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Taxes and Attorney Fees: Make Lawsuit Income Schedule C Income by Regulation

January 13th, 2018 Leave a comment Go to comments

Update January 15: See the next post for essential connection with this one.  I now think I might be wrong in a lot because of not knowing the “trade or business” law well enough.  Read with caution! I’ll read some cases and revise as necessary. My conclusion that IRS regs can be revised easily, without objection, may or may  not survive.

Apparently the 2017 tax bill eliminates deductions for attorney fees by eliminating miscellaneous itemized deductions (see Professor Gregg Polsky’s Slate article). I knew a lot about this at one time, because I was thinking about taxation of my Citigroup qui tam suit if I won. I’m now intending just to donate the proceeds to charity via a transfer of the lawsuit to a foundation if I get closer to winning, though I was hoping to deduct some fees for 2017 even though no income had yet been generated.  So I discovered the unsatisfactory legal treatment of contingency fees. Personal injury lawsuit income isn’t taxed at all, so the problem doesn’t arise, but income from libel suits and tax, SEC, or government contract whistleblower suits is taxable, and contingent fees are commonly 40%.

Here is the situation. I will use Polsky’s example. Suppose I hire a lawyer on 40% contingency fee and win $500,000 in a libel suit, but expert witnesses, etc. cost $100,000 in expenses. The way it works is that the lawyer will have paid the expenses but ask for reimbursement if I win (not if I lose, apparently, by custom, a curious side point) and he will get his $200,000 fee. Formally, however, the lawyer gets a check for $500,000 made out to me, and then he takes out $300,000 and gives me $200,000.

Formally, I have $500,000 in income. I used to be able to deduct most or all of the $300,000 (I forget if there was some kind of floor on that kind of deduction that had to be subtracted). I was left with $200,000 of net income, on which I might pay 30% tax (for simplicity) of $60,000, leaving me with $140,000. That’s reasonable.

After the 2017 tax bill, I can’t deduct any legal expenses. Thus, I pay $150,000 in tax, leaving me with $50,000 in income, a 75% tax rate. Polsky notes that if I live in California or New York my total taxes including state taxes might well come to a 50% rate, $250,000, in which case I end up with -$50,000 income, a 125% tax rate.

There is a solution. I think I can create a corporation or LLC with me owning 100%   of the shares,  and sell either the right to sue or, more likely, any proceeds from a lawsuit, to the corporation. I could sell them for $1, to transfer them. I should do this before the end of the lawsuit, so the value is inchoate and I haven’t had the taxable event of earning the income.  A corporation can deduct legal expenses, so we return to the pre-2017 situation.

Well, not quite. The lawsuit may incur expenses before the lawsuit’s income is received, and the income might never be received. To do this, the corporation should borrow from the plaintiff or sell shares to him. Unlike before 2017, the taxpayer won’t be able to deduct anything  in the years before the lawsuit is resolved, because these new sums are investments, not costs. The corporation will incur costs, and will carry them forward as Net Operating Losses to set off against eventual income. If the lawsuit wins, the outcome is as if all the expenses are deductible, except for timing (interest payments, discounting, small-dollar stuff). If the lawsuit loses, then the expenses become a capital loss for the plaintiff. That’s easy if new shares  were issued- they are now worthless when the corporation is dissolved. I think if transferrable debt was issued that works too, as a capital loss as with a corporate bond that goes bust. There, it is a bit more delicate, though, because I think personal bad debts are not deductible, and I don’t know about  non-transferrable bad debts owed by a closely held corporation.

I think the scheme avoids the Assignment of Income doctrine. That tax doctrine says that a taxpayer can’t assign future income from his property or his labor to someone else and avoid getting taxed on it. He can’t assign half his income to his wife, for example, to try to get each of them into a lower tax bracket. My scheme relies on lawsuit proceeds not being like real estate proceeds. It is different because a lawsuit’s value is inchoate, like giving someone the right to an unpatented idea. An Eli Lilly employee assigns Eli Lilly that right, and the employee doesn’t pay taxes on the $10 million value of an idea that turns out to be good. There is caselaw that strongly supports the idea that lawsuits are that way too– even, as I recall, if there has been a judgement, so long as appeal is still possible. That last case was so wild that I don’t think it should hold up— that is, I think the judge was mistaken— but it shows that assignment at an early stage would be fine.

How about  the Form over Substance doctrine?  That doctrine says that if the taxpayer sets up a scheme that is exactly equivalent to the original situation in every aspect except possibly taxation, he can’t reduce his taxes. I think we’re okay there too. There are good business reasons to incorporate lawsuits— principally, that the plaintiff can sell off shares to get cash immediately and to reduce his risk.

It shouldn’t be necessary to incorporate like I’ve suggested, though.  Tax law is bad in this situation, wrong, I would say if I were a judge. Look at the substance of what’s going on. The plaintiff is engaged in a business venture. He is paying expenses necessary to generate income.  There is no reason this should not be Schedule C income. The libel plaintiff should be treated like someone who sets out to run a  home catering business and needs to pay expenses and hire a lawyer.

One solution would be for Congress to  amend the tax code to change the law.  For some reason, Congress has a hard time passing even Pareto-improving bills, though, probably because of fighting over who gets what share of the bargaining surplus— for example, each of the 100 senators might insist on being the sole sponsor, so the bill fails 99-1 whoever sponsors it.

A second solution would be for the IRS to amend the regulations. The IRS can do this unilaterally, subject to challenge in court. If it really is pareto-improving, nobody will challenge it.  In fact, since nobody has standing to challenge another person’s illegal tax gift from the IRS, even if it was an illegal regulation, nobody would challenge it. But even if it was challenged, it should win in court. Maybe there are no adverse precedents, even. It might just be that the IRS decided wrongly at some point in time to classify lawsuit income as miscellaneous income (I might be wrong as to the name) instead of Schedule C income. Or, it might be nobody has even tried putting it on their Schedule C.

In any case, what’s needed is for the IRS to propose a new regulation making lawsuit income Schedule C business income. It should be income from personal services or something similar, ineligible for the new 20% pass-through credit even though it is business income. This could be done before April if they move quickly. I guess this would be a suitable occasion, though, for a temporary regulation, issued at the same time as the new proposed regulation is put in the Federal Register for the 30 or 90 day comment period, or even before it is, though the new regulation should be proposed and finalized before 2019.

Caveats: Here are the points I’m  unsure of:

  1. In what states can lawsuits be incorporated? How does that relate to the venue?
  2. In what kinds of suits can the corporation become the plaintiff, as opposed to just getting the income?
  3. Is there any problem for a  sole proprietorship deducting huge legal fees on Schedule C?
  4. Do courts grant Chevron deference to revisions of regulations that run directly contrary to judicial precedent?
  5. To avoid the form over substance doctrine would the corporation have to sell 10% of the shares to an independent party?
  6.  How precisely does the IRS classify lawsuit income now, and why isn’t it on Schedule C?
  7. Has anyone ever tried putting lawsuit income on Schedule C instead of directly onto the 1040? Would the IRS object?
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