Paul L. Caron

Monday, June 1, 2020

Lesson From The Tax Court: Litigation Funding Agreements Were Not Loans

Tax Court (2017)David A. Novoselsky and Charmain J. Novoselsky v. Commissioner, T.C. Memo. 2020-68 (May 28, 2020) (Judge Lauber), teaches us that a repayment contingency in a litigation funding agreement means the funds are not a loan for federal income tax purposes.  Mr. Novoselsky was a lawyer who received $1.4 million in advances to fund litigation. Repayment was contingent on litigation success.  He did not report it as income.  He should have.  Details below the fold.

Background: Litigation Funding
Litigation funding is when a third party gives money to either a client or a lawyer to help pay the costs of litigation.  In return the third party takes a cut of any winnings.  It was already established in 2012 when the ABA Commission on Ethics 20/20 sent this Informational Report to the House of Delegates.  In February 2020, the New York City Bar Association Litigation Funding Working Group sent this sure-to-be-influential Report to the Bar President identifying various issues with litigation funding and making various recommendations on how the Bar should address those issues.

Litigation funding has become common enough to attract federal attention.  Senator Grassley introduced a bill in 2019 called the Litigation Funding Transparency Act that requires various disclosures to the court and parties about litigation funding.

Notice I keep saying “litigation funding.”  I do not say “litigation loans.”  That is because it appears that a central provision of litigation funding agreements makes repayment of the money contingent on the success of the litigation being funded.  The impact of that central provision on the tax consequences of the funding agreement is the lesson for today.

Law: What Loans Disguise
Loans don’t count as gross income to the borrower.  No-one is quite sure why.  There are two leading theories, both of which are reflected in case law and statutes.  I call them the balance sheet theory and the expectancy theory.  Here's the quickest summary I can give:

The balance sheet theory says the borrowed funds are not income because the loan creates an immediate offsetting debit on the taxpayer’s balance sheet. The taxpayer is no wealthier because the taxpayer’s assets are burdened by the obligation to repay. Accordingly, when the taxpayer is discharged from debt, those assets are “free up” and that freeing up constitutes the gross income. See e.g. United States v. Kirby Lumber, 284 U.S. 1 (1931). 

The expectancy theory ignores the balance sheet. It says that the borrowed funds are not income right now because of timing: the loan proceeds are just temporary.  They must be paid back.  In effect, the loan represents an advance on the future income that will be used to repay the loan.  If we require taxpayers to report the loan as income now then we would need to allow a deduction for later repayments to avoid double taxation.  See e.g. Commissioner v. Tufts, 461 U.S. 300 (1984)(“When a taxpayer receives a loan, he incurs an obligation to repay that loan at some future date. Because of this obligation, the loan proceeds do not qualify as income to the taxpayer. When he fulfills the obligation, the repayment of the loan likewise has no effect on his tax liability....The choice and its resultant benefits to the taxpayer are predicated on the assumption [i.e. expectation] that the mortgage will be repaid in full.”).

Notice that both theories assume that the loan proceeds will be repaid.  Sometimes that assumption proves incorrect and the taxpayer’s debt obligation is cancelled.  That cancellation creates what I call the Phantom of the Tax Code.  Most folks call it either Discharge of Indebtedness (DOI) or Cancellation of Debt (COD) income.

But not every transfer of money is a loan.  Sometimes the transfer is compensation for goods or services.  Sometimes its a gift.  Sometimes it is a contribution of capital in a joint venture.  Sometimes its the result of a swindle.  Other times repayment may be conditioned, on a particular future source of funding or on an expectation of profit-sharing rather than specific repayment.  None of these are loans.

Disputes about loans generally arise in the deduction context.  The classic case of Bugbee v. Commissioner, T.C. Memo 1975-45 illustrates.  Mr. Bugbee was a friendly barkeeper who kept giving money to one of his lushiest customers, Mr. Billings.  They executed formal promissory notes each time.  They both testified in Court that the money was to help Mr. Billings meet expenses until one of his various business ideas worked out.  Turns out, Mr. Billings was a strong talker but a weak walker. After several years with no repayment, Mr. Bugbee got wise, stopped giving away his money, and deducted what he had given away as a bad debt.  The IRS denied the deduction and came up with a bunch of different reasons why the transfers of money were not loans.  It’s a great case to teach what loans disguise.

As most pertinent here, the IRS argued that because Mr. Billings was such an obvious loser when Mr. Bugbee gave him money, repayment was necessarily contingent on the future success of Mr. Billings’ talked-about ventures.  If true, that contingency would mean the payments were not loans.  The Court disagreed that repayment was contingent:

“The facts in the case at bar do not reveal that any repayments by Billings were conditioned on his ultimate success. Although petitioner expected to be repaid after Billings had established one of his ventures, we have found that petitioner was to be repaid from any assets that Billings might have. Billings himself testified that these advances were personal, unconditional loans for which he was liable.”

