It Was the Worst of Times, Except . . .

It happens in most closely-held businesses: so long as the business is profitable and cash keeps flowing into the hands of the owners, everyone is happy. When the spigot slows, or is just plain turned off, however, the investor-owners (as distinguished from the management-owners) will have questions that they want answered, and quickly. When responses are not forthcoming, or are viewed as evasive, a lawsuit may not be far behind. iStock_000000181896XSmall11

In any litigation, there are few real winners. A lawsuit arises in the first place because someone was wronged, or believes to have been wronged, and there has certainly been an economic loss. Enter the attorneys, the accountants, perhaps, the “experts,” and rapidly-mounting costs.  Years may pass, and who knows what becomes of the business in the interim.

Sounds awful, right? But what if someone told you that, under the right circumstances, the costs may be cut by at least forty percent? You may say, “Tauric defecation.” (Any readers from Bronx Science out there?) “No,” I would reply, “it’s called tax savings.”

The Facts of a Recent PLR

Taxpayer was a shareholder in several closely-held corporations that owned and operated Business for many years. Taxpayer personally or jointly managed the finances of all the closely-held corporations that operated Business.

Taxpayer, E and F formed a closely-held corporation (“Corp.”), an S corporation, to operate Business in a new location. The shareholders agreed that Taxpayer was to manage Corp. and receive a management fee. The distribution of the remaining net profits was allocated among the shareholders based on their ownership percentages. For several years, E consistently received monthly distribution checks from Taxpayer. However, at some point the checks became less regular. After not receiving checks for several months, E made several inquiries of Taxpayer. There were several meetings and many letters and e-mails in which E asked Taxpayer for Corp.’s financial records. E eventually received some of the records, but they did not explain why Corp. was losing money. E filed a lawsuit against Taxpayer asserting causes of action that included fraud, breach of fiduciary duty, and breach of contract.

The jury found Taxpayer liable for breach of fiduciary duty and fraud. It also awarded E punitive damages. The court awarded costs to E. The final judgment against Taxpayer consisted of compensatory and punitive damages, prejudgment interest, costs, and post-judgment interest.

Taxpayer paid E the amounts ordered by the judgment of the trial court. In addition, Taxpayer paid legal fees to his accounting consultants and expert at trial, as well as to the attorneys he retained to defend him in the lawsuit at the trial court.

The Law

Section 162 of the Code provides a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. The regulations promulgated under Sec. 162 provide that deductible expenses include the ordinary and necessary expenditures directly connected with or pertaining to the taxpayer’s trade or business. The regulations under Section 263 of the Code provide that a taxpayer must capitalize an amount paid to another party to acquire any intangible from that party in a purchase or similar transaction. To qualify as a deduction  allowable under Sec. 162, an expenditure must satisfy a five part test: it must

(1) be paid or incurred during the taxable year,

(2) be for carrying on a trade or business,

(3) be an expense,

(4) be necessary, and

(5) be ordinary.

Thus, personal expenditures incurred outside of a taxpayer’s trade or business are not deductible under Sec. 162. In addition, capital expenditures under Sec. 263 are not deductible.

Once In A Lifetime

Even though a particular taxpayer may incur an expense only once in the lifetime of its business, the expense may qualify as ordinary and necessary if it is appropriate and helpful in carrying on that business, is commonly and frequently incurred in the type of business conducted by the taxpayer, and is not a capital expenditure. “Ordinary” in this context does not mean that the payments must be habitual or normal in the sense that the same taxpayer will have to make them often. A lawsuit affecting the “safety” of a business may happen only once in a lifetime. Nonetheless, the expense is an ordinary one because we know from experience that payments for such a purpose, whether the amount is large or small, are the common and accepted means of defense against attack. The term “necessary,” under Sec. 162, imposes the requirement that the expense be appropriate and helpful for the taxpayer’s business. However, if litigation arises from a capital transaction (e.g., the sale of property) then the costs and legal fees associated with the litigation are characterized as acquisition costs and must be capitalized under Sec. 263.

The Origin of the Claim

A payment will be deductible under Sec. 162 as a trade or business expense only if it is not a personal expenditure or a capital expenditure. The controlling test to distinguish business expenses from personal or capital expenditures is the “origin of the claim.” Under this test, the origin and character of the claim with respect to which an expense was incurred – rather than its potential consequences upon the fortunes of the taxpayer – is the controlling test of whether the expense was “business” or “personal” and, hence, whether it is deductible or not. Similarly, the origin and character of the claim with respect to which a settlement is made, rather than its potential consequences on the business operation of the taxpayer, is the controlling test of whether a settlement payment constitutes a deductible expense or  a nondeductible capital outlay. It should be noted that the “origin-of-the-claim” test does not contemplate a mechanical search for the first in the chain of events that led to the litigation but, rather, requires an examination of all the facts. The inquiry is directed to ascertaining the “kind of transaction” out of which the litigation arose. One must consider the issues involved, the nature and objectives of the litigation, the defenses asserted, the purpose for which the claimed deductions were expended, and all the facts pertaining to the controversy. Generally, amounts paid in settlement of lawsuits are currently deductible if the acts that gave rise to the litigation were performed in the ordinary conduct of a taxpayer’s business.

Similarly, amounts paid for legal expenses in connection with litigation are allowed as business expenses where such litigation is directly connected to, or proximately results from, the conduct of a taxpayer’s business.

The IRS Rules

The IRS determined that Taxpayer’s payments to satisfy the judgment awarded against him were ordinary and necessary expenditures. Under the origin of the claim test, E’s claims against Taxpayer had their origin in the conduct of Taxpayer’s trade or business – the management of Corp. Taxpayer’s activities that gave rise to the lawsuit did not result in the acquisition of a capital asset, did not perfect or defend title to an existing asset, and did not create a separate and distinct asset. Taxpayer did not receive a long-term benefit from the payments. An examination of all the facts indicated that the litigation payments were business expenses, and not personal or capital expenditures. Thus, the IRS concluded that the expenditures that Taxpayer paid, that resulted from the lawsuit by E against Taxpayer as the managing shareholder of Corp., were deductible under Sec. 162, provided that Taxpayer was not reimbursed for any of the payments by insurance or similar compensation.

Be Aware

In some cases, the deductibility of litigation-related expenses may not be relevant, as where the taxpayer’s costs are reimbursed by insurance.

In many other cases, however, the taxpayer and his or her attorneys ought to be aware of the opportunity for tax savings.

Although there is little that can be done about the facts when litigation has begun, a taxpayer should determine the kind of transaction out of which the litigation arose. He or she must consider the background of the litigation, its nature and its objectives. In turn, the defenses asserted may be framed in order to support the treatment of the litigation and settlement expenditures, as ordinary and necessary expenditures incurred in the conduct of the taxpayer‘s trade or business.

The goal in defending any litigation is damage-control, which includes the reduction of the economic cost of conducting and settling the litigation. The ability to reduce such cost through tax deductions can go a long way in making the economics of a deal easier to swallow.