Originally published on Forbes.com Aug 23rd, 2013
Thanks largely to Richard Bagley, Northrop-Gruman paid the federal government over $111,000,000 to settle a claim against its recently acquired subsidiary TRW. That was in 2003. This month, a US District Court ruled that Mr. Bagley is entitled to a refund of the taxes that he paid on his share of the settlement. He had received $36,651,295 of which $18,477,815 was paid to attorneys.
If you ever want an illustration of how important it can be whether a deduction is itemized or goes against adjusted gross income, you need go no further than this case. The difference for Mr. Bagley was $3,874,407.
The Whistleblower
If you read the case, you will probably not find it to be the most inspiring whistleblower story ever. Mr. Bagley was Chief Financial Manager for TRW’s space and technology group. He was responsible for contract proposal pricing, indirect expense budgeting and control, and accounting.
Bagley understood the accounting schemes at TRW and how the costs flowed through the accounting system into the invoices and payment requests which TRW submitted to the government for payment. Starting about 1989 and continuing through 1991, during his employment with TRW, Bagley became aware of false claims made by TRW to the government.
On or about March 29, 1991, Bagley signed a certification to the Federal government that TRW’s “indirect” expense claim for the TRW Space and Technology Group for 1990 represented reimbursable costs. The certification was under penalty of perjury and, at the time he signed it, Bagley believed that it was incorrect. Bagley signed another certification to the Federal government verifying TRW’s “indirect” expense claim for TRW’s 1991 year. He also signed the 1991 certification under penalty of perjury even though he did not believe it was correct at that time.
In TRW’s 1990 and 1991 indirect expense certifications, Bagley certified, to the best of his knowledge and belief, that he had reviewed each year’s Indirect Cost Proposal, that all costs in the proposal were allowable in accordance with the requirement contracts, that the proposal included no costs that were unallowable, and that all costs were properly allocable to in accordance with applicable regulations. Bagley signed the certifications to the government even though he knew they were wrong in order to retain his job.
After Mr. Bagley was laid off by TRW and after he lost a wrongful termination lawsuit, he decided to start a False Claims Act lawsuit against TRW. In an FCA suit, you are suing on behalf of the United States. If the suit is successful, you are entitled to a piece of the action.
The essence of Bagley’s FCA lawsuits was that TRW allocated certain costs to the government as indirect expenses when those costs were not properly pooled as indirect costs and not allowable as charges to the government.
Was Bagley In Business For Himself ?
The issue in this case is whether Bagley must include his income from the qui tam lawsuits as “other income” on his 2003 federal tax return and deduct the attorneys fees on Schedule A, as he did on his first amended return, or whether he can properly report the qui tam award on Schedule C and deduct his attorney fees as ordinary and necessary business expenses, as he did in his second amended return.
Mr. Bagley kept very good track of the time that he spent and it was quite substantial. He logged 5,963 hours which was over 25% of the time that the attorneys devoted to case. By all accounts his role in winning the case was critical:
Bagley stayed involved with the prosecution of the FCA claims by his private counsel team because “they weren’t accountants and hadn’t spent 25 years working with TRW and didn’t have an in-depth understanding of TRW’s accounting system or the people or the products or anything about the company which was necessary to understand how the frauds occurred and where the evidence was.”
Bagley drafted and/or edited at least 73 documents in furtherance of the FCA litigation activity. Bagley also played a primary role with respect to calculating damages and, to that end, attended 40 to 50 meetings with the DCAA between 1997 and 2003. He also spent substantial hours doing his own damage calculations
The Decision
The court went through a “hobby loss” type analysis to determine whether Mr. Bagley was engaged in a trade or business. He passed most of those tests – profit motive, acting in a business-like manner, expertise, time and effort – with flying colors. He even convinced the Court he was not enjoying himself, although this does seem like a situation fraught with the potential for schadenfreude.
The government’s only really serious argument was that this was a one-time thing. The Court was not impressed with that argument:
The government contends that Bagley’s one-time pursuit of a FCA award was not performed with frequency and that he never replicated his activity, and therefore his FCA activity does not meet the “common-sense perception of a trade or business.” However, the standard elucidated by the Supreme Court and the Ninth Circuit does not require that Bagley be engaged in a business activity that repeats with frequency. In fact, courts have recognized long projects with only one pay-out as a trade or business.
The ruling was in his favor.
Personal Connection
As usual I am way behind in the cases and ruling I want to share with you. When that happens, I will often skip ones that have been well covered, if I don’t have anything special to say. This case has received a bit of attention including a post from Joe Kristan. I had to write about it, though, because of an experience I had. Quite a few years ago, one of my partners asked me about deductibility of attorneys fees for a False Claims Act litigant. I really beat my brains out on the issue and concluded that they should definitely be trade or business deductions. I am really pleased that the Court came to the same conclusion.
You can follow me on twitter @peterreillycpa.