I keep teaching my students that transactions always have two sides.  Thus, if Mr. Bugbee’s payments to Mr. Billings were truly loans, they were not income to Billings.  But if they had not been loans, then not only would Mr. Bugbee not be allowed the §165 deduction, Mr. Billings might have had income.  Today’s case involves the income side of a purported loan transaction. 

During 2009 and 2011 (the years at issue), Mr. Novoselsky was a lawyer in Chicago.  He was apparently trying to put together some class action suits, at least one of which involved a class of doctors.  Mr. Novoselsky convinced several of the affected doctors to shovel money to him to fuel his various litigation efforts.  Each shovel came in the form of a “Letter Agreement for Litigation Support.”  The letters characterized the money as a “litigation support loan...made on a nonrecourse basis.”  They provided that the money would be repaid “at the successful conclusion” of the particular lawsuit being funded.  Mr. Novoselsky also convinced other attorneys to help fund some of the lawsuits.  In return for the advance of money, these agreements gave the other attorneys a cut of the eventual fee awards and an opportunity to jump in with their own clients.  Again the agreements characterized the funding as nonrecourse loans and provided repayment would come only from “the proceeds of any attorney fees and/or costs awarded by the court.”

In short, Judge Lauber found that, “under the terms of each agreement...Mr. Novoselsky’s payment obligation was contingent on the success of the litigation that the counter-party was supporting. *** If the litigation was unsuccessful, Mr. Novoselsky was not obligated to repay his counter-party anything.” 

Under these agreements, Mr. Novoselsky received $410,000 in 2009 and $1 million in 2011.  He did not report those amounts as income.  On audit, the IRS dinged him for taxes, interest, and penalties.  He petitioned Tax Court for review. 

Lesson:  It's Not a Loan If Repayment is Contingent
Judge Lauber cites Tufts as support for the proposition that loan proceeds are excluded from gross income because “a genuine loan is accompanied by an obligation to repay.”  So I think he may like the expectancy theory.  He explains that the repayment obligation must be unconditional and he cites to ten different cases, explaining four of them, to show the critical need for an unconditional repayment obligation.  Because Mr. Novoselsky’s repayment obligation was entirely conditional, the payments to him were not loans.

In one sense all loans are contingent: future events might prevent repayment.  That's called risk.  But the obligation to repay still remains.  The contingency here is flipped.  The obligation to repay is triggered by a potential future event: winning a judgment.

Judge Lauber also looks at some of the various multi-factor tests courts use to determine whether an arrangement is truly a loan even when the obligation to repay is not contingent.  Regardless of the formulations, Judge Lauber says, the bottom line is there must be a genuine intention to create a debt, with “a reasonable expectation of repayment regardless of the success of the venture.” And here Judge Lauber cites to his own 75-page opinion in Illinois Tool Works v. Commissioner, T.C. Memo 2018-121, where he did a very deep dive into what makes a loan a loan in upholding a taxpayer’s sophisticated loan structure.

While there is a lot more to learn about loans, the lesson here is simple: a contingent repayment obligation makes it all but impossible to claim that a transaction is a loan for federal income tax purposes.

Lesson 2: Bankruptcy Is Different
After Mr. Novoselsky filed his petition in Tax Court, he filed for bankruptcy protection.  That put the Tax Court case on hold.  The IRS filed a claim for the amount of deficiency created by the unreported income.  At the same time it objected to Mr. Novoselsky receiving any discharge, alleging that he failed to list, as creditors with claims against him, the folks who had advanced him litigation funding.  That failure violated applicable bankruptcy law.  It appears that Mr. Novoselsky then basically nonsuited his bankruptcy case by submitting a waiver of discharge under 11 U.S.C. §727(a)(10) and the bankruptcy court closed the case.  He did not receive a discharge.

Back in front of Judge Lauber, Mr. Novoselsky argued that the IRS should be estopped from arguing that the litigation funding agreements were not loans because they had advanced a contrary position in bankruptcy.

Judge Lauber teaches us a quick lesson that whether or not a transfer of money is a loan for tax purposes is not determinative of whether it is a loan for bankruptcy purposes.  Bankruptcy law requires debtors to list all “claims” against them.  The term “claim” includes loans but is much, much broader.  It is, literally, Bankruptcy 101 that a “claim” is “a right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured.” 11 U.S.C. 101(5)(a) (emphasis supplied).

So, no, the IRS was not at all inconsistent: these litigation funding agreements did give rise to claims against Mr. Novoselsky, even if those claims were not loans under federal tax law.

First, one might wonder what these litigation funds were if they were not loans.  Well, if they came from clients, Judge Lauber noted that they would be “advance payments for the legal services that the counter-parties expected him to perform.”  That means Mr. Novoselsky should have put them in his trust accounts, drawing upon them and accounting for them as he incurred expenses or earned fees.  But it appears he did not do that, instead exercising full control over the funds as received.  In the case of the attorneys, they would be akin to infusion of capital in return for a share of the expected profit from a joint venture.  Again, once Mr. Novoselsky took the money, he had "undeniable accessions to wealth, clearly realized...over which [he had] complete dominion." Commissioner v. Glenshaw Glass, 348 U.S. 426, 431 (1955).  That made it income to him absent some rule of exclusion.

