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Novoselsky v. Comm’r, T.C. Memo. 2020-68 | May 28, 2020 | Lauber, J. | Dkt. No. 22400-13
Short Summary: During 2009 through 2011, Mr. Novoselsky, an attorney, practiced law with a focus on class action litigation. In those years, he executed “litigation support agreements” with various individuals and entities. Under those agreements, the individuals and entities made upfront payments to support the costs of litigation. If the litigation was successful, Mr. Novoselsky was obligated to pay the counter-party, from his award of attorney’s fees and costs, the initial payment advanced to Mr. Novoselsky plus a premium. However, if the litigation was not successful, Mr. Novoselsky had no obligation to return any funds to the counter-party.
Mr. Novoselsky and his wife filed joint returns with a Schedule C, Profit or Loss From Business, to report the business activities of Mr. Novoselsky’s law firm. On the Schedule C, Mr. Novoselsky did not report any of the funds advanced to him pursuant to the litigation support agreements in which he had no obligation to repay the counter-party. The IRS examined the returns and issued a notice of deficiency to Mr. and Mrs. Novoselsky. In the notice of deficiency, the IRS determined that the advanced funds for which there was no repayment obligation should be reported as gross income to Mr. Novoselsky. In addition, the IRS asserted accuracy-related penalties with respect to these items.
Key Issue: Whether the funds advanced to Mr. Novoselsky constitute a loan or gross income and whether Mr. and Mrs. Novoselsky are liable for accuracy-related penalties.
- The payments Mr. Novoselsky received from third parties constituted gross income to Mr. Novoselsky and not loans. Specifically, the payments were not loans because any obligation for Mr. Novoselsky to repay was contingent on future events and therefore did not constitute valid debt for federal income tax purposes.
- In addition, the payments under the litigation agreements do not represent bona fide loans under factors used by federal courts to distinguish between debt and other payments because: (1) Mr. Novoselsky did not execute a formal promissory note; (2) no fixed schedule for repayments was established; (3) Mr. Novoselsky provided no collateral or security; and (4) no payments of principal or interest were ever made.
- Mr. and Mrs. Novoselsky are liable for accuracy-related penalties because: (1) they have put forth no evidence showing reasonable cause; and (2) Mr. Novoselsky is an attorney who had knowledge and education required to determine his tax obligations correctly.
Key Points of Law:
- The Commissioner’s determination of tax liability is generally presumed correct. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). In order for this presumption to attach in unreported income cases, the IRS must show a “rational foundation” for the IRS’ determination that the taxpayer received such income. Pittman v. Comm’r, 100 F.3d 1308, 1313 (7th Cir. 1996), aff’g, T.C. Memo. 1995-243. Once the Commissioner makes the required threshold showing, the burden shifts to the taxpayer to prove by a preponderance of the evidence that the Commissioner’s determinations are arbitrary or erroneous. Walquist v. Comm’r, 152 T.C. 61, 67-68 (2019).
- I. R.C. § 61(a) defines gross income as “all income from whatever source derived,” including income derived from business. If a taxpayer is a cash method taxpayer, the taxpayer must include cash sums received in the tax year unless the receipts are nontaxable. Treas. Reg. § 1.451-1(a).
- Because a genuine loan is accompanied by an obligation to repay, loan proceeds do not constitute income to the taxpayer. Comm’r v. Tufts, 461 U.S. 300, 307 (1983). For this rule to apply, however, the obligation to repay “must be unconditional and not contingent upon some future event.” Frierdich v. Comm’r, 925 F.2d 180, 185 (7th Cir. 1991). “Perhaps the most important underlying principle is that no valid debt exists unless there is an unconditional obligation of another to pay * * * a definite sum of money.” Henderson, 375 F.2d at 39.
- 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 purpose. Taylor v. Comm’r, 27 T.C. 361 (1956), aff’d, 258 F.2d 89 (2d Cir. 1958); Clark v. Comm’r, 18 T.C. 780, aff’d, 205 F.2d 353 (2d Cir. 1953). The same analysis applies to payment obligations conditioned on the outcome of litigation. See Bercaw v. Comm’r, 165 F.2d 521, 525 (4th Cir. 1948); Estate of Paine v. Comm’r, T.C. Memo. 1963-275.
- 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. See Busch v. Comm’r, 728 F.2d 945, 948 (7th Cir. 1984), aff’gC. Memo. 1983-98; Ill. Tool Works Inc. Comm’r, T.C. Memo. 2018-121.
- A gift, for federal income tax purposes, is one made out of a “detached and disinterested generosity” or “out of affection, respect, admiration, charity or like impulses.” Comm’r v. Duberstein, 363 U.S. 278, 285 (1960).
- As a general rule, funds that a taxpayer receives in trust for another person are not includable in the taxpayer’s gross income. Canatella v. Comm’r, T.C. Memo. 2017-124.
- For individual taxpayers, the substantial understatement penalty applies if the understatement of income tax for a particular year “exceeds the greater of—(i) 10 percent of the tax required to be shown on the return * * *, or (ii) $5,000.” R.C. § 6662(d)(1)(A). The section 6662 penalty does not apply to any portion of an underpayment “if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to * * * [it].” I.R.C. § 6664(c)(1). The decision as to whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances. Treas. Reg. § 1.6664-4(b)(1). Circumstances that may signal reasonable cause and good faith “include an honest misunderstanding of fact or law that is reasonable in light of all the facts and circumstances, including the experience, knowledge, and education of the taxpayer. Id.
Insight: The Novoselsky decision shows the breadth of I.R.C. § 61 and its statutory language that gross income includes all income from whatever source derived. Because the taxpayer received advances from third parties in which there was no obligation to repay, the Tax Court determined the payments represented gross income. Notably, if Mr. Novoselsky used the payments for deductible business expenses, he would be entitled to a deduction to offset the gross income, but the decision does not address this issue.
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