1981 Tax Ct. Memo LEXIS 393 | Tax Ct. | 1981
1981 Tax Ct. Memo LEXIS 393">*393 A, an individual, incorporated his sole proprietorship as C corporation (petitioner). As C's president and sole shareholder, A made all management decisions and was solely responsible for C's acquisition of new business. Following C's incorporation, A (and his wife) were indicated for criminal tax violations and charged with having failed to include certain receipts of the sole proprietorship as business income on their joint returns. C paid A's legal fees in connection with the criminal tax case.
MEMORANDUM FINDINGS OF FACT AND OPINION
FAY,
FINDINGS OF FACT
Some of the facts have been stipulated and are found accordingly.
Petitioner, Jack's Maintenance Contractors, Inc., was a Louisiana corporation whose principal place of business was Belle Chasse, La., at the time the petition was filed1981 Tax Ct. Memo LEXIS 393">*395 herein.
In or around 1967, Jack Farmer (hereinafter Farmer) went into business for himself with a handful of employees as Jack's Maintenance Contracting Company (the Company). Farmer operated the Company out of his home as a sole proprietorship. His principal business activities were painting, sandblasting, waterproofing, and doing general repair work on bridges, high stacks (smokestacks), high towers, large buildings, and other tall structures. Farmer was solely responsible for the acquisition of new business, for making estimates, and for submitting bids on available work. In the initial years, Farmer got some jobs simply by keeping his eyes open for work that needed to be done and then volunteering his services. In addition to handling all sales and estimates, purchasing supplies, and hiring employees; Farmer put in long hours doing much of the actual work himself.
The Company was very successful. Its gross receipts grew from $ 46,736 in 1967 to $ 546,863 in 1971.
On April 25, 1972, the Company was incorporated as Jack's Maintenance Contractors, Inc. (petitioner or the corporation). Farmer was petitioner's president and sole shareholder. By this time, Farmer used a1981 Tax Ct. Memo LEXIS 393">*396 working foreman to supervise crews in the field on some jobs. Petitioner's workforce grew to 40 or 50 employees by the mid-1970's, and gross receipts grew to $ 2,596,206 for 1976. Nevertheless, Farmer continued to be solely responsible for all important business decisions of the corporation. Most importantly, Farmer alone estimated the costs and submitted the bids for work to be done by petitioner. Moreover, the creditors and suppliers of the business continued to rely on the credit of Farmer, who was personally responsible for all of the corporation's outstanding bank loans. In short, Farmer was vital to petitioner's financial health. He could not have been replaced.
Starting in 1976 or 1977, that is, subsequent to the year in issue, petitioner first employed additional estimators. Sometime thereafter, administrative personnel were hired to help manage the corporation, which had 120 to 200 employees by the time of trial in 1980. However, the growth of the business since 1975 has remained largely dependent on the personal reputation and experience of Farmer.
In March of 1973, Farmer and his wife, Darlene, were first contacted by a special agent of the Internal Revenue1981 Tax Ct. Memo LEXIS 393">*397 Service concerning the possibility of criminal tax violations of the Internal Revenue Code by them. On December 24, 1974, the case was referred to the Department of Justice. On or about January 15, 1975, Farmer and his wife retained attorney Michael Fawer (Fawer) to represent them in the proposed criminal case.
On July 31, 1975, Farmer and his wife were indicted for violations of sections 7201 1 (attempt to evade or defeat tax) and 7206(1) (untrue declaration under penalties of perjury) with respect to their income tax returns for 1970 and 1971. Each such violation would have been a felony. The indictments charged the Farmers with omitting from Schedule C of their returns certain gross receipts of the sole proprietorship, Jack's Maintenance Contracting Company. Farmer and his wife had filed joint returns for those years.
The jury trial of the case
During 1975, petitioner-corporation paid Fawer $ 25,407.02 for representing the Farmers. Fawer's retainer of $ 10,000, paid by petitioner in January 1975, was initially recorded on petitioner's books and records as an account receivable due from officers. Subsequent to the end of the taxable year, this amount was removed from the "Accounts Receivable-Officers" account and recorded as a "legal & accounting" expense. Other payments totaling $ 15,407.02 made by petitioner to Fawer in 1975 well all recorded as "legal & accounting" fees.
On its income tax return for 1975, petitioner-corporation deducted the payments to Fawer as legal expenses incurred in its trade or business. This deduction was disallowed by respondent in his statutory notice.
