Can an S Corporation Deduct Assumed Litigation Costs From Assigned Legal Claim?
In Garcia v. Commissioner [1], the Taxpayers were a married couple embroiled in litigation over alleged corporate fraud by an international bank specialist. The specialist’s fraud devalued the couple’s minority interest in a “South African exploration and gold mining investment company” (“R&E”).
The Taxpayers along with other investors funded most of the expensive litigation from their own pockets. Around February 2012, each investor/co-plaintiff committed to fund a set amount to a common fund to pay for legal fees. The Taxpayers committed to pay approximately $64,000.[2]
Around February 2012, the Taxpayers also assigned their interest in the lawsuit to a newly formed corporation (“JGx5”). In return, JGx5 assumed the obligation to pay the legal fees. JGx5 also owned 4 pieces of real estate.
JGx5 included the rental income and deducted the legal fees on its 2012 Form 1120S.
The IRS denied the legal expense deduction on Form 1120S and issued a statutory notice of deficiency. And, as always, in addition to the tax benefit of the deduction itself, the IRS was asserted accuracy related penalties, which upped the ante by 20% of the proposed deficiency.[6]
The Taxpayer’s petitioned US Tax Court to challenge the IRS’s determination.
The Taxpayers’ S Corporation
In February 2012, the Taxpayers incorporated JGx5 under California law and caused JGx5 to elect to be taxed as an S corporation.[3] JGx5 owned four rental properties (single-family residences in southern California). In 2012, three of the properties were rented out and the fourth was being rehabbed.
Special Minutes of the S Corporation and Assignment of Legal Claim
In February 2012, about three weeks after forming JGx5, the Taxpayers’ signed two documents, each entitled “Special Minutes of JGx5 Enterprises”.
The first “special minutes” document set forth default treatment of certain transactions between the Taxpayers and JGx5, including that transfers of money in and out of the company will be deemed to be loans.
The second “special minutes” document assigned, to JGx5, the Taxpayers’ rights for “any investment made” by the Taxpayers.
“The other document, captioned ‘Special Minutes’, states that petitioners ‘assign their litigation rights for any investment made by [Taxpayers] to JGX5 Enterprises.’ It also states that ‘the business of JGX5 is to make investments, including the funding of litigation costs * * * [i]n exchange for * * *a[n] ownership interest in the litigation recovery, if any.’ The document further states that ‘this memo is to provide further clarity that [R&E] litigation funding is being done through JGX5 Enterprises and that JGX5 Enterprises will earn a fair return on its investment for funding such litigation.’ The document states: ‘RESOLVED, that JGX5 accepts litigation and the costs thereof in return for a reasonable assignment of shares necessary to cover the costs of litigation and provide for a reasonable recovery.’”[4]
However, according to the opinion, the Taxpayers did not actually assign the stock to JGx5. Furthermore, JGx5 did not take any additional steps to put the legal funds (i.e., co-plaintiffs) or the South African court on notice that the Taxpayer’s right had been assigned to JGx5.
Payments to Meet the Taxpayers’ Commitment
To meet their litigation fund commitment, the Taxpayers made multiple payments to the common legal fund. In 2012, the taxpayers wired two payments totaling approximately $52,000 from their personal brokerage account. The Taxpayers made their first payment of approximately $40,000 in February 2012 and the second payment of $12,000 in June 2012. The remaining amount was paid by JGx5 in December 2012.
The Stakes: Ordinary Deduction to S Corporation or Miscellaneous Itemized Deduction
The issue in the Tax Court case can be reduced to: whether the Taxpayers could convert a personal deduction related to nonbusiness, income-producing expenses under § 212 as miscellaneous itemized deduction on Schedule A of their Form 1040 into an ordinary deduction by the closely held corporation taxed as an S Corporation under § 162.