Second, one may wonder what this case means for other litigation funding agreements.  That is, it appears from both the ABA report and the NYC Bar report (both linked above) that most litigation funding is done by commercial lenders who (1) often lend directly to the clients and not the lawyers, and (2) when they do lend directly to lawyers, they take a security interest in the lawyer’s receivables to secure the debt.  I do not know much about litigation funding so I may have misread that, but it may be that commercial lenders dominate the market.

Here, it appears that the funding agreements were from clients, potential clients, or fellow attorneys.  The agreements were sloppily written.  There were no formal promissory notes.  I assume commercial lenders have more carefully crafted agreements.

It would seem not to matter, however, whether the agreements are finely crafted or are homebrew.  The lesson here seems to be that if the repayment of the funding is contingent on the success of the lawsuit, it’s not a loan, no matter how well the litigation funding agreement hews to the formalities of loans.

As usual, I welcome comments, especially those (gently) correcting my own ignorance.  That's how we all learn.  And that, dear readers, is the point of these Lessons From The Tax Court.  And if you find error, well---to borrow from Tony Kornheiser---I promise to do better next time. 

Bryan Camp is the George H. Mahon Professor of Law, back in his office (at least for now), at Texas Tech University School of Law.

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In this case, the deal was that the lender could look to repayment only out of the recovery. If the recovery was insufficient to pay the debt in full, the lender suffered the shortfall. The economics is the same as a nonrecourse loan. If the amount of collateral is insufficient to pay the debt, the lender suffers the shortfall when the borrower surrenders the collateral. The only real difference is that in the instant case there’s a possibility that the “collateral” could end up worthless because of a defense verdict, whereas in a traditional NR loan the collateral will worst case generally (but not always) end up being worth something (but not if the collateral was Hertz stock). But I don’t think the riskiness of the collateral ought to change the tax character.
Regarding Steven’s comment, I agree with him that there’s logical inconsistency between this case and the numerous cases that have held that contingent fee attorneys can’t deduct the expenses they advance to their client on a nonrecourse basis. Those cases are the muddled cases I referred to earlier and are the topic of the linked ssrn article. These arrangements look like back-to-back nonrecourse loans to me. Yet this case treats the first loan as an advance payment and the IRS and earlier courts have treated the second loan as debt, despite the fact that their terms are so similar. (If anything the first loan looks more like debt because it bears an interest rate while the client advances don’t.) The court in this case notes the client expense issue in footnote 9 but doesn’t go into any analysis beyond concluding that that’s a different tax issue.

Posted by: Gregg Polsky | Jun 1, 2020 11:31:15 AM

@Steven: But this is an unreported income case, not a deduction case. That is, in your hypo, is not the attorney who self-finances litigation paying expenses out of already taxed dollars? So if Mr. N. had properly included these advances as income, then he, too, would be able to (eventually) take the deduction for costs as appropriate. Then it would be a deduction case. I also wonder why he did not put the monies in the client trust account.

Posted by: bryan | Jun 1, 2020 10:21:39 AM

@Gregg: but nonrecourse debt still requires repayment, no? I thought that was part of the S.Ct.'s analysis in both Crane and Tufts. Beulah Crane was obligated to pay the debt she had inherited. The borrower commits to repayment regardless of success of venture. Sure, future events might cause the borrower to cease repayments and the nonrecourse loan becomes, functionally, a forced sale. That's Woodsam. But I do not see that as the same kind of contingency in this case, where repayment was conditioned on the success of the venture.

Posted by: bryan | Jun 1, 2020 10:15:01 AM

This is an interesting case. I have two comments. First, the court’s conclusion that conditional loans aren’t debt for tax purposes is difficult to square with the notion that nonrecourse loans can be (and typically are) debt for tax purposes. In a NR loan, repayment is conditional because if the value of the collateral drops below the outstanding loan balance full repayment will not be made (and if the value of the collateral drops to zero, no repayment will be made). In this case, the loan was nonrecourse in that the lender could look only to the lawyer’s recovery for repayment. Some courts have really muddled this issue, and this case is an example. I’ve discussed the nonrecourse/conditional issue in a related context in this article:

Second, traditional litigation finance structures are quite varied. The parties generally treat the arrangement as a loan or as a financial derivative for federal tax purposes, which if respected would not result in immediate taxation of the funding. Here’s a paper that delves into these structures and their tax issues in great depth:

Posted by: Gregg | Jun 1, 2020 10:10:16 AM

Attorneys routinely advance costs for filing fees, experts, etc. in contingency matters with the understanding that they will be repaid from proceeds. If they lose the case, there's no recovery. The IRS does NOT permit the lawyer to deduct those costs as incurred, but only once the case is resolved. If the expense isn't deductible until the end, why would funds advanced for this purpose be income when received?

Posted by: steven sorell | Jun 1, 2020 9:43:02 AM