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Novoselsky v. Commissioner (T.C. Memo. 2020-68)

On May 28, 2020, the Tax Court issued a Memorandum Opinion in the case of Novoselsky v. Commissioner (T.C. Memo. 2020-68). The issues before the court in Novoselsky were (1) whether (1) the litigation advance support payments were loans or gross income, and whether petitioners were liable for accuracy-related penalties.

Background Facts

During 2009 and 2011, the petitioner-husband (PH) practiced law with a focus on class action litigation. In those years he executed “litigation support agreements” with various individuals and entities (counterparties). Under these agreements the counterparties made an upfront payment to support the cost of litigation. If the litigation was successful, petitioner was obligated to return to the counterparty, from his award of attorney’s fees and costs, the counter-party’s initial payment plus a premium. If the litigation was unsuccessful, petitioner had no obligation to pay the counterparty anything. The petitioners did not report the payments thus received as gross receipts on the Schedules C, Profit or Loss from Business, for PH’s law practice.

Under the terms of each “litigation support agreement,” PH’s payment obligation was contingent on the success of the litigation that the counterparty was supporting. In other words, PH 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, PH was not obligated to repay his counterparty anything. Under these agreements PH received litigation support payments totaling $410,000 in 2009 and $1 million in 2011.

Support Agreements – Loans or Income?

A genuine loan is accompanied by an obligation to repay, and, therefore, loan proceeds do not constitute income to the taxpayer. Commissioner v. Tufts, 461 U.S. 300, 307 (1983). However, the obligation to repay must be unconditional, meaning that it is not subject to or contingent upon some future event. Frierdich v. Commissioner, 925 F.2d 180, 185 (7th Cir. 1991); United States v. Henderson, 375 F.2d 36, 39 (5th Cir. 1967), aff’g T.C. Memo. 1989-393. As the Fifth Circuit stated in:

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. Henderson, 375 F.2d at 39. In Taylor v. Commissioner, 27 T.C. 361 (1956), aff’d, 258 F.2d 89 (2d. Cir. 1958), the Tax Court held that the advances were not loans because repayment was conditional upon the profitable management of the accounts, noting that a valid loan does not exist where there is a conditional obligation to repay. Id. at 368; Clark v. Commissioner, 18 T.C. 780, 782 (1952), aff’d, 205 F.2d 353 (2d Cir. 1953) (wife obligated to repay funds only if she received sufficient dividends); Mercil v. Commissioner, 24 T.C. 1150, 1153 (1955) (amount claimed as the debt must be certainly, unconditionally, and in all events payable).

In the litigation context, a conditional repayment has the same effect of converting a loan into a debt. See Bercaw v. Commissioner, 165 F.2d 521, 525 (4th Cir. 1948) (guardian required to return advance only arose in event of successful termination of litigation). Similar to the Bercaw case, PH received total advances in excess of $1.4 million. He was to use these funds to commence or continue specified litigation. The agreements made clear that the advances were repayable out of the attorney’s fees and costs petitioner hoped to receive upon “the successful conclusion of this litigation.” Thus, if the case were unsuccessful, the advance would be retained by PH. Because PH did not have an “unconditional obligation” to repay the counterparties a definite sum of money, such advances were not loans, but income. See Henderson, 375 F.2d at 39.

Analysis on Multi-Factor Approach (Different Path, Same Finish Line)

Courts have used a variety of tests to guide the determination of whether particular types of advances should be treated as “loans” for Federal tax purposes. In Busch v. Commissioner, 728 F.2d 945, 948 (7th Cir. 1984), aff’g T.C. Memo. 1983-98, the Seventh Circuit enunciated an 8-factor test. In Ill. Tool Works Inc. v. Commissioner, T.C. Memo. 2018-121, at *29, the Tax Court considered a 14-factor test. The Fifth Circuit, alone, has put forth a 9-, 11-, and 13-factor test. See Tex. Farm Bureau v. United States, 725 F.2d 307, 311 (5th Cir. 1984) (13-factor test); Alterman Foods, Inc. v. United States, 505 F.2d 873, 877 n.7 (5th Cir. 1974) (9-factor test; Dillin v. United States, 433 F.2d 1097, 1100 (5th Cir. 1970) (11-factor test).

Thus, characterizations of the “multifactor” tests are unpredictable, but the tests generally share some or most of seven core 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. Welch v. Commissioner, 204 F.3d 1228 (9th Cir. 2000), aff’g T.C. Memo. 1998-121; Todd v. Commissioner, T.C. Memo. 2011-123, aff’d, 486 F. App’x 423 (5th Cir. 2012); see also Saunders v. Commissioner, T.C. Memo. 1982-655, aff’d, 720 F.2d 871 (5th Cir. 1983).

The Court’s skepticism of the multifactor tests is laid bare when it notes that the most that can be said is that “they prove a source of helpful guidance. MoneyGram Int’l, Inc. & Subs. v. Commissioner, 153 T.C. No. 9, *51 (Dec. 3, 2019). After spending all that time looking at the various formulations and permutations of the multifactor formulas, the court determined that “at bottom” the Tax Court must decide whether “there was a genuine intention to create a debt, with a reasonable expectation of repayment.” Litton Bus. Sys., Inc. v. Commissioner, 61 T.C. 367, 377 (1973).

This determination is “purely a question of fact.” Busch, 728 F.2d at 949. The facts in Novoselsky, were not in the petitioners’ favor, and the court found that the litigation advancements were in the nature of income.

(T.C. Memo. 2020-68) Novoselsky v. Commissioner

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