September 2013

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.

Mr. Bagley was the chief financial manager of TRW’s space and technology group.  During that time, he learned of improper billing practices in bills submitted to the federal government. Although at times he internally questioned those at TRW involved with the practices that led to these incorrect billings, he personally signed these bills under penalties of perjury despite his knowledge that they were improper. After he was laid off from TRW, he filed an unsuccessful wrongful termination lawsuit and was unable to find replacement work. He then filed a False Claims Act (“FCA”) lawsuit against his former employer.

The 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 over $36 million: (i) $27 million for his portion of the government’s recovery from his former employer for his whistleblower efforts and (ii) $9 million in legal fees paid to his attorneys.  He separately paid $9 million to his legal counsel as a contingency fee.

Initially, and consistent with the 1099-MISC form he received from the government, Mr. Bagley reported his $27 million as “other income”  on his tax return and deducted $9 million in attorneys’ fees on Schedule A (ignoring the second $9 million paid to his counsel).  He subsequently amended the return to include these legal fees. He later filed a second amended return, reporting both the award and the attorneys’ fees paid on his behalf ($36 million) as gross income and the $18 million paid to his attorneys in total as expenses on Schedule C, and listing his occupation as “private attorney general.”  The IRS rejected this final treatment and the resulting $4 million income tax refund.  The court disagreed with the IRS and upheld Mr. Bagley’s tax position.

26 U.S.C. Section 162(a) allows deduction of all “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”  To be engaged in a trade or business, a taxpayer must be involved in the activity with continuity, regularity and a focus on making a profit. The Judge’s ruling recognized the following factors (among others) 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:

  1. He reportedly spent almost 6,000 hours on his cases
  2. He had expertise in the matter at hand, including his general accounting and government contracting background, which significantly contributed to the claim’s success
  3. He acted in a businesslike manner, keeping time records, reviewing documents, and attending meetings
  4. His work did not provide him with personal pleasure and was thereby not a hobby
  5. He was not otherwise employed during this time
  6. The legal expenses were ordinary and necessary to prosecute the FCA lawsuits

While this particular decision depended on facts specific to this case and the Court specifically cited the unique aspects of Mr. Bagley’s pursuit of his claim in its decision, it offers interesting guidance to other whistleblowers who incur significant time and expense in pursuit of their bounty.

Fulcrum Inquiry is a forensic accounting firm that performs fraud and accounting investigations. We use this experience in operating whistleblower collection and reporting systems that improve governance processes for both businesses and nonprofit organizations.