Taxes in Your Practice: Ninth Circuit holds litigator liable for tax deficiency and fraud penalty
Scott E. Vincent
Scott E. Vincent is the founding member of Vincent Law, LLC in Kansas City.
Vol. 78, No. 2 / March - April 2022
The United States Court of Appeals for the 9th Circuit recently found that a disbarred lawyer who had specialized in tax fraud litigation was liable for income tax deficiencies and a tax fraud penalty.
The 9th Circuit affirmed the tax court’s decision in Isaacson v. Commissioner, finding that the Internal Revenue Service properly imposed tax deficiencies and a 75% tax fraud penalty relating to legal fees intermingled with client funds and not reported as income.
Lon Isaacson (Isaacson or Taxpayer) was a long-time trial lawyer, practicing tax fraud litigation. Isaacson was disbarred in 2013 for willfully violating Rule 4-100 of the California Rules of Professional Conduct, which requires that client funds be kept in trust accounts, imposes recordkeeping requirements, and bars lawyers from commingling client funds. Before the disbarment, Isaacson represented four individuals who had been sexually abused as children by members of the Catholic clergy (clergy lawsuit). Isaacson personally knew these clients, who considered him to be both a lawyer and trusted friend.
With some variations, the four clients’ fee agreements included up to a 60% contingent fee for Isaacson and reimbursement for as much as 110% of Isaacson’s costs. Terms also included purporting to allow Isaacson to deposit client funds in non-IOLTA accounts with Isaacson retaining interest on the deposits. Some of the clients communicated to Isaacson that they did not want him to manage investment of future settlement proceeds and did not want future settlement proceeds invested at Union Bank of Switzerland (UBS).
Isaacson had a relationship with UBS and its advisors, and he had previously established a UBS account where he deposited proceeds from the clergy lawsuit settlements (UBS account). On documents opening the UBS account, Isaacson identified the account as for a sole proprietorship, listed himself as the principal officer and beneficial owner of the account, and handwrote the word "Trustee" after his law firm's typed name on the line listing the account owner's information. Isaacson did not identify this account as a client trust account, and he did not indicate that the source of account funds would be client trust funds. Instead, Isaacson indicated that the source of funds for the UBS account would be "income from the business/organization."
In 2007, as part of a global settlement involving several clerical organizations and hundreds of victims of childhood sexual abuse, Isaacson secured a collective settlement of $12.75 million for his four clients in satisfaction of their pending claims. Isaacson allocated this settlement among the clients and charged each of the four clients a 60% fee, which was not formally challenged despite some complaint by two of the clients.
Isaacson deposited the settlement funds from the clergy lawsuit in the UBS account in 2007. The tax court found Isaacson then treated the UBS account as a personal account and not an account held in trust for the benefit of his clients. For example, in December 2007, Isaacson had a personal need for liquidity and directed UBS to sell $1.85 million of auction rate securities, but then that same day he directed UBS to repurchase the $1.85 million of securities just sold. Also in December 2007, Isaacson emailed UBS asking for clarification of which auction rate securities were "purchased for my benefit", the "amount of my present holdings, and the interest I have earned to date". Once UBS responded, Isaacson directed UBS to transfer $50,000 of earned interest to his personal trainer and social acquaintance as a gift. Later in December 2007, Isaacson sent UBS handwritten instructions to transfer $600,000 from the UBS account into his law firm's Bank of America account, and UBS transferred the funds that day.
In 2008, Isaacson continued to use and manage the funds in the UBS account. In January 2008, he withdrew $100,000 from the UBS account and deposited the money into his law firm's Bank of America account. Later in January 2008, he withdrew $1.3 million from the UBS account and deposited the money into another account he controlled at California Bank & Trust. On Jan. 29, 2008, Isaacson paid one of the clients his portion of the clergy lawsuit settlement funds.
In February 2008 the market for auction rate securities froze, and UBS engaged outside advisors, including Howard Privette II with the Paul Hastings law firm, to review auction rate securities matters which included the UBS account. After reviewing Isaacson’s activity with the UBS account, Privette was concerned that the UBS account was not a valid client trust account under California law and therefore posed a risk to UBS because of potential unknown ownership interests. Accordingly, on March 10, 2008, UBS placed a legal hold on the UBS account. After a series of letters and affidavits from Isaacson and his clients, UBS later lifted the hold on the UBS account. Isaacson and his clients later engaged in litigation with UBS over investment of the clergy account funds in auction rate securities, resulting in a settlement in favor of Isaacson and his clients and a partial distribution of settlement proceeds to them in 2009.
