Does Judge Sotomayor Have a Tax Problem?

Following up on this morning's post, Judge Sotomayor's Law Practice: A Tax Dodge?:  the issue was first flagged by Glenn Reynolds (Tennessee), and he notes that he "was just following Ralph Winter’s advice from my Business Associations class in law school:  When you see a business arrangement that doesn’t seem to make any sense, just say 'it’s probably for tax reasons,' and you’ll be right nine times out of ten."  At my invitation, Linda Galler (Hofstra) expands on the potential tax issues surrounding Judge Sotomayor's sideline legal practice:

While I am supportive of Judge Sotomayor's nomination to the Court, and do not think that the facts in the New York Times article suggest that there is a problem large enough to preclude confirmation, I do think there is an interesting tax issue. There is also an interesting non-tax issue, which I will address first.

Most law firms have strict policies prohibiting partners and associates from engaging in legal work “on their own.” This is because conflicts of interest problems can be created. For example, the New York Times article indicates that Judge (then attorney) Sotomayor reviewed contracts for an insurance salesman. What kind of contracts were they, and who was the other party? If the other contracting party was an insurance company that was represented by the judge’s law firm, or later sought representation, the firm could have found itself in an awkward position. This suggests three possible alternatives: (1) the firm had a policy and Judge Sotomayor violated it, (2) the firm had no policy, or (3) Judge Sotomayor wasn’t really practicing law out of her home so getting the firm’s permission was never an issue for her.

Which brings us to the tax issue. The judge presumably did not bring her clients into the firm because she could not justify charging them the fees generally charged to other clients. Otherwise, she (like most lawyers) would have represented the client through the firm. If that is the case, then she was either doing the side legal work for free or for almost-free. Does the amount of work that she did and the income that she brought amount to a trade or business, justifying Schedule C (above the line) deductions? If she had represented the clients through the firm, then expenses either would have been the firm’s expenses (perhaps deductible by the firm but not by Judge Sotomayor) or, if she paid them herself, they would have been deductible below the line since she was an employee.

Her position as to this issue is slightly stronger with respect to the side work that she did when she was employed by the district attorney’s office because she could not have gotten permission to represent the clients “at work.” The question remains, however, whether her side activities amounted to a trade or business.

Moreover, what were the expenses? If they were minimal, who really cares. But suppose she was taking home office deductions. If my earlier presumption is correct, then the receipts from her side practice were likely to have been trivial or insignificant at best. Maybe she claimed to run a law practice out of her home so that she could take home office deductions when she was really (just) an employee whose employer provided her with an office, and the home office deductions would then have been improper. (Employees generally are not permitted to deduct the costs associated with home offices, no matter how much work they actually perform at home. But people who run businesses out of their homes often can.)