JGx5 claimed the $64,000 of payments, including those made by the Taxpayers, as a deduction for legal expenses. In the notice of deficiency, the IRS initially sought to deny the deduction of the legal fees entirely. The IRS determined that the legal expenses were not deductible under § 162 as ordinary and necessary business deductions of JGx5.[5]
However, before trial, the IRS agreed that the legal expenses could be deducted on the Taxpayers’ personal income tax return, but there was a catch. The IRS determined that the $64,000 was allowable as an investment nonbusiness income producing expenses under § 212,
Under § 212, the Taxpayers’ aggregate miscellaneous itemized deductions would only be deductible to the extent it exceeded 2% of the Taxpayer’s AGI (i.e., the 2% Floor). And the tax benefit of the deduction may be further reduced by application of the alternative minimum tax (§ 56(b)). In 2012, the husband reported wages of $429,222, so 2% Floor would have potentially reduced the deduction by $8,000 to $10,000 (assuming the taxpayers had some additional income).
However, if the deduction by the S corporation was upheld, then deduction by the S corporation would offset other income reported by the S corporation and thereby reducing the income flowing to the Taxpayer’s on Schedule K-1. Thus, the deduction would not be subject to the 2% Floor.
The Court’s Legal Analysis and Holding
The Tax Court “assign[ed] little significance to the ‘Special Minutes’” that purported to assign the legal R&E legal claim and costs to JGx5.
Transfers between a corporation and its sole shareholders are subject to heightened scrutiny, and the labels attached to such transfers mean little if not supported by other objective evidence. E.g., Boatner v. Commissioner, T.C. Memo. 1997-379, aff’d without published opinion, 164 F.3d 629 (9th Cir. 1998). [7]
The Tax Court was not convinced that the Special Minutes actually provided “objective evidence” that they “altered in any way the [Taxpayers’] relationship to the [legal fund] or their personal obligation for the legal expenses.”[8] The opinion noted that the legal fund still invoiced the Taxpayers and not JGx5. And JGx5 never sought to intervene in the legal proceedings (i.e., to put the South African court on notice that JGx5 has assumed the Taxpayer’s position as claimants).
The judge did not believe that the Special Minutes purporting to create loans was effective for federal income tax purposes. Specifically, the Tax Court did not believe that the documents provided objective evidence of a “bona fide expectation of repayment.” In addition, the first payment was also made before the formation of JGx5, which cuts against the Taxpayers’ reported form.
As a result, the Tax Court held that the expenses were expenses of the Taxpayers’ and not JGx5.
Can someone ever deduct the payment of another person’s expense?
The General Rule and the Exception
The Tax Court notes that a taxpayer generally may not deduct the payment of another person’s expense.[9] However, there is an exception if “a taxpayer pays someone else’s expenses to protect or promote his own separate trade or business.”[10]
This exception typically applies only where the taxpayer pays the obligations of another person or entity in financial difficulty and where the obligor’s inability to meet his obligations threatens the taxpayer’s own business with direct and proximate adverse consequences. Hood v. Commissioner, 115 T.C. at 180-181; see also Square D Co. v. Commissioner, 121 T.C. 168, 200 (2003).[11]
“[T]he showing a corporation must make to deduct the expenses of its shareholder is a strong one.” Hood v. Commissioner, 115 T.C. at 181. The test is sometimes expressed as having two prongs: (1) the taxpayer’s primary motive for paying the expenses must be to protect or promote the taxpayer’s business and (2) the expenditures must constitute ordinary and necessary business expenses for the furtherance or promotion of the taxpayer’s business. Lohrke v. Commissioner, 48 T.C. at 688; see also Capital Video Corp. v. Commissioner, 311 F.3d 458, 464 (1st Cir. 2002), aff’g T.C. Memo. 2002-40; Menard, Inc. v. Commissioner, T.C. Memo. 2004-207, rev’d on other grounds, 560 F.3d 620 (7th Cir. 2009).” [Emphasis added]
However, the Tax Court held that the Taxpayers did not meet either prong of the test.
Application to the JGx5’s Deduction
The Taxpayer’s failed the first prong because they did not show that the expenses were “incurred primarily for the benefit of JGx5 and that any benefit to the petitioners was only incidental.”[12] On the other hand, the benefit to the Taxpayers was obvious.
