Tax Planning for Contingent Loans

Tax is often about timing. Timing issues are those where the taxpayer defers the requirement to pay taxes to a later date. Preferably a later date that is many, many years in the future.

The hope is that the taxpayer can retain the amounts that would have been paid in tax today and use the amounts to produce additional wealth. If successful, this is equivalent to a loan from the government.

In other cases, the hope is that the tax deferral is long enough that the tax imposed is lower or is avoided altogether. For example, the taxpayer may plan on retiring in the future and expect to be in a lower tax bracket at that time. Or the taxpayer may try to defer the tax until sometime after death, which can allow the taxpayer to escape paying the tax altogether.

Tax deferral is authorized in a number of situations, such as Section 1031 exchanges, Section 468 for reclamation costs, Section 453 for trading stamp companies, and others.

Tax attorneys often look for ways to defer tax. Some are more creative than others. Structuring advances as loans is but one example. The Novoselsky v. Commissioner, T.C. Memo. 2020-68, case provides an opportunity to consider tax deferral and loans.

Facts & Procedural History

The taxpayer is a class action lawyer. He entered into several agreements with third parties to fund his litigation projects.

The agreements specified that funds were advanced to him had to be repaid with a premium if the litigation was successful. He did not have to repay the advances if the litigation was unsuccessful.

For tax purposes, he treated the advances as non-taxable loans.

The IRS audited his tax returns for two years and counted the advances as taxable income, rather than loans, and imposed accuracy-related penalties. Litigation ensued in tax court.

The IRS basically proposed an accounting method change. The change required the taxpayer to recognize the income upon receipt rather than over time as the income was earned.

Advances as Non-Taxable Loans

Loans are generally not subject to income tax. Whether an advance is a non-taxable loan under our Federal tax law depends on the circumstances.

It is common to plan for these circumstances. For example, in the M&A space, deals are often structured around advances qualifying as loans. The opposite is also true. Deals are also structured so that advances are not loans. The tax court cites its Illinois Tool Works Inc. v. Commissioner, T.C. Memo. 2018-121, which is one of the leading cases in distinguishing loans from corporate dividends. The factors in Illinois Tool Works are often analyzed in providing tax advice for various loan structures.

There is a body of tax law that explains how to ensure that an advance is a loan for Federal income tax purposes. For an advance to be respected as a loan, it has to be a legitimate loan. There generally has to be a promissory note or other written evidence of the loan, interest has to be paid according to the terms of the loan, and the parties need to account for the advance as if it is a loan.

Advances With Contingent Repayment Obligations

In addition, the requirement to repay the loan has to be absolute. A contingent obligation to repay will not work.

The court summarizes several prior court cases that have held that contingent obligations are not loans:

  • Taylor v. Commissioner, 27 T.C. 361 (1956), aff’d, 258 F.2d 89 (2d. Cir. 1958) – the taxpayer advanced funds to her nieces and nephew to open securities accounts and repayment was “conditional upon the profitable management of the accounts.”
  • Clark v. Commissioner, 18 T.C. 780 (1952), aff’d, 205 F.2d 353 (2d Cir. 1953) – the taxpayer advanced funds to his wife to purchase stock in a newspaper company by which she was employed and repayment was only required if “the newspaper earned sufficient profits and she received sufficient dividends to make repayment.”  
  • Bercaw v. Commissioner, 165 F.2d 521, 525 (4th Cir. 1948) – the taxpayer advanced funds to a guardian for the purpose of commencing litigation and repayment was required “from any funds recovered by the suit [in] an amount equivalent to such advance.”  Thus, the obligation to repay the advance only arose in the event of a successful termination of the litigation.

As applied in this case, the court reasoned that the taxpayer was not obligated to repay the advances unless the litigation was successful. The tax court held that the advances were not loans. They were taxable income.

Given the court’s view, the advances in this case would have to be repaid even if the litigation was unsuccessful. But what exactly is success? Does success mean the receipt of money from the other party to the litigation or something else?

The Accrual Method

While not addressed in this case, the taxpayer may have been able to achieve the tax deferral he was seeking by electing to be taxed on the accrual method.

With the accrual method, the taxpayer would report the income when he invoiced his client. The income tax liability would be deferred if he invoiced his client at the end of the litigation.

Of course, there are other considerations. The ability to defer tax on accounts receivable is an example. Cash basis taxpayers can defer paying tax on receivables until they are paid. A taxpayer who will have accounts receivables may prefer the cash method. This can be mitigated by having a policy of writing off old balances sooner rather than later.

While most law firms prefer the cash method of accounting, this shows that there could be exceptions for firms that receive large upfront payments.

If the taxpayer had other cases, perhaps he could have formed a separate legal entity to handle these particular legal matters and elected the accrual method for that legal entity.

Leave a Reply

Your email address will not be published. Required fields are marked *