FBAR Case

 

Let’s talk about the FBAR (Report of Foreign Bank and Financial Accounts). It currently goes by the name “FinCen Form 114.”

This thing has been with us since 1970. It came to life as an effort to identify foreign financial transactions that might indicate money laundering or tax evasion. 

Sounds benign.

The filing requirement applies to a United States person, defined as

·      A citizen or resident of the U.S.

·      A domestic partnership

·      A domestic corporation

·      A domestic trust or estate

 We’ll come back that first one in a moment.

Next, one needs a financial interest or signature authority in a foreign financial account to trigger this thing.

A foreign financial account includes a bank account, which is easy enough to understand. It would also include a broker account (think Charles Schwab, but overseas). Some are not so intuitive, though.

·      A foreign insurance policy with cash value is reportable.

·      A foreign hedge fund is not.

·      A foreign annuity policy is reportable.

·      A foreign private equity fund is not.

·      A foreign cryptocurrency account is not reportable.

Some require a google search to understand what is being said.

·      A Canadian registered retirement savings plan is reportable.

·      A Mexican fondo para retiro is reportable.

Next, the foreign financial account has to exceed a certain dollar balance ($10,000) at some point during the year.

That $10,000 balance has been there for as long as I can remember. You will have a hard time persuading me that $10,000 in 1986 is the same as $10,000 now, but that number is apparently eternal and unchanging.

The $10,000 is tested across all foreign financial accounts. If it takes your fourth foreign account to put you over $10 grand, then you are over. Testing is done. All your accounts are reportable on a FBAR.

Like so many things, the FBAR started with reasonable intentions but has morphed into something near unrecognizable.

Fail to file an FBAR and the standard penalty is $10 grand. Fail to file for two years and the penalty is $20 grand. Have two foreign accounts and fail to file for two years and the penalty is $40 grand.

And that is assuming the error is unintentional. Do it on purpose and I presume they will execute you.

I exaggerate, of course. They will just bankrupt you.

It puts a lot of pressure on defining “on purpose.”

Let’s look at Osamu Kurotaki (OK).

OK was born in Japan and lives in Japan. He obtained a U.S. green card, making him a U.S. permanent resident. One of the pleasures of being a permanent resident is filing an annual tax return with the United States, irrespective of whether you live in the U.S. or not. One can talk about a foreign income exclusion or foreign tax credit – which is fine – but that annual filing makes sense only if someone intends to eventually return to the U.S. It does not make as much sense if someone does not intend to return, someone like OK.

OK paid someone to prepare his annual U.S. tax return. He found a CPA who was bilingual.

In 2021 the U.S. Treasury assessed civil penalties against OK for more than $10 million. His footfall? He failed to file FBARs. Treasury also upped the ante by saying that his failure was “willful.”

Huh?

Treasury is requesting summary judgement that OK willfully failed to file FBARs, prefers waffle over sugar cones and rooted for the Diamondbacks in the World Series. 

The Court wanted to know how Treasury climbed the ladder to get to that “willful” step.

So do I.

Here is what the Court saw:

·      OK is a Japanese speaker and does not speak English “at all.”

·      OK relied on his bilingual CPA to make sense of U.S. tax filing obligations.

·      His CPA provided annual tax questionnaires in both English and Japanese. The English was for theater, I suppose, as OK could not read English.

·      The CPA’s translation now becomes critical. Here are instructions to the FBAR in English:

U.S. taxpayers are required to report their worldwide income; that is, income from both U.S. and foreign sources.”

·      Here is the Japanese translation:

U.S. resident taxpayers are required to report their worldwide income, that is, income from both US. and foreign sources."

OK told the Court that he did not think he had a filing obligation because he was not a “U.S. resident.”

I get it. He lives in Japan. He works in Japan. His kids go to school in Japan. He is as much a “U.S. resident” as I am a Nepalese Sherpa.

Except …

OK was green card – that is, a “permanent” resident of the U.S.

Technically …

The Court cut OK some slack. Technically - and in a law school vacuum - he was a “resident.” Meanwhile - in the real world – no one would think that. Furthermore, OK hired a CPA who made a mistake. Even a trained professional erred interpreting the Treasury’s word salad. 

The Court said “no” to summary judgement.

Treasury will have to argue its $10 million-plus proposed penalty.

And I believe the Court just outlined reasonable cause.

Perhaps OK should consider turning in that green card. 

Our case this time was Osamu Kurotaki v United States, U.S. District Court, District of Hawaii.