Litigator Who Specialized in Tax Fraud Cases Is Liable for Tax Fraud Penalty

(Parker Tax Publishing March 2022)

The Ninth Circuit affirmed the Tax Court and held that a disbarred lawyer who had specialized in tax fraud litigation was liable for tax deficiencies and a 75 percent tax fraud penalty because he failed to report legal fees earned from a lawsuit as income on his 2007 income tax return. The Ninth Circuit also agreed with the Tax Court that the taxpayer's underpayment of tax was done with fraudulent intent and he was thus liable for the Code Sec. 6663 fraud penalty. Isaacson v. Comm'r, 2022 PTC 49 (9th Cir. 2022).

Background

Lon Isaacson, a trial attorney for several decades, specialized in, among other practice areas, tax fraud litigation. In 2013, Isaacson was disbarred for willfully violating the California Rules of Professional Conduct. The rule he violated, Rule 4-100, requires attorneys to place client funds into trust accounts, imposes various recordkeeping requirements, and bars attorneys from commingling funds. Before his disbarment, however, Isaacson maintained an active litigation practice that included the representation of four individuals who had been abused as children by members of the Catholic clergy (clergy lawsuit). Isaacson personally knew these four clients and they considered him to be both their attorney and a trusted friend. In the course of retaining Isaacson, the clients made clear that they did not want Isaacson to manage their investment activities with respect to any future settlement funds.

The clergy lawsuit was settled in 2007 and Isaacson secured a collective settlement of $12.75 million for his four clients and charged them a 60 percent fee. Two of those clients disputed the 60 percent fee, contending that the appropriate fee was 40-50 percent. However, those two clients never requested a fee dispute arbitration. Isaacson received the lawsuit settlement funds into a UBS account and, in doing so, comingled his fee and his clients' funds in that account. After the settlement funds were deposited in the UBS account in December of 2007, Isaacson treated the account as if it were a personal account and not an account held in trust for the benefit of his clients. For example, on December 12, 2007, he directed UBS to sell off $1.85 million of auction rate securities on December 18, 2007, which UBS did. That same day he again contacted UBS and stated that he no longer needed to show liquidity and directed UBS to repurchase the $1.85 million of securities just sold. Also on December 18, 2007, he 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 informed him of the interest earned, Isaacson authorized a $50,000 transfer of earned interest to his personal trainer and social acquaintance as a gift. Subsequent litigation with UBS over the investment of funds in the auction rate securities resulted in a settlement in favor of Isaacson and his clients and a partial distribution of settlement proceeds to them in 2009.

To prepare his 2007 income tax return, Isaacson retained Patrick Karis, C.P.A. Isaacson provided Mr. Karis with his QuickBooks ledgers, which did not account for the UBS account or transactions, to prepare his 2007 income tax return. He also failed to tell Mr. Karis of the existence of the UBS account. Instead, in 2008, Isaacson had a legal assistant at his law firm draft a memorandum (which Isaacson represented to be a tax opinion letter) advising that funds held in a client trust account would not represent income. The memorandum purported to provide "authority supporting our position that our client, taxpayer, is not responsible to report income he never actually or constructively received." The memorandum did not identify Isaacson as the hypothetical taxpayer-client.

Allegedly relying on his legal assistant's memorandum, Isaacson did not report any legal fees earned from the clergy lawsuit settlement as income on his 2007 income tax return. Isaacson's 2007 income tax return was selected for audit and Isaacson insisted throughout the audit that the funds derived from the clergy lawsuit settlement did not constitute income because UBS had invested the funds without his authorization.

The IRS issued Isaacson a notice of deficiency and assessed a fraud penalty under Code Sec. 6663. The IRS sought an income tax deficiency of a more than $2.8 million, and a 75 percent fraud penalty of approximately $2.1 million. Isaacson petitioned the Tax Court and, in Isaacson v. Comm'r, T.C. Memo. 2020-17, the Tax Court held that Isaacson was liable for the deficiency and fraud penalty after finding that, in December 2007, he received the clergy lawsuit settlement funds into the UBS account, which he alone controlled and that the IRS had proven, by clear and convincing evidence, that Isaacson's underpayment of tax was done with fraudulent intent.

Isaacson appealed to the Ninth Circuit. Isaacson argued that the Tax Court erred because he purportedly held the funds resulting from the settlement of an action for the benefit of his clients and was not required to report his legal fees in 2007 because of an "ongoing" fee dispute with at least two of them.

Analysis

The Ninth Circuit affirmed the Tax Court's decision and held that Isaacson failed to report legal fees as income on his 2007 federal tax return, and that he did so with fraudulent intent. The court rejected Isaacson's contention that the funds were being held for his clients' benefit after noting that, subsequent to the funds being wired into his investment account at UBS, Isaacson treated the funds as his own. Just days after the funds were invested, the court observed, Isaacson directed UBS to sell $1,850,000 of securities purchased with the settlement funds and later instructed UBS to transfer $50,000 from his investment account to his personal trainer.

This course of conduct indicated to the court that, from the moment Isaacson established the UBS account, he intended to use the funds therein for his own benefit. Once the clergy lawsuit settlement funds were deposited into the account, the court noted, he did just that. According to the court, Rule 4-100 did not operate as any constraint on Isaacson's use of the funds for his own benefit. The court also concluded that while Isaacson's argument that a fee dispute existed found some support in the record, the record as a whole supported the conclusion that no fee dispute existed. The court concluded that, even assuming there was a fee dispute between him and his clients, Isaacson should have recognized his asserted fees as income for 2007.

For a discussion of the tax fraud penalty in Code Sec. 6663, see Parker Tax ¶262,125.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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