Managing shareholder may deduct lawsuit damages and legal fees

Plain-English summary

An individual managed a closely held corporation and was sued by another shareholder for fraud, breach of fiduciary duty, and breach of contract. A jury found the manager liable and awarded compensatory and punitive damages, and the manager also incurred legal and expert costs at trial and on appeal. Applying the origin-of-the-claim test, the IRS found that the claims arose from the individual's business conduct as managing shareholder rather than from a personal or capital transaction. It ruled that the judgment payments, legal fees, and related costs paid in the two ruling years were deductible under IRC § 162(a), provided the individual had not received insurance or similar reimbursement.

Ruling snapshot

• Question: Could a managing shareholder deduct damages, judgment amounts, and legal expenses from litigation over the management of a closely held corporation?
• Outcome: Approved
• Key authorities: IRC §§ 162(a), 263(a); Treas. Reg. §§ 1.162-1(a), 1.263(a)-4(c)(1)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201548011 Third Party Communication: None
Release Date: 11/27/2015 Date of Communication: Not Applicable
Index Number: 162.00-00
Person To Contact:
---------------------, ID No. ----------------
---------------------------- Telephone Number:
---------------------------- --------------------
----------------------------- Refer Reply To:
CC:ITA:B02
PLR-107175-15
Date:
August 24, 2015

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Legend

Taxpayer = ------------------------
Corporation = -------------------------------
State = ------------
Date 1 = -----------------------
Date 2 = ------------------
Date 3 = ------------------
Date 4 = -------------------
Date 5 = ------------------
Date 6 = --------------------------------------
Year 1 = ------
Year 2 = ------
Year 3 = ------
Year 4 = ------
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Year 6 = ------
A = ----------------------------------
B = ---
C = --------------------
D = ------------------
E = -------------------
F = --------------------
G = ---------------------
H = -----------
I = ----------
J = ----------
K = ----------
L = ------
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M = ----------
N = --------
O = --------
P = -----
Q = ------
R = ---------------------------------------------------------------------------------

S = --------------------------------------------------------------------------------

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T = -------------
U = -------------
V = ----

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

This is in response to your request for a private letter ruling dated Date 1. You

requested a ruling that legal expenditures consisting of compensatory damages,
punitive damages and all related legal expenses paid in Year 1, Year 2 and Year 3 that
resulted from a lawsuit against you as the managing shareholder of a corporation are
deductible under section 162 of the Internal Revenue Code. By letter dated Date 2, you
agreed that the ruling would only address the expenditures for the Year 2 and Year 3
tax years.
FACTS
Taxpayer is an individual. Taxpayer is a shareholder in several closely held
corporations that own and operate A in State. Taxpayer personally or jointly manages
the finances of all the closely held corporations that operate A. Taxpayer has been in
the business of operating A for B years. Taxpayer was also a shareholder in a
corporation that owned C and another that owned an D. In Year 4, Taxpayer, E and F
formed a closely held corporation called Corporation, a subchapter S corporation for
federal tax purposes, to purchase and operate a A. In Date 3, the Corporation
purchased a G located in H, State. Taxpayer contributed $I for J percent of the stock; E
contributed $K for L percent of the stock and F contributed $M for N percent of the
stock. The shareholders agreed that Taxpayer was to manage the Corporation and
receive a management fee of O percent of the net profits. The distribution of the
remaining net profits was allocated based on the ownership percentages.
From Date 4 through Date 5, E consistently received monthly distribution checks
from Taxpayer. E only received P monthly checks in Year 5 and Q in Year 6. When E
inquired after not receiving any distribution checks from Date 6, Taxpayer told E that R.
There were several meetings and many letters and e-mails in which E asked Taxpayer
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for the Corporation’s financial records. E eventually received some of the records, but
they did not explain why Corporation was losing money. E filed a lawsuit in Year 6
against Taxpayer asserting causes of action including fraud, breach of fiduciary duty,
and breach of contract. The allegations in the complaint included that Taxpayer S. The
lawsuit also named as defendants other entities controlled by Taxpayer. The jury found
Taxpayer liable for breach of fiduciary duty and fraud. The jury also awarded E punitive
damages. The trial court denied the liability claims against the entities named as
defendants. The court awarded costs to E and denied costs to Taxpayer. The final
judgment against Taxpayer was for $T, consisting of compensatory and punitive
damages and prejudgment interest, plus costs of $U, and postjudgment interest of V
percent per annum. Taxpayer filed an appeal, and the appellate court affirmed the trial
court’s judgment. In Year 2, Taxpayer paid E amounts ordered by the judgment of the
trial court. In addition, Taxpayer paid legal fees in Year 2 and Year 3 to his accounting
consultants and expert at trial, as well as to attorneys he retained to defend him in the
lawsuit at the trial court and during his appeal.
LAW AND ANALYSIS
Section 162(a) of the Internal Revenue 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 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 1.263(a)-4(c)(1) provides that a taxpayer must
capitalize an amount paid to another party to acquire any intangible, including an
ownership interest in a corporation, partnership, or other entity, from that party in a
purchase or similar transaction.
To qualify as a deduction allowable under section 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.
Commissioner v. Lincoln Savings and Loan Association, 403 U.S. 345, 352 (1971).
Thus, personal expenditures incurred outside of a taxpayer’s trade or business are not
deductible under section 162. In addition, capital expenditures under section 263 are
not deductible.
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. See
Commissioner v. Tellier, 383 U.S. 687, 689 (1966); Deputy v. Du Pont, 308 U.S. 488,
495-96 (1940); Welch v. Helvering, 290 U.S. 111, 113-14 (1933).
PLR-107175-15 4

