PLR 1045005: Restitution and legal expenses paid for an employee were deductible business expenses

Plain-English summary

The IRS ruled that an S corporation could deduct restitution and legal expenses it paid on behalf of an employee involved in a criminal investigation and related civil actions. The employee's conduct arose from providing operational services for the corporation's client, and the corporation had an indemnification obligation. The IRS treated the restitution as compensatory rather than as a fine or similar penalty, and concluded that the restitution and legal expenses were ordinary and necessary business expenses. The ruling did not express an opinion on other tax consequences.

Ruling snapshot

• Question: May the corporation deduct restitution and legal expenses paid on behalf of an employee for a lawsuit and settlement?
• Outcome: Approved
• Key authorities: IRC §§ 162 and 263; Treas. Reg. § 1.162-1

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201045005 [Third Party Communication:
Release Date: 11/12/2010 Date of Communication: Month DD, YYYY]
Index Number: 162.25-05
Person To Contact:
----------------------- -----------------------------, ID No. -------------
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----------------------------------- Telephone Number:
-------------------------------------------------- ---------------------
---------------------------------------------------- Refer Reply To:
CC:ITA:B03
PLR-108360-10
Date: 7/29/10

Taxpayer’s Name: -------------------------------------------

Taxpayer’s Address: --------------------------------------

Taxpayer’s EIN: ----------------

Employee ------------------

Wife ------------------------

State A -----------

Corp B ------------------------

Business C ---------------------------------------------------------------

Corp D ------------------------

Location E ------------------------------------

Business F --------------------------------------------------------------------------------

---

Date a -------

b -----
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Date c ----------------------

Date d -------------------

Date e -----------------------------------------

Date f --------------------

g -----------

h ----

Date i -------

j ----------

k -----------

Dear ---------------:

This responds to your letter dated February 15, 2010, requesting a ruling on the federal
income tax treatment with respect to the deductibility of amounts paid by the Taxpayer
with respect to an employee’s lawsuit and settlement, thereof.

Ruling Requested

Taxpayer requests a ruling that it will be entitled to a deduction, under section 162(a) of
the Internal Revenue Code, for payments made on behalf of Employee regarding
restitution and legal expenses attributable to Employee’s lawsuit and settlement.

Applicable Facts

Taxpayer is a domestic subchapter S corporation that was incorporated in State A in
Date a. Corp B is the sole owner of all of the stock of Taxpayer. Employee and Wife
are joint owners (as tenants by the entirety) of b percent of the stock of Corp B.

Article VIII, section 8.01 of Taxpayer’s By-Laws provides an indemnification for its
directors, officers, employees or agents who, while serving at the request of the
corporation become a party to litigation whether civil, criminal, or administrative.

From c to d, Taxpayer was engaged in providing Business C services to Corp D.

Corp D was in the business of providing investment services to its clients. Specifically,
the purpose of Corp D was to invest and reinvest monies for its clients in bank
certificates of deposit (“CDs”) seeking the best rates of return available at the time in the
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marketplace. Corp D used a database of information to search banks nationwide for the
best terms and rates of return available for CDs, and Corp D invested its clients’ monies
accordingly.

Taxpayer, through Employee, provided Business C services to Corp D. Employee was
responsible for finding the rates for bank CDs, assisting in placing CDs for the
customers of Corp D, producing paperwork related to those purchases including trade
tickets, trade confirmations, interest credit memos, and other Business C activities for
the benefit of its client, Corp D. Taxpayer was compensated a flat fee of approximately
$j per year for providing such services to Corp D.

Near the end of Taxpayer’s relationship with Corp D, on or about Date e, Employee
became aware that Corp D had wrongfully liquidated CDs of clients and had not
reinvested the proceeds as it was supposed to do. Rather, Corp D held the investment
funds of such clients in Corp D’s general account but mailed a statement to Corp D’s
client that reflected the monies were still invested in a CD, when, in fact, they were not
so invested.

Taxpayer, through Employee, subsequently ceased providing services to Corp D. In
addition, Employee eventually notified the Office of the United States Attorney for
Location E (the “Enforcement Section”) of the allegedly fraudulent investment activities
of Corp D.

During the Enforcement Section’s investigation, it was determined that Corp D had
defrauded numerous clients through embezzlement of investment funds by the sole
owner of Corp D. It was also determined by these governmental authorities that neither
Employee nor Taxpayer participated in the fraudulent scheme.

As a result of the governmental investigation, it was determined that Employee’s
notification to the Enforcement Section was not timely. It was further determined that
Employee should have alerted the authorities about his knowledge regarding the
activities of Corp D and its sole owner at an earlier date. Therefore, the Enforcement
Section concluded that Employee was guilty of the crime of misprision. Taxpayer
represents that misprision means a failure by a person, not an accessory, to timely
notify a government authority of the occurrence of an ongoing felony and concealment
of such felony. Consequently, Employee agreed to plead guilty to the crime of
misprision because Employee had knowledge that Corp D had sent erroneous and false
statements to clients and Employee had not timely informed governmental authorities of
the crimes being committed by Corp D.

