“Private Attorney General” Can Deduct His Lawyers’ Fees as Trade or Business Expenses

In a case of first impression, a federal district court held that a taxpayer who zealously and single-mindedly pursued False Claims Act lawsuits against his former employer was engaged in the trade or business of prosecuting those lawsuits and he could deduct legal expenses related to that trade or business as ordinary and necessary business expenses (Bagley, No. 2:10-cv-00483-RT-FMO (C.D. Cal. 8/5/13)). As a result, the taxpayer was entitled to deduct his attorneys’ fees on Schedule C instead of Schedule A and was entitled to an income tax refund of almost $4 million.

During the time that the taxpayer, Richard Bagley (who had an MBA and an M.S. in taxation), was the chief financial manager of TRW’s space and technology group, he became aware of improper billing practices in bills submitted to the federal government. He signed these incorrect bills under penalties of perjury even though he knew that they were wrong. After he was laid off from TRW in 1993, he filed a wrongful termination lawsuit, which he lost. His job at TRW was his last job other than pursuing the claims against TRW.

In 1994, Bagley filed the first of two lawsuits against TRW under the False Claims Act (FCA), which permits private citizens to bring lawsuits against any person who knowingly presents to the U.S. government a false or fraudulent claim for payment or approval. These actions are called qui tam suits because they are brought by individuals on behalf of the government.

In pursuing these lawsuits, Bagley devoted 5,963 hours to the cases; his expertise in the issues in the case, both from being present when they occurred and from his accounting and government contracting knowledge, were central to the success of the claims. Bagley received a qui tam award of $27.2 million, which was 24.5% of the FCA payment the government received from TRW—one of the highest percentages ever awarded to an individual in an FCA suit.

At his attorneys’ direction, Bagley filed his 2003 return for the year in which he received the $27.2 million FCA award by reporting all of it his income and deducting the $9 million in attorneys’ fees he paid directly on Schedule A. This return omitted a payment of almost $9 million in statutory attorneys’ fees that were paid directly to a second law firm. Bagley later filed an amended return for that year, which reported all of the FCA award he received and all of his attorneys’ fees, but this time he reported them on Schedule C and deducted the fees as trade or business expenses. The IRS denied his refund claim. (The court noted that Bagley listed his occupation on his 2003 return as “private attorney general.”)

To be engaged in a trade or business, a taxpayer must be involved in the activity with continuity and regularity and with the dominant intent of making a profit. In determining that Bagley had the requisite profit motive, the court pointed to the fact that he prosecuted the case in a businesslike manner by keeping time records, reviewing documents, and attending meetings. He and the lawyers he hired to represent him in the suit were experts in their respective fields. He also met the time-and-effort test, worked only on the lawsuits during the years they were in progress, and had no element of personal pleasure. Pursuing the claims was not a hobby.

As for the continuity and regularity requirement, the court found Bagley’s devotion to the cause outweighed the government’s argument that the pursuit of an FCA award was an activity he never repeated. A trade or business activity does not require that a taxpayer repeat the activity for it to qualify as a trade or business. The final requirement was that the legal expenses be ordinary and necessary, which the court found the attorneys’ fees were because Bagley was in the trade or business of prosecuting the FCA lawsuits.

The government’s final argument to prevent Bagley from treating the attorneys’ fees as trade or business expenses was that the origin-of-the-claim doctrine required characterizing the lawsuit as Bagley’s personal expense because he was prosecuting a personal claim. The court sided with Bagley, finding that his prosecution of the claim was a business enterprise, and thus that the claims were business expenses under the origin-of-the-claim analysis.