Tax Issues With Lawyer Legal Funding

• Publication year: 2021
• Author: Robert W. Wood

Tax Issues with Lawyer Legal Funding

Robert W. Wood

Robert W. Wood practices law with Wood LLP (www.WoodLLP.com) and is the author of Taxation of Damage Awards and Settlement Payments and other books available at www.TaxInstitute.com. This discussion is not intended as legal advice.

When you receive a loan, is the money taxable? Of course not, because you must pay back the money. That obligation prevents the loan money from being income. Of course, if the loan is later forgiven, that forgiveness can trigger tax, unless you can fall within one of the few exceptions to cancellation of debt income (such as bankruptcy or insolvency).¹ Thus, loans aren't taxed.

Can lawyers borrow too, just like anyone else? Of course, and, for that reason, many lawyers and litigation funders are fretting about Novoselsky v. Commissioner.² In that case, a lawyer was taxed on litigation funding loans. It's one of those classic bad-facts bad-law situations, and therefore, much of the hype needs explanation. In fact, this perfect storm is full of tax lessons.

David Novoselsky, a solo Chicago lawyer, raised $1.4 million, using loan agreements he drafted himself. The IRS and tax court said they were not loans, so the proceeds were taxable as income from the start. The court agreed with the IRS that he should have reported the $1.4 million "loans" as income. Novoselsky couldn't complain to his tax lawyer for putting this mess together because there was no tax lawyer. There was not even a business lawyer.

It was all DIY. Novoselsky was an entrepreneurial litigator, so, in 2009 and 2011, he signed up "litigation support agreements" with eight doctors and lawyers around Chicago. They fell into three groups, each with a pre-existing stake in the litigation: (i) doctors who were plaintiffs in lawsuits Novoselsky was cooking up; (ii) doctors whose economic interests were aligned with those of the plaintiffs; and (iii) lawyers with whom Novoselsky had fee-sharing agreements.

He documented them as nonrecourse loans, promising a high rate of interest or a multiple of the investment. He did not report them as income on his 2009 and 2011 tax returns, but, on audit, the IRS said the $1.4 million was not a loan. When Novoselsky refused to extend the statute of limitations—standard fare in an audit—the IRS assessed taxes and penalties over $600,000.

Novoselsky went to tax court, but proceedings were stayed when he declared bankruptcy in 2014. Novoselsky acted as his own bankruptcy lawyer too, and he...