For preparation of his 2007 income tax return, Isaacson retained an outside CPA and provided the CPA with QuickBooks ledgers relating to his practice. However, these ledgers did not account for the UBS account and transactions. Isaacson also failed to tell the CPA that the UBS account existed. In 2008, Isaacson had a legal assistant in his law firm draft a memorandum advising that funds held in a client trust account would not represent income. The memorandum, which Isaacson represented to be a tax opinion letter, purported to provide "authority supporting our position that our client, taxpayer, is not responsible to report income he never actually or constructively received." This memorandum does not identify Isaacson as the hypothetical taxpayer-client. Allegedly relying on the legal assistant memorandum, Isaacson did not tell his CPA about the receipt of the clergy lawsuit settlement funds, nor did he report any legal fees earned from the clergy lawsuit settlement as income on his 2007 income tax return.
On audit, the IRS sought an income tax deficiency of more than $2.8 million, and a 75% fraud penalty under Code Section 6663 of over $2 million. Isaacson petitioned the tax court, and the tax court held that Isaacson was liable for the tax deficiency and fraud penalty asserted by the IRS. The tax court found that when Isaacson deposited the clergy lawsuit settlement funds into the UBS account in December 2007, he alone controlled the UBS account. The tax court further found that the IRS had proven, by clear and convincing evidence, that Isaacson's underpayment of tax was done with fraudulent intent.
Isaacson appealed the decision to the Court of Appeals for the 9th Circuit. Isaacson argued that he held the funds resulting from the clergy settlement for the benefit of his clients and was not required to report his legal fees in 2007 because of a fee dispute with at least two of the clients.
The 9th Circuit Findings
The 9th Circuit reviewed the tax court conclusions of law de novo and its factual findings for clear error. The 9th Circuit specifically indicated it would defer to the tax court factual findings “unless we are left with the definite and firm conviction that a mistake has been committed”.
The 9th Circuit first noted that from the time the settlement funds were wired into the UBS account, Isaacson treated the funds as his own. He immediately commingled the settlement funds with money he had previously deposited in the UBS account, and he directed UBS to invest the funds consistent with his personal risk preferences. Days after the funds were invested, for "liquidity" reasons, Isaacson directed UBS to sell $1,850,000 of securities purchased with the settlement funds. The following week, Isaacson instructed UBS to transfer $50,000 from the UBS account to his personal trainer. Based on these findings, the 9th Circuit found that the tax court did not err in concluding that Isaacson's conduct demonstrated his dominion and control over the funds.
The 9th Circuit also found that the tax court did not abuse its discretion by estopping Isaacson from arguing that a fee dispute existed with his clients. This argument was plainly inconsistent with Isaacson's representations to the Superior Court of California that no such dispute existed during the relevant time period, which resulted in a Superior Court disbursement of $6,883,047.05 of settlement funds to Isaacson. The 9th Circuit also found that, even absent judicial estoppel, they would still affirm the tax court because “the record as a whole supports the conclusion that no fee dispute existed.” Notably, the tax court had also concluded that even assuming there was a fee dispute with his clients, Isaacson should have recognized his asserted fees as income for 2007.
The 9th Circuit also found no error in the tax court's imposition of the 75% fraud penalty. The court carefully considered relevant considerations for fraud and found that an inference of fraudulent intent was supported by the record from the tax court.
This 9th Circuit case is a cautionary example regarding handling of client settlement funds and trust accounts. The lawyer/taxpayer in this case violated ethical requirements in this regard. The case further illustrates income tax and timing considerations with client settlements and disputed contingent fees. Another important note here in a fee dispute with multiple clients: the portion of fees that is undisputed should be recognized as income as soon as all the events which fixed the lawyer’s right to the fees occur. As evidenced by this case, the all events test may occur in stages in a multiple client situation or when only a portion of a fee is disputed.
1 Scott E. Vincent is the founding member of Vincent Law, LLC in Kansas City.
2 Isaacson v. Comm’r, 2022 PTC 49 (CA9 02/23/2022).
3 Isaacson v. Comm'r, T.C. Memo. 2020-17 (U.S.T.C. Jan. 23, 2020)