Taxpayer in Trade or Business of Being a “Private Attorney General”

Expenses & Deductions

A district court held that a taxpayer who prosecuted an action against his former employer for false claims under the False Claims Act (FCA), 31 U.S.C. Sections 3729–3733, was in the business of prosecuting the FCA lawsuit and providing services to the government in prosecuting the lawsuit (or as the taxpayer described it, performing services as a “private attorney general”). Therefore, he was entitled to deduct his legal fees from the suit as ordinary and necessary business expenses.

Background

Richard Bagley worked for TRW in a variety of positions from 1967 until 1993. From 1987 to 1992, he was the chief financial manager for TRW’s space and technology group. He was responsible for, among other things, contract proposal pricing, indirect expense budgeting and control, and accounting. When he was chief financial manager of TRW’s space and technology group, he was responsible for ensuring the integrity of the accounting records and sending bills to the government.

Starting about 1989 and continuing through 1991, Bagley became aware of false indirect expense claims TRW was making to the government. Though he knew the claims were wrong, in 1990 and 1991, Bagley signed indirect expense certifications to the government so he would not lose his job. While he stated that he discussed the false claims issue with two of his superiors who he believed were responsible for the false claims, he took no actions to prevent TRW from submitting false claims during his employment there.

Bagley was laid off from TRW in 1993. After looking for employment for about a year, he filed a wrongful termination suit against TRW in mid-1994, which he lost. In November 1994, he filed an FCA lawsuit (commonly called a qui tam suit) on behalf of himself as relator and on behalf of the United States. He later filed a second qui tam suit. The government intervened on two of the eight claims Bagley made in the first suit, but it declined to intervene in the second suit, although he diligently attempted to convince the government that it should do so.

Because the government refused to intervene, Bagley continued to prosecute the second suit on his own. He was not an attorney and had no prior experience with FCA suits, so he hired two law firms that specialized in this area to assist him in prosecuting the suits. Over the suits’ nine-year life, the firms allegedly spent more than 20,000 hours on the litigation.

Though the law firms did the bulk of the work on the suits, Bagley was intimately involved in their prosecution. Including work done prior to filing the suits, from 1994 until 2003, when the FCA claims were settled, Bagley spent 5,963 hours on his FCA activities. During this time, he worked exclusively on prosecuting the suits, and otherwise he was not employed.

Bagley was useful in prosecuting the suits because, besides having firsthand knowledge of the billing fraud TRW committed, he had spent 25 years working for the company, he thoroughly understood its accounting system, and he had knowledge of the company’s people and products that was necessary to understanding how the fraud occurred and where the evidence of fraud could be found. He performed a variety of services for his attorneys, including reviewing documents, presenting evidence and issues, explaining aspects of the federal acquisitions regulations and the pricing provisions of the contracts involved, and interpreting the “code” TRW used in its memoranda. Bagley also drafted or edited at least 73 documents that attorneys used in the case and played a primary role in calculating damages, which required him to attend numerous meetings with the Defense Contract Audit Agency.

In June 2003, Northrop Grumman Corp. (Northrop), the successor to TRW, agreed to pay the United States $111.2 million to settle the FCA allegations in the two suits filed by Bagley. In 2003, the Justice Department awarded Bagley an FCA qui tam award in excess of $27 million. In 2003, Bagley paid the attorneys who had represented him throughout the suits close to $9 million as a contingency fee. In September 2003, Northrop wire-transferred approximately $9.4 million to his attorneys as payment of the statutory attorneys’ fee award expenses required by law. Both the award paid by the DOJ and the statutory attorneys’ fee award paid by Northrup were reported as income to Bagley and the IRS on a Form 1099-MISC, Miscellaneous Income.

In October 2004, Bagley filed his 2003 Form 1040, U.S. Individual Income Tax Return. That return reported the qui tam award as ordinary income and approximately $9.1 million in legal fees as Schedule A miscellaneous itemized deductions, but it failed to report the statutory attorneys’ fee award as income. In May 2005, Bagley filed a 2003 Form 1040X, Amended U.S. Individual Income Tax Return, which included the statutory fee award in income and again deducted the legal fees as miscellaneous itemized deductions on Schedule A.

In August 2007, Bagley filed a second amended return that included a claim for refund. On this return, he included the full amount of the FCA award and the statutory attorneys’ fee award as gross income on Schedule C, Profit of Loss From Business. He also deducted the full amount of the contingency fee he paid to his attorneys and the full amount of the statutory attorneys’ fee award as ordinary and necessary business expenses on Schedule C.

