Tax Matters

Shareholder Legal Fees
With the increased number of legal problems corporate officers, directors and shareholders face, it’s important to understand the correct tax treatment of legal fees a corporation pays on their behalf.

Kenneth Guarino created Capital Video Corp. to distribute pornographic videotapes. Because he was worried organized crime would try to take over the company or interfere with his other businesses, Guarino paid $1,728,000 in “tribute” to Natale Richichi, a known crime boss. The payment was to assure Richichi’s help in avoiding any problems. Guarino helped Richichi hide the payment from the IRS and conceal other assets from the government. Both men were indicted for conspiracy and fraud. Capital Video paid and deducted $250,000 in 1996 and $517,000 in 1997 for Guarino’s legal fees. The IRS denied the deductions and said the payments represented a constructive dividend to Guarino. The Tax Court ruled for the IRS and the taxpayer appealed.

Result. For the IRS. Legal fees to defend a business are deductible. Paying someone else’s expenses generally is not. However, if a payment was to “promote” a taxpayer’s business, then the fees are deductible. There is a two-part test CPAs can use to determine if such payments are deductible. First, the payment must have been made primarily to benefit the payor’s business. Second, the expenses must be ordinary and necessary.

The IRS and the courts usually evaluate the second test using the origin of the claim doctrine. It looks to the factors that gave rise to the litigation and not the outcome. The fact an indispensable employee was involved and the business would have trouble surviving without him or her is immaterial. Applying the second test to this case, the taxpayer must prove the illegal activities arose in connection with, or proximately resulted from, the corporation’s business activities, ignoring the effect of a conviction on the shareholder or the corporation.

The Tax Court found no evidence the payment or the conspiracy benefited the corporation. Therefore, it concluded the payments did not meet the deductibility tests. Since the taxpayer did not prove the finding of facts was clearly erroneous, the First Circuit Court of Appeals affirmed the Tax Court decision. The corporation was denied the deduction, and the taxpayer was forced to report a constructive dividend equal to the legal fees paid on his behalf.

The taxpayer’s case was weakened substantially because he helped the codefendant hide income and assets from the IRS, actions that would not benefit the corporation. In addition the fact the tribute payments also concerned other businesses negated the conclusion the expenses were ordinary and necessary for the paying corporation. Before any shareholder legal fees are deductible, the company must show a lawsuit was the direct result of actions the shareholder took for the primary benefit of the paying corporation. The courts usually will rule that actions that benefit the shareholder or are not directly beneficial to the corporation don’t promote its business. If a company cannot demonstrate an exclusive corporate business purpose, the deduction will be denied and the shareholder charged with receiving a constructive dividend.

Capital Video Corp. v. Commissioner, CA-1.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accountancy and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

Eighth Circuit Shifts Burden of Proof to IRS

Under IRC section 7491, in any court proceeding the IRS has the burden of proof with respect to any factual issue relevant to determining a taxpayer’s liability for any income, self-employment, gift, estate and generation skipping transfer taxes if

The taxpayer introduces credible evidence with respect to the issue.

The taxpayer has complied with the requirements to substantiate any item.

The taxpayer has maintained all required records.

The taxpayer has cooperated with reasonable requests from the IRS for witnesses, information, documents, meetings and interviews.

In the case of a partnership, corporation or trust, the taxpayer is described in IRC section 7430(c)(4)(A) (ii). The Senate committee reports show this means corporations, partnerships and trusts with net worth over $7 million are not eligible for the benefits of the burden-of-proof provision.

Mr. Griffin is a real estate developer. He and his wife jointly own all the stock of Griffin California Enterprises Inc., an S corporation. Griffin California owns 60% of two California partnerships, Orange Tree Commerce Center and Texas Jacks. Neither spouse owns a direct interest in either partnership. During 1995 and 1996, Mr. Griffin paid delinquent real property taxes on behalf of Orange Tree and Texas Jacks to avoid foreclosures on the partnerships’ assets. He deducted these payments on schedule E of his jointly filed individual tax return, saying the payments were made in connection with rental property he owned in Fairfield, California.

Upon audit, the IRS determined the deductions were improper and the payments should be treated as capital contributions to Griffin California and deducted by the partnerships. At trial the Tax Court noted that, as a general rule, “a taxpayer may not deduct a payment made on another’s behalf unless the payment represents an ordinary and necessary expense of the taxpayer’s own business, as distinct from the business of another person or of some other entity in which the taxpayer may have an ownership interest.” The court recognized an exception to this general rule allowing a payment to be personally deducted if it qualified as an ordinary and necessary expense of one’s own business—the Lohrke exception (see Lohrke, 48 TC at 688).

Mr. Griffin testified he had to pay the taxes to preserve his integrity and standing with the bank to stay in business. The Tax Court held that the Griffins had not proved the property tax payments were expenses of a business separate from the corporation in which the couple were mere investors. The court said in a footnote that, based on the preponderance of evidence, the decision would be the same even if the burden of proof were on the IRS. The Griffins appealed the case, claiming they had presented credible evidence they had made the payments to “promote” their own real estate and construction business.

Result. For the taxpayer, in part. The Eighth Circuit Court of Appeals vacated the Tax Court decision and remanded the case for further proceedings. Citing OkerLund, 53 Fed.Cl. 341, the Eighth Circuit said credible evidence is “the quality of evidence which, after critical analysis, the court would find sufficient upon which to base a decision on the issue if no contrary evidence were submitted (without regard to the judicial presumption of IRS correctness).” The conclusion was that Mr. Griffin’s testimony, in the absence of any evidence or presumptions to the contrary, was credible and that the Tax Court had erred in failing to shift the burden of proving the nonapplicability of the Lohrke exception to the IRS. In light of this failure, the case was remanded to the Tax Court to decide the issues.

The provisions shifting the burden of proof are relatively new; the effective date was July 23, 1998. Taxpayers—and their CPAs—should understand decisions such as Griffin so they are fully aware of their rights in any legal proceedings.

Griffin v. Commissioner, 91 AFTR2d, 2003-486.

Prepared by Karyn Bybee Friske, CPA, PhD, associate professor of accounting, and Darlene Pulliam Smith, CPA, PhD, professor of accounting, both of the T. Boone Pickens College of Business, West Texas A&M University at Canyon.