The Supreme Court in Welch discussed the meaning of the term “ordinary.” The
Court stated:
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 once in a lifetime. The
counsel fees may be so heavy that repetition is unlikely. None the less, 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.
Welch, 290 U.S. at 114. The Supreme Court in Welch also explained that the term
“necessary” under section 162 imposes the requirement that the expense be
appropriate and helpful for the taxpayer’s business. Id. at 113.
If litigation arises from a capital transaction, then the costs and legal fees associated
with the litigation are characterized as acquisition costs and must be capitalized under
section 263(a). See Woodward v. Commissioner, 397 U.S. 572, 575 (1970).
A payment will be a deduction under section 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.” Woodward v. Commissioner, 397 U.S. at 577-78; Anchor Coupling Co. v. United
States, 427 F.2d 429, 433 (7th Cir. 1970).
The origin of the claim test was first set forth by the Supreme Court in United States
v. Gilmore, 372 U.S. 39, 49 (1963). In Gilmore, the court held 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 basic test of whether
the expense was “business” or “personal” and hence whether it is deductible or not.
Although the Supreme Court in Gilmore considered whether an expense was business
or personal, the origin of the claim test has also been applied to distinguish between
business and capital expenditures. In Anchor Coupling, the court held that 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. Anchor Coupling, 427 F.2d at 431-32. See also Woodward v.
Commissioner, 397 U.S. at 578-79; United States v. Hilton Hotels Corp., 397 U.S. 580,
583-84 (1970).
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 nature and objectives of the litigation, the
PLR-107175-15 5

defenses asserted, the purpose for which the claimed deductions were expended,
the background of the litigation, and all the facts pertaining to the controversy.

