The Fifth Circuit Court of Appeals issued a decision on March 29, 2019, that explains some of the requirements for deducting litigation expenses. The facts of the case are bizarre, but the controlling legal principles are not.
In a nutshell, the taxpayer, was the sole shareholder of a company that was a commercial cleaning franchisor (“Company”). In November 2002, the taxpayer traveled on vacation with his girlfriend and two employees of his company to the Caribbean island of St. Maarten, where he owned a home. One of the employees was a bodyguard and the other was a former girlfriend. On November 28, 2002, the taxpayer’s current girlfriend died at the residence, likely from a cocaine overdose. The family of the decedent sued the taxpayer and the Company for wrongful death, claiming they facilitated her access to and ingestion of the cocaine that led to her death.
As the litigation progressed, the Company’s board of directors met with the taxpayer and its litigation counsel to discuss the status of the litigation. The taxpayer agreed to contribute $250,000 to his own defense costs, even though he believed the claims against him were frivolous, and counsel explained that the case against the Company was weak, but that it should settle because of the possibility of a negative outcome and the prevailing consensus that the case could have a “negative impact on the company’s relationship with its franchisees and the company’s business.”
The Company and the taxpayer ultimately settled the lawsuit for $2.3M, payable over two years. The taxpayer contributed $250,000 of the settlement amount, and the Company reimbursed him for this amount. The Company deducted the full $2.3M on its tax return for the year at issue, and this deduction flowed through to the taxpayer because the Company is an S corporation and he is its sole shareholder.
On audit, the IRS disallowed the $2.3M deduction in full, and the taxpayer filed a petition for relief in the United States Tax Court. The Tax Court ruled in favor of the IRS, and the taxpayer appealed to the Fifth Circuit. The Fifth Circuit affirmed, framing the issue as “whether a settlement payment to avoid liability arising from the death of the sole shareholder’s girlfriend is a deductible business expense for his S corporation.” Given this statement of the issue, it’s not hard to see why the Court ruled against the taxpayer.
“Whether a settlement payment to avoid liability arising from the death of the sole shareholder’s girlfriend is a deductible business expense for his S corporation.”
The general rule is that only ordinary and necessary business expenses are deductible, and legal expenses do not become deductible just because they are paid for services that relieve the taxpayer of a liability. Dating back to 1963, the Supreme Court has held that the deductibility of legal expenses is governed by the origin-of-the-claim test, whereby litigation and settlement costs are deductible based on the origin of the claim with respect to which the expense was incurred, rather than on the potential consequences of the litigation to the taxpayer. If a claim arises in connection with a taxpayer’s profit-seeking activity (i.e., its business), then the related expenses will be deductible business expenses as opposed to personal expenses.
In this case, both the Tax Court and the Fifth Circuit were of the firm view that the underlying cause of action, relating to the provision of cocaine by employees of the Company while on vacation, had nothing to do with the profit-seeking activities of the Company’s commercial cleaning business. It did not arise from, further, or use corporate property directly employed by the Company in its business. The taxpayer tried to distinguish his case on the fact that the Company was named directly in the lawsuit, but the Court declined his invitation to follow the “scarce out-of-circuit” cases that distinguish the origin-of-the-claim test when the taxpayer is a party to the suit.
“The taxpayer ignores the basic principle of examining each activity to ascertain whether its objective was to make a profit.”
The taxpayer also argued that because the Company only engages in profit-seeking activity, its employees’ actions within the scope of their employment must have arisen from such activity. The Fifth Circuit rejected this argument as well, stating that “[t]he taxpayer ignores the basic principle of examining each activity to ascertain whether its objective was to make a profit.” It was not enough to argue that the employees were acting within the scope of their employment because courts dig in and examine whether the employees’ activities arose from or were connected to the company’s profit-seeking activity. Here, they were not because the origin of the claim was the alleged provision of cocaine by the Company’s employees to the decedent, and that did not relate to the Company’s business.
The Court also disallowed the $250,000 deduction for the reimbursement payment made by the Company to the taxpayer. The taxpayer had argued it was deductible because the Company was required to make the payment under its corporate bylaws. This would have been a successful argument had he asserted it timely, but the Court concluded on procedural grounds that the taxpayer had waived the argument, and it moved on to consider whether a voluntary payment could be deductible. On this point, the Court held that payments to “protect and promote” the Company’s own interests could be deductible if they were ordinary and necessary and the origin-of-the-claim was business related. The Court nevertheless rejected the taxpayer’s argument, though it did so both on substantive and on procedural grounds. Substantively, the Court agreed with the Tax Court that the lawsuit did not arise in connection with the Company’s profit-seeking activity.
This case provides an interesting backdrop for companies to consider litigation expense deductibility. The key takeaway for businesses is to analyze carefully the legal claims asserted against it to ascertain whether they are related to a profit-seeking activity.
Although not implicated in this case, another consideration for businesses is whether there is a specific provision in the tax code that limits the deductibility of a litigation expense. For example, section 162(q) of the Internal Revenue Code generally denies a deduction for settlement payments and attorney’s fees relating to a sexual harassment or sexual abuse claim that is subject to a nondisclosure agreement.
If you have any questions or concerns about how this case might affect your business, please reach out to your Withum advisor by filling out the form below.
Author: Daniel Mayo, JD, LLM | firstname.lastname@example.org