A federal district court, in the matter of Bagley, No. 2:10-cv-00483-RT-FMO (C.D. Cal. 8/5/13), has determined that Richard Bagley was engaged in the trade or business of pursuing False Claims Act lawsuits against his former employer and was thereby entitled to deduct legal expenses related to that endeavor as ordinary and necessary business expenses.
The False Claims Act (FCA) allows private citizens to bring lawsuits against any person who knowingly submits 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 this instance, Mr. Bagley received an award of $27.2 million, 24.5% of the government’s recovery from his former employer for his whistleblower efforts.
Initially, Mr. Bagley reported his $27.2 million of income and deducted the $9 million in attorneys’ fees he paid on Schedule A. He later filed an amended return, reporting both the award and the attorneys’ fees on Schedule C and listing his occupation as “private attorney general.” The IRS rejected this second treatment and the resulting $4 million income tax refund. The court disagreed with the IRS and upheld Mr. Bagley’s tax position.
To be engaged in a trade or business, a taxpayer must be involved in the activity with continuity and regularity and a focus on making a profit. The Judge’s ruling recognized the following factors in its decision that Mr. Bagley was involved in a trade or business and could deduct his legal fees as ordinary and necessary business expenses:
- He reportedly spent almost 6,000 hours on his cases
- He had expertise in the matter at hand, including his general accounting and government contracting background, which significantly contributed to the claim’s success
- He acted in a businesslike manner, keeping time records, reviewing documents, and attending meetings
- His work did not provide him with personal pleasure and was thereby not a hobby
- The legal expenses were ordinary and necessary to prosecute the FCA lawsuits
While this particular decision depended on facts specific to this case, it offers interesting guidance to other whistleblowers who incur significant expense in pursuit of their bounty.