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.

Do You File An Accurate Return Or A Timely Return?

I have alerted the staff here at CTG command center that I prefer and expect to file all business returns, especially passthrough returns, on a timely basis, irrespective of whether we have all required information. Granted, there is some freeplay – we cannot file if we have no information, for example, or if so much information is missing that a filing would not be construed as substantially correct.

The reason?

Penalties for late filing.

Let’s say that you and a partner have an LLC. The return is due in March and can be extended to September. You file an extension but, for whatever reason, do not file the partnership return until December.

What just happened?

(1)  You might think that the return is only 2 months late, as it was extended until September. That is incorrect. You have until September 15 to file the return. Fail to do so, and it is as if you never filed an extension. That return is now late beginning March 16.

(2)  So what? Here is so what: the penalty is $195 per K-1 per month. There are two K-1s: you and a partner. The penalty is $390 per month. Multiply that by the number of months, and you can see how this gets expensive fast.

(3)  You might be able to get out of this penalty. Revenue Procedure 84-35 allows an avenue for small partnerships with 10 or fewer partners, for example. Depending on the facts, however, there may be no easy out. Like fire, you do not want to be playing with this.

There are a hundred variations on the theme. Let me give you one. This one involves an estate tax return. Let’s review the key points, and you decide whether there is cause for a late-filing penalty. 

• The decedent died February 24, 1986.
• On May 6, 1986 the estate was admitted to probate.
• The wife was appointed executrix.
• The estate hired an attorney.
• The estate tax return was due November 24, 1986 (nine months after death). No extension was filed.
• In January, 1987 the executrix filed an inventory with the probate court. Four assets were listed but given no value. One of those assets was an interest in a trust, which asset took on a life of its own. 
• The assets which were valued - that is, excluding the four which were unvalued - were enough the require the filing of a federal estate tax return.
• In 1991 (five years later) the estate filed suit concerning the trust.
• In 1994 the common pleas court entered judgement.
• In 1996 the executrix filed a revised and final accounting with the probate court.
•  In 1997 the estate finally filed a federal estate tax return. 

     The IRS immediately went after late filing penalties. Why wouldn’t it? The tax return was filed more than 10 years after the decedent died.

The gross estate was over $2 million. Those items that could not initially be valued came in around $200 grand.

The IRS charged in and chanted its standard wash-rinse-repeat hymn: the taxpayer cannot escape penalties for the non-extension or late filing of a return pursuant to the Supreme Court’s Boyle decision.

But the estate punched back with reasonable cause: the executrix did not have values for some of the assets that were eventually distributable from the estate. Heck, they had to sue to even get to some of those assets!

What do you think? Is there reasonable cause?

Let me give you a clue: the disputed assets were about 10% of the final estate.

And we come back to a phrase I used early on: “substantially correct.” Tax Regulations require only that the estate return be “as complete as possible.” There are numerous cases where pending litigation – even if the outcome is expected to materially affect the estate’s final tax liability – has not been considered reasonable cause for not filing a return.

The Court pointed out two things:

(1)  The executrix knew (or should have known) early on that the estate was large enough – even excluding the disputed items – to require filing a return.

(2)  She could have paid at least the tax on that amount, or estimated and also included tax on the disputed items.

a.     The Court pointed out that disputed assets were only 10% of the estate.

The executrix did not have reasonable cause. She should have filed and paid something, even if she later had to amend the estate tax return.

My thoughts?

I agree with the Court. I believe the estate was ill-advised. 

There is a sub-story in here concerning the attorney (who thought the accountant was taking care of the estate tax return) and the CPA (who was never told to prepare an estate tax return, at least not until years after the return would have been due). Why didn’t the attorney reach out earlier to the CPA, at least for peace of mind? Who knows? Why didn’t the long-standing CPA – who would have known the decedent - ask about an estate return? Again, who knows?

Our case this time was Estate of Thomas v Commissioner.

COMMENT: I am looking (translation: I printed but have not yet read) a case where a taxpayer did use estimates but still got nailed with penalties. We may come back to that one in the near future.