Boagni v. Commissioner, 59 T.C. 708, 713 (1973), acq., 1973-2 C.B. 1. See also
Scallen v. Commissioner, T.C. Memo. 1987-412, aff’d, 877 F.2d 1364 (8th Cir. 1989)
(applying origin of claim rule, Tax Court held that settlement payments relating to suit
against partner for his alleged failure to properly carry out his duties as sole general
managing partner in liquidation of partnership were deductible as business expenses).
Courts have held that it is ordinary and necessary to defend claims arising from a
taxpayer’s trade or business. Kornhauser v. United States, 276 U.S. 145 (1928). In
Kornhauser, amounts petitioner paid in defense of a suit for an accounting brought by a
former partner were held deductible as expenses incurred in connection with the
conduct of petitioner’s partnership business. Id. at 153. See also Great Island Holding
Corp. v. Commissioner, 5 T.C. 150, 163 (1945), acq., 1945 C.B. 7 (settlement payment
by majority shareholder, president, and director of corporation relating to settlement of a
lawsuit for mismanagement of corporate affairs held deductible as it proximately related
to his business activity); Rev. Rul. 78-210, 1978-1 C.B. 39 (amounts paid for judgments
and legal fees arising from alleged negligent acts of physician employees were
deductible by medical association as section 162 expenses where the contract provided
that the association would hold the employees harmless from claims for negligent
actions).
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, 973
(1957), aff’d, 256 F.2d 764 (2d Cir. 1958), acq., 1969-2 C.B. xxiv (allowing petitioner to
deduct amounts paid in settlement of legal proceedings charging petitioner with
mismanagement in the liquidation of assets); Butler v. Commissioner, 17 T.C. 675, 679-
81 (1951), acq., 1952-1 C.B. 1 (settlement payment arising from shareholder suit for
damages against principal officer for mismanagement of corporate affairs held
deductible as an ordinary and necessary business expense directly connected to and
proximately resulting from his business activity); Rev. Rul. 79-208, 1979-2 C.B. 79
(permitting taxpayer to deduct payments to settle lawsuit and obtain a release from
breach of contract claims under a franchise agreement).
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. See, e.g., Howard v. Commissioner,
22 B.T.A. 375, 378 (1931), acq., 1945 C.B. 4 (holding that legal fees incurred by
taxpayer to settle a shareholder’s claim of misrepresentation in the conduct of business
are deductible as business expenses); D’Angelo v. Commissioner, T.C. Memo. 2003-
295 (petitioner entitled to a section 162 deduction for legal fees paid in defending suits
alleging breach of fiduciary duty, mismanagement, and breach of contract in his
capacity as an officer, partner, and shareholder of entities in which he had an ownership
interest).
PLR-107175-15 6

In Rev. Rul. 80-211, 1980-2 C.B. 57, the taxpayer was sued civilly for breach of
contract and fraud relating to the ordinary conduct of its trade or business. A judgment
was rendered that included punitive damages. The ruling allowed the taxpayer to
deduct amounts paid as punitive damages under section 162(a) as an ordinary and
necessary business expense because the acts that gave rise to the civil suit were
performed in the ordinary course of the taxpayer’s business.
In the instant case, Taxpayer’s payments to satisfy the final judgment awarded
against him, including legal fees and costs, are ordinary and necessary expenditures.
Under the origin of the claim test, E’s claims against Taxpayer clearly had their origin in
the conduct of Taxpayer’s trade or business. 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 indicates
that the litigation payments were business expenses, and not personal expenditures or
capital expenditures.
RULING
Thus, based solely on the facts and representations submitted, we conclude that
legal expenditures, consisting of compensatory damages, punitive damages and all
other amounts ordered by the judgment of the trial court, as well as Taxpayer’s legal
fees described above, that Taxpayer paid in Year 2 and Year 3 that resulted from a
lawsuit by E against Taxpayer as the managing shareholder of Corporation are
deductible under section 162(a), provided that Taxpayer has not been reimbursed for
any of the payments by insurance or similar compensation.
CAVEATS
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. No opinion is expressed as to the federal tax treatment of the transaction
under any other provisions of the Internal Revenue Code and the Treasury Regulations
that may be applicable or under any other general principles of federal income taxation.
This letter ruling is only applicable to matters under our jurisdiction. See Rev. Proc.
2015-1, 2015-1 I.R.B. 1, 18, Section 1. No opinion is expressed as to the tax treatment
of any conditions existing at the time of, or effects resulting from, the transaction that
are not specifically covered by the above ruling.
This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) 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 Taxpayer and accompanied by a penalty of perjury statement executed by
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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.
Enclosed is a copy of this letter ruling showing the deletions proposed to be made in
the letter when it is disclosed under section 6110.
Pursuant to a power of attorney on file with this office, a copy of this letter ruling is
being sent to Taxpayer’s authorized representative.
Sincerely,

                                    ______________________________
                                    NORMA C. ROTUNNO
                                    Senior Technician Reviewer, Branch 2
                                    Office of the Associate Chief Counsel
                                    (Income Tax & Accounting)

cc-:

Enc. Copy for section 6110 purposes