In pleading guilty to the charge of misprision, and at the order of the United States
District Court, Location E on Date f, Employee was sentenced to a period in prison. In
addition, the Federal Court also determined that Employee should be held jointly and
severally liable with Corp D for payments of restitution in the amount of $g, which
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represents the clients’ losses resulting from misprision during a h month period. That
amount was paid by Taxpayer on behalf of Employee in Date i.

It is represented that Taxpayer and Corp B have other clients and customers, and are
concerned that they maintain their business names and reputations in order to continue
their business activities.

Based upon the above, separate civil actions were brought against the Taxpayer,
Employee, as well as Corp D and its owner. Taxpayer and Employee were required to
hire defense attorneys and incurred legal expenses over $k.

Law

Section 162(a) of the Code provides that there is allowed as a deduction all the ordinary
and necessary expenses paid or incurred during the taxable year in carrying on any
trade or business.

Section 1.162-1(a) of the Income Tax Regulations provides that deductible business
expenses include the ordinary and necessary expenditures directly connected with or
pertaining to the taxpayer's trade or business.

Section 263(a) provides that no deduction shall be allowed for any amount paid out for
new buildings or for permanent improvements or betterments made to increase the
value of any property or estate.

Section 162(f) of the Code provides that no deduction shall be allowed under section
162(a) for any fine or similar penalty paid to a government for the violation of any law.

18 U.S.C § 3663A(c)(1)(A) and (B), provides in part, that this section applies to an
offense against property under this title, including any offense committed by fraud or
deceit, and in which identifiable victims have suffered a pecuniary loss.

18 U.S.C. §3663(A)(b)(1)(B) provides in part, that the order of restitution under § 3663A
shall require the defendant to pay an amount equal to the greater of the value of the
property on the date of the damage, loss or destruction, or the value of the property on
the date of sentencing, less the value of any part of the property that is returned.

Discussion

To qualify as a deduction allowable under section 162 of the Code, 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. Commissioner v. Lincoln Savings and Loan Association, 403 U.S. 345, 352
(1971)..
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Generally, an expense arising from a taxpayer's trade or business is ordinary and
necessary, and therefore, is deductible under section 162 of the Code. Ditmars v.
Commissioner, 302 F.2d 481, 485 (2nd Cir.1962).

The Supreme Court, in Welch v. Helvering, 290 U.S. 111 (1933), has discussed the
meaning of the term “ordinary.” The Court stated:

   Ordinary in this context does not mean that the payments must be habitual or
   nominal in the sense that the same taxpayer will have to make them often. A
   lawsuit affecting the safety of a business may happen once in a lifetime. The
   counsel fees may be so heavy that repetition is unlikely. 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, and the common and
   accepted means of defense against attack. Welch, 290 U.S. at 114. The
   Supreme Court in Welch also explained that the term “necessary” under section
   162 of the Code imposes only the minimal requirement that the expense be
   appropriate and helpful for the taxpayer's business.

In Old Town Corporation v. Commissioner, 37 T.C. 845 (1962), acq., 1962-2 C.B. 52,
the court held that a payment by a corporation to settle a claim asserted against it in a
lawsuit by a former employee constituted an ordinary and necessary business expense.
Citing Welch, the court held that the settlement payment was ordinary because it
resulted in the protection of the corporate assets that were subject to the lawsuit.

Taxpayers' payment will be deductible under section 162 of the Code as a trade or
business expense only if it is not a personal expenditure, a capital expenditure under
section 263 of the Code, or subject to 162(f). The controlling test to distinguish business
expenses from personal or capital expenditures is the “origin of the claim” test. Anchor
Coupling Company v. United States, 427 F.2d 429, 433 (7th Cir.1970), cert. denied, 401
U.S. 908 (1971).

The origin of the claim test was first set forth by the Supreme Court in United States v.
Gilmore, 372 U.S. 39 (1963). In Gilmore, the Court held that the controlling test of
whether an expense is “business” or “personal” is to consider 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. See also Woodward v. Commissioner,
397 U.S. 572 (1970); United States v. Hilton Hotels Corp., 397 U.S. 580 (1970).

Although these Supreme Court cases considered whether an expense was business or
personal, the origin of the claim test has also been applied to distinguishing between
business and capital expenditures. For example, in Anchor Coupling, the court held that
examination of the origin and character of the claim with respect to which a settlement is
made, rather than the estimation of the potential consequences of the claim upon the
business operations of the taxpayer, is the controlling test in determining whether a
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settlement payment constitutes a deductible business expense or a nondeductible
capital outlay. Anchor Coupling, 427 F.2d at 431 (citing Gilmore, Woodward, and Hilton
Hotels, supra).

The Tax Court has described the origin of the claim rule as follows:

   Quite plainly, the “origin of the claim' rule does not contemplate a mechanical
   search for the first in the chain of events which led to the litigation but, rather,
   requires an examination of all the facts. The inquiry is directed to the
   ascertainment of the “kind of transaction” out of which the litigation arose ...
   Consideration must be given to the issues involved, the purpose for which the
   claimed deductions were expended, the background of the litigation, and all facts
   pertaining to the controversy. Boagni v. Commissioner, 59 T.C. 708, 713 (1973),
   acq., 1973-2 C.B. 1.