The IRS denied Bagley’s claim for refund. According to the IRS, Bagley should have deducted the contingency fees and the statutory attorneys’ fee award on Schedule A as miscellaneous itemized deductions subject to the 2% floor, as Bagley had done on his first amended return. Subsequently, Bagley filed a refund suit in district court.

The District Court’s Decision

The district court held that Bagley was in the business of prosecuting FCA lawsuits and that the legal fees he incurred in his suits were ordinary and necessary expenses of that business. Therefore, he properly deducted the legal fees as trade or business expenses on Schedule C on his second amended return.

Bagley contended that the court should apply the standard set forth in case law for determining whether his activities as a qui tam relator were a “trade or business” and whether the legal fees were “ordinary and necessary” under Sec. 162(a). The IRS asserted that the court should apply the “origin of the claim” test to the legal fees, under which a court looks to the origin and character of the claim with respect to which a litigation expense was incurred to determine whether it was a business or personal expense.

The court averred that these tests are merely different methods of analyzing whether a taxpayer incurred litigation expenses on behalf of a trade or business, the former focusing on the nature of the taxpayer’s activity itself and the latter on the nature of the litigation. Therefore, the court decided to apply both to determine the character of Bagley’s litigation expenses.

The court found that to be engaged in a trade or business, Bagley must have had a profit motive for his FCA activities and that he must have participated in them on a regular and continuous basis. Based on Regs. Sec. 1.183-2(b), which lists the factors the IRS considers relevant to whether a taxpayer had a profit motive for an activity, the court weighed eight factors to determine whether Bagley had a profit motive: (1) the manner in which he carried on his FCA prosecution activity; (2) the expertise of Bagley and his advisers; (3) the time and effort he expended; (4) his success in carrying on similar activities; (5) his history of income or losses with respect to the FCA prosecution activity; (6) the amount of occasional profits he earned; (7) his financial status while he carried on the FCA prosecution activity; and (8) any element of personal pleasure or recreation in the activity. The court found that each individual factor, other than the fourth, indicated that Bagley had a profit motive for the FCA activity, so it concluded he met the profit motive requirement.

For determining whether Bagley pursued the FCA activity regularly and continuously, the court applied the Supreme Court’s standard in Groetzinger, 480 U.S. 23 (1987). In that case, in determining whether a gambler was in the trade or business of gambling, the Court stated: “[I]f one’s gambling activity is pursued full time, in good faith, and with regularity, to the production of income for a livelihood, and is not a mere hobby, it is a trade or business within the meaning of the statutes with which we are here concerned.”

Given that Bagley had spent many hours working diligently on the FCA suits over nine years, using his specialized knowledge and skills to perform work that was highly useful in the suits, the court found that he met the Groetzinger standard. The IRS argued that Bagley’s activity did not qualify because it was a one-time pursuit that he did not replicate, but the court maintained that the Groetzinger standard did not require that a person be engaged in a business activity that he repeats with frequency.

The district court also had little trouble determining that the legal fees were ordinary and necessary expenses of the FCA activity. The court noted that to successfully pursue an FCA suit as a relator, the relator must retain a licensed attorney. Thus, the court concluded that litigation fees are an ordinary expense when engaged in litigating an FCA lawsuit, because the very nature of the business requires their expenditure.

Finally, the district court turned to the origin-of-the-claim standard that the IRS had advocated. Under this standard, the origin and character of a claim with respect to which an expense is incurred controls whether the expense is a business or personal expense. The IRS contended that the role of a relator in a qui tam suit is that of an informer who provides information in return for a reward, and the relator’s contribution to the litigation of qui tam actions is no different from other types of informants whose value to the action is commensurate with the extent of their inside information. Because the court must look only at the underlying origin and character of the activity that gave rise to the claim, it is only the activity of being an informant—not the qui tam relator’s efforts during trial—that is relevant in determining what is the origin of the claim.

Bagley argued, and the court agreed, that the underlying claim was the fraud perpetrated on the government. As a relator in an FCA suit, he was not prosecuting a personal claim. Rather, he was prosecuting a claim on behalf of the government and acting as an agent or private attorney general for the government, and he was awarded for the information and services he provided while prosecuting that claim. Thus, the court determined that the legal fees Bagley paid were deductible business expenses under the origin-of-the-claim test.

Reflections

While it seems questionable that Bagley should be so richly rewarded for prosecuting a fraud that he actually played a part in, the district court makes a persuasive argument that he pursued the FCA suit as a trade or business and he was therefore entitled to a deduction for the enormous legal fees charged by his attorneys.

Bagley, No. 2:10-cv-00483-RT-FMO (C.D. Cal. 8/5/13)