Analysis of and reflections on recent cases and rulings.

• Author: Beavers, James A.
• Position: TAX TRENDS

Gross Income

Litigation support payments are income, not loans

The Tax Court held that litigation support payments the taxpayer received, which he was not required to repay if the related litigation was not successful, were gross income and not nontaxable loan proceeds.

Background

During 2009-2011 David Novoselsky practiced law in the Chicago metropolitan area. To finance some of his litigation, he entered into litigation support agreements under which he received purported loans from the counterparties to the agreements. The counterparties who supplied this support were plaintiffs in litigation being handled (or proposed to be handled) by Novoselsky, persons whose interests were economically aligned with the interests of such plaintiffs, lawyers with whom Novoselsky had fee-sharing arrangements, or individuals seeking a high return on a speculative investment.

Under the terms of each of these litigation support agreements, Novoselsky's repayment of the loans was contingent on the success of the litigation that the counterparty was supporting. Novoselsky was not obligated to repay the funds advanced to him unless the litigation in question yielded proceeds in the form of attorney's fees and/or costs. If the litigation was unsuccessful, he was not obligated to repay any part of the loans to the counterpart)'. Under these agreements, Novoselsky received litigation support payments totaling $410,000 in 2009 and $1 million in 2011.

On the joint tax returns Novoselsky filed with his wife in 2009 and 2011, he did not include any of the litigation support payments he received in gross receipts on his Schedules C, Profit or Loss From Business. Novoselsky did not include the payments on his returns because he considered them loans that were not includible in income. The IRS audited his 2009 and 2011 returns. It found that the payments were not loans and that Novoselsky was required to include them in gross income. The IRS issued notices of deficiency for both years, reflecting adjustments for the unreported payments and accuracy-related penalties. Novoselsky petitioned the Tax Court, challenging the IRS's determinations.

The year after filing his Tax Court petition, Novoselsky filed for bankruptcy. In his bankruptcy petition, he did not list the counterparties to his litigation support agreements as creditors. In both bankruptcy court and Tax Court, Novoselsky argued that the United States (in bankruptcy court) and the IRS (in Tax Court) were taking inconsistent positions on whether the litigation support agreement payments were loans and that the doctrine of judicial estoppel precluded them from taking these inconsistent positions.

The Tax Court's decision

The Tax Court held that the payments made to Novoselsky under the litigation support agreements by the counterparties were not loans and were includible in his gross income under Sec. 61(a). It found that the payments were not loans because Novoselsky only had a conditional obligation to repay the counterparties.

As the court explained, Sec. 61(a) defines gross income as "all income from whatever source derived," including income derived from business. The Supreme Court has held that because a genuine loan is accompanied by an obligation to repay, loan proceeds do not constitute income to the taxpayer (Tufts, 461 U.S. 300 (1983)). As the Tax Court held (and the Seventh Circuit affirmed), for this rule to apply, however, the obligation to repay "must be unconditional and not contingent upon some future event" (Frierdich, 925 F.2d 180, 185 (7th Cir. 1991), aff'g T.C. Memo. 1989-393). Where an obligation to pay arises only upon the occurrence of a future event, the Tax Court has consistently held that a valid debt does not exist for federal tax purposes (see, e.g., Taylor, 27 T.C. 361 (1956) (funds advanced to open securities accounts not loans...