OPINION
In 1975, petitioner, a corporation, paid legal fees to an attorney defending petitioner's president and sole shareholder, Jack Farmer (Farmer), who was charged with criminal income tax evasion and perjury on his returns for the years 1970 and 1971. Farmer's wife was also1981 Tax Ct. Memo LEXIS 393">*399 involved by virtue of the couple's having filed joint returns for those years. The criminal case centered on certain gross receipts allegedly omitted from the Farmers' returns relating to petitioner's predecessor, Farmer's sole proprietorship. The issue presented is whether petitioner may deduct the legal fees it paid for the Farmers' defense under
Respondent analyzes the case as follows: The legal expenses were paid in connection with Farmer's criminal tax problems, which involved tax years prior to petitioner's incorporation. Therefore, respondent contends, the expenses did not originate in petitioner's conduct of its trade or business. Respondent argues that the hardship to petitioner which would result from Farmer's conviction and incarceration are of no import because
Petitioner argues that the legal fees it paid for Farmer's defense were vital to the survival of its business. Petitioner contends that Farmer's role in the affairs of the corporation was indispensable and that he could not have been replaced. Petitioner argues that
1981 Tax Ct. Memo LEXIS 393">*401 Respondent has misconceived the issue in this case by confusing the questions "whether deductible" and "deductible by whom." The "origin of the claim" test of
In
the characterization, as "business" or "personal," of the litigation costs of resisting a claim depends on whether or not the claim
Thus, on the ground that the divorce action was based on the taxpayer's marital relationship and not any income-producing activity, the deduction was disallowed. The "origin of the claim" test set forth in
Applying
The real issue in this case is whether one person can deduct the expenses of another; that is, whether petitioner, as the corporate successor to Farmer's sole proprietorship, may deduct the legal fees it paid for Farmer's defense. The general rule is that a taxpayer may not deduct the payment of another's expenses. See
However, in
As in the case of most general rules, an exception to this one has been developed. In a number of cases, the courts have allowed deductions when the expenditures were made by a taxpayer to protect or promote his own business, even though the transaction giving rise to the expenditures originated with another person and would have been deductible by that person if payment had been made by him.
A review of these cases leads us to conclude that in some situations in individual may deduct the expenses of another person. * * * The tests as established by all of these cases are that we must first ascertain the purpose or motive which cause the taxpayer to pay the obligations of the other person. Once we have identified that motive, we must then judge whether it is an ordinary and necessary expense of the individual's trade or business; that is, is it an appropriate expenditure for the furtherance or promotion of that trade or business? If so, the expense is deductible by the individual1981 Tax Ct. Memo LEXIS 393">*405 paying it.
In
This case falls within1981 Tax Ct. Memo LEXIS 393">*406 the rule of
Second, the expenses in issue were "ordinary" within the meaning of
This case actually falls within a special subset of the
An illustrative case is
1981 Tax Ct. Memo LEXIS 393">*409 To reflect the foregoing,
Footnotes
1. All section references are to the Internal Revenue Code of 1954, as amended.↩
2. Deficiencies for 1970 and 1971 were paid by the Farmers and have not since been contested.↩
3. Alternatively, petitioner argues, presumably to protect the interests of Farmer himself, that its payment of Farmer's legal fees should be considered as a repayment of corporate indebtedness to Farmer. Because we decide this case on the grounds set forth in the text, we do not reach this issue. Moreover, whether the benefits to Farmer constituted loan repayments or corporate dividends to him matters not one whit to petitioner-corporation, who would be entitled to no deduction in either case and who does not argue that the payments on Farmer's behalf were in the nature of compensation.
For similar reasons, we reject petitioner's reliance on
, 365 F.2d 792">801 (8th Cir. 1966), affg. in part and revg. in partParker v. Commissioner , 365 F.2d 792">365 F.2d 792T.C. Memo 1965-77">T.C. Memo. 1965-77 . The issue decided inParker was whether the founder and chief officer of a religious mail-order corporation received taxable income when the corporation paid for his criminal defense on a morals charge. Despite some broad dicta by the Court of Appeals, deduction by the corporation of such legal fees plainly was not in issue. It cannot be overemphasized that when identical facts involve both inclusion by a corporate employee or shareholder and the corporation's deduction, these are different issues which are not necessarily interdependent. The correct characterization of a transaction will of course apply to both parties, but the issues need not be symmetrically related.In a loan/dividend case, the corporation gets no deduction no matter how the issue is resolved as to the shareholder-employee. See
(6th Cir. 1968), affg. a Memorandum Opinion of this Court. CompareBerthold v. Commissioner , 404 F.2d 119">404 F.2d 119 (5th Cir. 1970), affg.Haber v. Commissioner , 422 F.2d 198">422 F.2d 19852 T.C. 255">52 T.C. 255 (1969) (loan/compensation). In a dividend/reasonable compensation case, the shareholder employee has income of some kind no matter how the issue is resolved as to the corporation. See (1979), appeal filed (6th Cir., Mar. 14, 1980). And corporate payments which also benefit an employee may or may not result in income (or whatever character) to him (which may or may not be accompanied by an offsetting deduction) without regard to deductibility by the corporation. Cf.Kennedy v. Commissioner , 793">72 T.C. 793 , 72 T.C. 931">948-950 & nn. 20, 21 (1979), appeal filed (9th Cir., Nov. 20, 1979). See generallyGreenspun v. Commissioner , 72 T.C. 931">72 T.C. 931 . Keeping the precise issue presented sharply in focus will dissipate much of the apparent conflict to be found in some cases in this general area.Blackburn v. Commissioner , T.C. Memo. 1973-254↩4. There may well be cases in which the
Lohrke andGilmore lines of cases ultimately come into conflict. Cf.365 F.2d 792"> , (religious mail-order corporation's payments for principle officer's defense on a morals charge might be deductible underParker v. Commissioner ,supra Lohrke but notGilmore ). See also , 934↩ n. 6 (3d Cir. 1976). This is not such a case.Newark Morning Ledger Co. v. United States , 539 F.2d 929">539 F.2d 929