The Tax Court held that litigation support payments the taxpayer received, which he was not required to repay if the related litigation was not successful, were gross income and not nontaxable loan proceeds.
Background
During 2009-2011 David Novoselsky practiced law in the Chicago metropolitan area. To finance some of his litigation, he entered into litigation support agreements under which he received purported loans from the counterparties to the agreements. The counterparties who supplied this support were plaintiffs in litigation being handled (or proposed to be handled) by Novoselsky, persons whose interests were economically aligned with the interests of such plaintiffs, lawyers with whom Novoselsky had fee-sharing arrangements, or individuals seeking a high return on a speculative investment.
Under the terms of each of these litigation support agreements, Novoselsky's repayment of the loans was contingent on the success of the litigation that the counterparty was supporting. Novoselsky was not obligated to repay the funds advanced to him unless the litigation in question yielded proceeds in the form of attorney's fees and/or costs. If the litigation was unsuccessful, he was not obligated to repay any part of the loans to the counterparty. Under these agreements, Novoselsky received litigation support payments totaling $410,000 in 2009 and $1 million in 2011.
On the joint tax returns Novoselsky filed with his wife in 2009 and 2011, he did not include any of the litigation support payments he received in gross receipts on his Schedules C, Profit or Loss From Business. Novoselsky did not include the payments on his returns because he considered them loans that were not includible in income. The IRS audited his 2009 and 2011 returns. It found that the payments were not loans and that Novoselsky was required to include them in gross income. The IRS issued notices of deficiency for both years, reflecting adjustments for the unreported payments and accuracy-related penalties. Novoselsky petitioned the Tax Court, challenging the IRS's determinations.
The year after filing his Tax Court petition, Novoselsky filed for bankruptcy. In his bankruptcy petition, he did not list the counterparties to his litigation support agreements as creditors. In both bankruptcy court and Tax Court, Novoselsky argued that the United States (in bankruptcy court) and the IRS (in Tax Court) were taking inconsistent positions on whether the litigation support agreement payments were loans and that the doctrine of judicial estoppel precluded them from taking these inconsistent positions.
The Tax Court's decision
The Tax Court held that the payments made to Novoselsky under the litigation support agreements by the counterparties were not loans and were includible in his gross income under Sec. 61(a). It found that the payments were not loans because Novoselsky only had a conditional obligation to repay the counterparties.
As the court explained, Sec. 61(a) defines gross income as "all income from whatever source derived," including income derived from business. The Supreme Court has held that because a genuine loan is accompanied by an obligation to repay, loan proceeds do not constitute income to the taxpayer (Tufts, 461 U.S. 300 (1983)). As the Tax Court held (and the Seventh Circuit affirmed), for this rule to apply, however, the obligation to repay "must be unconditional and not contingent upon some future event" (Frierdich, 925 F.2d 180, 185 (7th Cir. 1991), aff'g T.C. Memo. 1989-393). Where an obligation to pay arises only upon the occurrence of a future event, the Tax Court has consistently held that a valid debt does not exist for federal tax purposes (see, e.g., Taylor, 27 T.C. 361 (1956) (funds advanced to open securities accounts not loans when repayment conditional on profitable management of accounts); Clark, 18. T.C. 780 (1952) (funds advanced to buy newspaper stock not loans when repayment conditional on receiving sufficient dividends to make repayments); and Bercaw, 165 F.2d 521 (4th Cir. 1948) (funds advanced to bankroll litigation, with repayment conditional on the success of the litigation)).
The Tax Court determined that Novoselsky's repayment obligation was conditional and the litigation support agreements did not give rise to loans for federal income tax purposes. He received the litigation support payments under agreements that made clear that the advances were repayable out of the attorneys' fees and costs he hoped to receive upon "the successful conclusion of this litigation." Novoselsky further did not dispute that he had no obligation to pay the counterparties anything if the litigation yielded no proceeds. Thus, he did not have an unconditional obligation to pay the counterparties.
Multifactor analysis: The IRS also suggested that the Tax Court might have applied a multifactor analysis to determine whether the litigation support payments were loans or income. Courts have routinely used a number of versions of a multifactor test to determine whether an advance is a loan in a variety of contexts. The Tax Court stated that it would have come to the same conclusion under such an analysis and discussed how it came to this conclusion.
The Tax Court found Frierdich, in which it applied a multifactor analysis, to be the most relevant precedent for Novoselsky's case. In it, a client gave the taxpayer, an attorney, $100,000 to handle the estate of her late husband. The taxpayer and the client executed a promissory note providing for 8% annual interest, but there was no fixed schedule for repayment of principal or interest. Rather, both were due at the closing of the estate.
The Tax Court looked at a number of factors, including the existence of the note, its terms, its repayment schedule, the taxpayer's ability to pay and whether payments were made, and whether the note was conditional. Relying mainly on the fact that repayment of the note was conditional on the closing of the estate, the court held that the advance was not a loan but a payment for legal services to be provided in the future. Comparing the facts in Frierdich to those in Novoselsky's case, the court noted that the facts even more strongly indicated that the advance payments to Novoselsky were not loans because "repayment of the advances was not just linked to successful conclusion of the litigation; repayment was not required at all unless the litigation was successful." Therefore, it would have found that the litigation support payments were income if amulti-factor analysis was applied.
Judicial estoppel: Novoselsky also argued, as he had unsuccessfully in bankruptcy court, that under the doctrine of judicial estoppel, the IRS should not be allowed to contend in Tax Court that the litigation support agreements gave rise to gross income. Under the doctrine of judicial estoppel, a party is prevented from taking a position in litigation and then later taking a clearly inconsistent position when it is favorable to do so. Novoselsky claimed, under the doctrine, that because the government had claimed in his bankruptcy case that the agreements with his counterparties gave rise to "claims" for bankruptcy purposes, the IRS could not claim they gave rise to income for federal income tax purposes in Tax Court.
The Tax Court, as had the bankruptcy court, rejected this argument, finding that the United States' position that the counterparties in the litigation support agreements had "claims" against Novoselsky's bankruptcy estate was not inconsistent with the IRS's position in Tax Court that their advances to him were not "loans." As the bankruptcy court determined, the counterparties had contingent rights to payment from Novoselsky because he was obligated to return their advances (with a premium) if the litigation they supported was successful, so they had "claims" against his bankruptcy estate. This was not, in the Tax Court's view, inconsistent with the argument the IRS was making that an advance "must be unconditional and not contingent upon some future event" in order to constitute a loan. Consequently, the doctrine of judicial estoppel did not apply.
Reflections
When the Tax Court analyzes whether an advance payment is income or a loan under a multifactor test, it generally looks at seven factors: (1) whether the promise to repay is evidenced by a note or other instrument; (2) whether interest was charged; (3) whether a fixed schedule for repayments was established; (4) whether collateral was given to secure payment; (5) whether repayments were made; (6) whether the borrower had a reasonable prospect of repaying the loan and whether the lender had sufficient funds to advance the loan; and (7) whether the parties conducted themselves as if the transaction were a loan.
Whether repayment of the loan is contingent on future events is considered under the seventh factor. Although, as in the application of many multifactor tests applied by courts, one factor is not dispositive to the outcome, as this case suggests, if repayment of an advance is totally contingent on a future event, it is unlikely the advance will be treated as a loan.
Novoselsky, T.C. Memo. 2020-68
