Winning a lawsuit can mean losing on your tax return. The tax law treats the expenses of most lawsuits, like attorney fees, as “miscellaneous itemized deductions.” Miscellaneous itemized deductions are deductible for regular tax only to the extent they exceed 2% of adjusted gross income. Worse, they are not at all deductible in computing alternative minimum tax.
The result of this can be a very high effective tax rate on the net winnings of a lawsuit — sometimes even over 100%. Now a California taxpayer may have found a way out of this AMT trap.
Richard Bagley was an accountant for TRW. He blew the whistle on alleged accounting misdeeds at his employer and filed suits under the False Claims Act. This FCA allows people to in effect take the law into their own hands by suing people for fleecing the government. Such suits are called “qui tam” suits. If the plaintiffs win, they get a share the of the recovery of the overbilling. Such plaintiffs are called “relators.”
Nine years later, Mr. Bagley won $36.6 million in his settlement, along with $9.4 million for attorneys fees. His actual attorney fees were nearly $18.5 million. Mr Bagley paid taxes on this income the usual way, but then claimed a $3.8 million refund, arguing that his attorney fees were properly business expenses. Regular business expenses are fully deductible for both AMT and regular tax.
This week a California federal judge held that Mr. Bagley was in the “trade or business” of pursuing the lawsuit, and could take his deductions as ordinary business expenses. The judge reviewed tax law rules on what constitutes a “trade or business,” and concluded:
In this case, this court concludes that the evidence clearly supports a finding that, in addition to coming forward with the false claims information and filing the FCA lawsuits, Bagley provided services to the government, including, inter alia, drafting memoranda and summaries explaining the false claims schemes by TRW, reviewing documents produced to TRW, doing damages calculations, and explaining the evidence and claims to the government.
Based on the foregoing, the court concludes that Bagley has met his burden of proof to show that his activities as a relator from 1994 to 2003 were a “trade or business” for purposes of Section 162(a).
It’s an interesting result. It is still subject to appeal, and even if it is upheld by the Ninth Circuit, the IRS could still fight the issue in the rest of the country. By its own terms, it might be limited to taxpayers who have to go to extraordinary lengths to win a lawsuit. From the opinion (my emphasis):
Bagley maintained a contemporaneous log of hours he worked in relation to the litigation of the qui tam actions. The log started in June of 1994, when Bagley was assisting his attorneys in preparing the first FCA complaint. Bagley spent approximately 5,963 hours on his FCA activity.
The crux of the problem with the government’s argument is contained in its assertion that “[t]he litigation activities in which Bagley took part do not entitle him to different tax treatment than a similarly-situated plaintiff who, by mere happenstance, encounters an opponent who is not adverse and settles shortly after the filing of the suit.” However, Bagley’s litigation activities, and the regular, continuous way he undertook them combined with skill and a good-faith effort to make a profit, are precisely what may distinguish him from other relators, who have not pursued their FCA disclosure and investigation in the same manner.
Despite its limitations, this could be an important case for the taxation of lawsuit proceeds and expenses. It certainly would be wise for plaintiffs to keep records to try to document that their lawsuits constitute a “trade or business.”