Tax Due When Money Is In Your Hands (Even If They Aren’t Clean)

Dealing with tax often comes down to two questions: (1) What is income and (2) When is it taxable?

Tax Code Section 61(a) offers broad guidance on the first question: Gross income means all income from whatever source derived. But answering the second question can be more challenging.

Most individual taxpayers use the cash basis method of accounting, which means that income is reported when received, and expenses are deducted when paid. Sec. 1.451-1(a) of the Income Tax Regs makes clear that the receipt of income comes down to control. Sometimes this is easy: Did the taxpayer have the ability to take the money? If the taxpayer’s ability to take the money is limited, the income isn’t considered received. That argument is what a taxpayer leaned on—unsuccessfully—in a recent Tax Court case.

The taxpayer in this case was a California lawyer who represented four clients in an abuse case against the Catholic Church. The matter settled for $12.75 million in July of 2007, and the taxpayer was entitled to contingency fees plus costs. As part of the representation, the clients agreed that any award would initially be held for their benefit in a non-IOLTA account (Interest on Lawyers’ Trust Account).

Shortly before the fees were paid, the taxpayer opened an account at UBS, naming himself as the beneficial owner. He wrote “Trustee” on the bank paperwork but didn’t otherwise indicate that this was a client trust account. He did, however, tell his financial adviser that he expected to receive a large sum of money from the lawsuit.

The settlement funds were eventually invested at UBS in risky auction-rate securities. Most states, including California, don’t allow attorneys to use investment accounts or any accounts other than depository bank accounts for a non-IOLTA client trust fund. The taxpayer, however, didn’t treat the account as a client account; he treated it as though it belonged to him. Among other things, he directed UBS to buy and sell securities, and used income from the account to make personal gifts.

UBS Placed a Hold

On Jan. 29, 2008, the taxpayer paid one of the clients his respective share of the settlement funds. The other funds remained in the account—just as the market for auction-rate securities froze. Under increased scrutiny, UBS took a closer look and, worried that it wasn’t a valid client trust account, placed a hold on it.

The taxpayer attempted to unfreeze the account by telling UBS that his law firm and his clients owned the funds. By way of support, he attached statements signed by the clients confirming the origin of the money and that they were satisfied with the taxpayer’s services.

The taxpayer and his clients also sued UBS. Eventually there was a settlement. But there was also a catch: At the outset of the lawsuit, the taxpayer and the clients had hired another firm. When that relationship soured, the taxpayer dismissed the firm without paying fees the firm claimed it was owed. The firm liened the account. Another lawsuit followed, and after a complicated flurry of arbitration and litigation, the matter eventually wrapped in 2011.

The taxpayer’s troubles, however, weren’t over. His 2007 tax return was selected for examination by the Internal Revenue Service. In 2014, he was socked with a deficiency of $2,583,374 and a Section 6663 penalty of $1,937,531.

The taxpayer petitioned the Tax Court. He argued that he hadn’t reported the funds in 2007 because, among other things, UBS had invested the funds without authorization. That assertion had already been determined to be false in Superior Court, and the Tax Court noted that “[t]his was untrue when first asserted and remained untrue when petitioner asserted it again throughout the examination of his 2007 income tax return.”

The taxpayer next argued that he couldn’t recognize the settlement income because the clients had disputed his fees. Under the rules of professional conduct in most states, when a lawyer holds funds for the benefit of clients in a trust account, the funds aren’t income to the lawyer. Typically, once a lawyer has billed for his services against amounts held in the account, the lawyer has earned the fee. At that point, the lawyer is in constructive receipt of the income even if she doesn’t withdraw the funds.

However, the Tax Court found that the taxpayer had previously represented that there were no fee disputes. The court specifically referenced the statements signed by the clients offered to UBS, confirming that there was no dispute.

Still, the taxpayer contended instead that his fee wasn’t properly includable in 2007, but in the 2009 tax year when the fee “dispute” was allegedly resolved. That argument might have made sense if the taxpayer had then reported the income in 2009. He didn’t. But, he argued, the statute of limitations now barred any assessment for 2009.

Fraudulent Intent

After consideration, the court found that the IRS proved “by clear and convincing evidence” that the taxpayer understated his income for 2007. With that, the court next examined whether the imposition of a civil fraud penalty was proper.

The court found that the taxpayer “repeatedly understated his income over the course of several years.” The taxpayer conceded that he claimed $831,154 in improper deductions and failed to report $140,000 in income for the 2008 tax year. In tax year 2006, he erroneously reported $813,000 in legal fees as liabilities instead of income. And the year before that? He reported only $33,203 in net profits to the IRS but represented to UBS that he earned $75,212. The court found this pattern of behavior “particularly troubling and indicative of fraudulent intent.”

Also concerning? The taxpayer didn’t maintain proper financial records and offered many “implausible and inconsistent explanations” for his actions. The court pointed to a memorandum prepared by a legal assistant that the taxpayer purported to be a tax opinion letter. The court characterized it as “a fig leaf covering petitioner’s failure to report his legal fees for the year earned.”

The taxpayer should have known better, the court says, because of his background: He had been a trial attorney for 38 years, with an emphasis on tax fraud litigation. “Had been” is the right tense: in 2013, the taxpayer was disbarred for willfully violating the California Rules of Professional Conduct. It was his fourth disciplinary action proceeding.

Not all tax miscues involve behavior that’s so egregious as to land you before a disciplinary board or other licensing agency. But the rules remain the same: Income is reportable when received, even if your hands aren’t clean.

The case is Lon B. Isaacson v. Commissioner, T.C. Memo. 2020-17.

This is a weekly column from Kelly Phillips Erb, the TaxGirl. Erb offers commentary on the latest in tax news, tax law, and tax policy. Look for Erb’s column every week from Bloomberg Tax and follow her on Twitter at @taxgirl.