The Taxpayer’s failed the second prong because the they failed to show that “the legal expenses in question represent ordinary and necessary business expenses in the furtherance of the business of JGx5.” JGx5 listed its business activity code as 531110, which corresponds to “Lessors of Residential Buildings & Dwellings (including equity REITs)” on its 2012 Form 1120S. JGx5 held four different residential rental properties. There is no arguable connection between the litigation expenses and protecting the rental activities.
With respect to the second prong, the Taxpayer’s argued that the closely held corporation will benefit from the litigation rights if a favorable settlement or judgment is obtained. However, the Tax Court noted that focusing on the who receives the benefit from the litigation claim is not the proper test.
Instead, the Tax Court looks to the origin of the claim.[13] For purposes of this analysis, the Tax Court looked to the origin of the subject of the litigation and not the consequences to the taxpayer.[14] Here the Tax Court noted that the underlying legal claim and litigation arose while the Taxpayer’s held the stock of R&E and before JGx5 was formed. The purpose of the litigation was to secure repayment for Taxpayers’ investment in R&E, not to protect JGx5’s activities.
Trade or Business of Funding Litigation?
The Taxpayer’s also argued that they were in a trade of business of funding litigation. The Tax Court dispenses with this argument quickly by noted that the R&E litigation was the only claim being funded by JGx5.
Accuracy Related Penalties.
The Tax Court upheld the accuracy related penalties (substantial understatement penalty[15]) because the Taxpayers did not attempt to show that they had reasonable cause.
Takeaways
- Transactions and related documentation between an S corporation and its sole shareholder will draw heightened scrutiny. As discussed before, form is critical. But the form must be backed by substance. Documents purporting to alter the legal rights between the sole shareholder and the S corporation will not necessarily stand up to IRS scrutiny on their own. They must also be supported by some evidence that they are effective under local law. In Garcia, the corporation did not take the additional steps that would indicate that was the legal owner of the R&E litigation claims (e.g., intervene in the South African court proceedings, put legal fund on notice that JGx5 was stepping into the Taxpayers’ shoes, etc.)
- Generic documents purporting to cause all transfers between a sole shareholder and the shareholder’s closely held corporation to be characterized as loans may not provide enough evidence of an intent to create a bona fide debt for federal income tax purposes.
- Claiming a deduction for the expense of another person or entity is difficult. The IRS will look behind a taxpayer’s documentation and look at the substance of an economic transaction.
Notes
[1] T.C. Summary Opinion 2018-38. Full opinion here.
[2] Note that the commitment was denominated in South African rand and the amounts in this summary are rounded. According to the Tax Court opinion, the litigation started as early as 2005. The legal proceedings began in 2011 and continued beyond 2012. It is not clear if the litigation has been resolved.
[3] The husband was the sole, legal owner of the corporation’s shares.
[4] Garcia at 5-6 (citing the second special minutes document).
[5] Unless noted otherwise, all “§” and “section” references are to the Internal Revenue Code, as amended.
[6] In this case, the IRS was asserted a 20% accuracy-related penalty for an underpayment attributable to a substantial understatement of income tax. Section 6662(a), (b)(2).
[7] Garcia at 9-10.
[8] Id at 10.
[9] Id at 9 (citing Deputy v. du Pont, 308 U.S. 488, 494-495 (1940); Betson v. Commissioner, 802 F.2d 365, 368 (9th Cir. 1986), aff’g in part, rev’g in part, T.C. Memo. 1984-264; Hood v. Commissioner, 115 T.C. 172, 179-181 (2000); J. Gordon Turnbull, Inc. v. Commissioner, 41 T.C. 358, 378 (1963) (“Legal fees paid on behalf of, and for services rendered to, another are generally not deductible as ordinary and necessary business expenses of the payer.”), aff’d, 373 F.2d 87 (5th Cir. 1967)).
[10] Id at 9 (citing Gould v. Commissioner, 64 T.C. 132, 134- 135 (1975); Lohrke v. Commissioner, 48 T.C. 679 (1967)).
[11] Id at 11-12.
[12] Id at 12 citing Capital Video Corp. v. Commissioner, 311 F.3d at 464.
[13] Id citing Gilmore v US, 372 U.S. 39 (1963).
[14] Id at 13 citing Capital Video Corp at 464.
[15] See IRC § 6662(b)(2).