Generally, amounts paid in settlement of lawsuits are currently deductible if the acts
which gave rise to the litigation were performed in the ordinary conduct of the taxpayer's
business. See, e.g., Federation Bank & Trust Co. v. Commissioner, 27 T.C. 960 (1957)
(allowing petitioner to deduct amounts paid in settlement of legal proceedings charging
petitioner with mismanagement in the liquidation of assets); Rev. Rul. 80-211, 1980-2
C.B. 57 (allowing corporation to deduct amounts paid as punitive damages that arose
from a civil lawsuit against the corporation for breach of contract and fraud in connection
with the ordinary conduct of its business activities); Rev. Rul. 79-208, 1979-2 C.B. 79
(permitting taxpayer to deduct payments to settle lawsuit and obtain a release from
claims under a franchise agreement); Kornhauser v. United States, 276 U.S. 145 (1928)
(attorney fees that are directly connected with, or are proximately result from a
taxpayer’s business, are deductible).

If litigation arises from a capital transaction, the settlement costs and legal fees
associated with such litigation are characterized as acquisition costs and must be
capitalized under section 263(a) of the Code. See Woodward v. Commissioner, 397
U.S. at 575 (holding litigation costs incurred by corporation in appraisal proceedings
mandated by state law to determine the value of dissenter's shares were part of the cost
of acquiring those shares); United States v. Hilton Hotels Corp., 397 U.S. at 583
(litigation costs incurred in appraisal action to determine fair purchase price were costs
to acquire property); Clark Oil and Refining Corp. v. United States, 473 F.2d 1217 (7th
Cir. 1972) (amounts paid in settlement of nuisance action that was brought to establish
price of property were capital expenditures).

However, business expenses are not converted into capital expenditures solely
because they have some connection to a capital transaction. In determining whether
litigation costs are deductible expenses or capital expenditures, the courts and the
Service have looked to the “origin of the claim” to which the settlement or other litigation
costs relate. See Woodward v. Commissioner, 397 U.S. at 577; United States v.
PLR-108360-10 7

Gilmore, 372 U.S. at 47. Under the origin of the claim test, the character of a particular
expenditure is determined by the transaction or activity from which the taxable event
proximately resulted. Gilmore, 372 U.S. at 47. The purpose, consequence, or result of
the expenditure is irrelevant in determining the origin of the claim, and therefore, the
character of the litigation cost for tax purposes. McKeague v. Commissioner, 12 Cl. Ct.
671 (1987), aff'd without opinion, 852 F.2d 1294 (Fed. Cir. 1988).

In the instant case, the payment by Taxpayer of restitution resulted from Employee
providing operational services, on behalf of the Taxpayer, to Corp D. It is clear that
Employee’s delay in reporting Corp D’s illegal activities arose from his ordinary business
activities, rather than a capital transaction. Under the origin of claim test, the
Employee’s conduct was within the normal course of business activities he performed
for the Taxpayer. As a result, Taxpayer made the restitution payment, on behalf of
Employee, under its contractual obligation to indemnify Employee. Therefore, after
examining all the facts and circumstances, the payment of restitution was a business
expense, and not a personal expense or a capital expenditure.

The next issue to be addressed is whether the restitution payment is deductible under
section 162(a) of the Code, or whether the payment is more akin to a fine or similar
penalty paid to a government for the violation of any law, and thus, nondeductible under
section 162(f). Under Employee’s plea agreement with the office of the United States
Attorney and 18 U.S.C § 3663A, it is clear Taxpayer’s restitution payment was intended
to be compensatory in nature. Again, applying the origin of claim test, since the
payment is compensatory, as opposed to a fine or penalty within the meaning of section
162(f) of the Code, Taxpayer’s restitution payment is not precluded from being
deductible under 162(a).

The origin of claim test will also be used in determining whether the legal fees are
deductible under section 162(a) of the Code. Since the legal fees were directly
connected to Taxpayer’s business activities and were for the protection of corporate
assets, as opposed to expenditures, such expenses are deductible under section
162(a).

Conclusion and Ruling

Based solely on the facts and representations submitted, we conclude and rule as
follows:

Under the origin of the claim test, Taxpayer’s payments made on behalf of Employee for
restitution and legal expenses attributable to Employee’s lawsuit and settlement had its
origin in the conduct of Taxpayers’ trade or business. An examination of all the facts
indicates that both the restitution and legal expenses were ordinary and necessary
business expenses, and not personal expenditures, capital expenditures or subject to
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section 162(f) of the Code, and therefore, such expenses are deductible under section
162(a).

DISCLAIMERS AND LIMITATIONS:

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

Under the powers of attorney on file in this office, a copy of this ruling is being sent to
your authorized representative.

                                   Sincerely,



                                   Christopher F. Kane
                                   Branch Chief, Branch 3
                                   (Income Tax & Accounting)