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Litigation Costs Attributable to Independent Contractor's Recovery of Punitive Damages Were Fully Deductible

Since the 1970s, G worked as an agent for the A Life Insurance Company. A fired G in 1986. After the firing, A did not remit the proper amount of commissions to G.

In 1987, G sued A for breach of contract, winning both actual and punitive damages in 1992. On his 1992 return, G included the actual damages in income on his Schedule C; he also claimed a deduction for the full amount of his legal costs. G did not report any of the punitive damages he received.

The IRS challenged G's treatment, contending that he was required to include the punitive damages in income and that the legal costs attributable to these punitive damages had to be deducted on Schedule A as a miscellaneous itemized deduction. The Tax Court (opinion Laro, J.) holds for G; because all of the legal costs were ultimately attributable to G's trade or business, they were fully deductible as business expenses.

Sec. 162(a) governs the deductibility of litigation costs as a business expense. Sec. 162(a) allows an individual to deduct all of the ordinary and necessary expenses of carrying on his trade or business. Sec. 212 governs the deductibility of litigation costs as an itemized deduction, when the costs are incurred as nonbusiness profit-seeking expenses. Sec. 212 allows an individual to deduct all of the ordinary and necessary expenses paid or incurred in producing income; managing, conserving or maintaining property held for the production of income; or determining, collecting or refunding a tax.

A deduction of litigation costs under Sec. 162(a) may be more desirable to an individual than a deduction under Sec. 212; the primary advantage rests on each deduction's effect on gross income and adjusted gross income (AGI). A deduction under Sec. 162(a) is subtracted in full from gross income to arrive at AGI. A deduction under Sec. 212 is subtracted from AGI to arrive at taxable income and is subject to certain floor limitations in Sec. 67(a). The benefit from a deduction of litigation costs under Sec. 212 may also be limited by application of the alternative minimum tax.

Whether an ordinary and necessary litigation expense is deductible under Sec. 162(a) or 212 depends on the origin and character of the claim for which the expense was incurred and whether the claim bears a sufficient nexus to the taxpayer's business. Ordinary and necessary litigation costs are generally deductible under Sec. 162(a) when the matter giving rise to the costs arises from, or is proximately related to, a business activity. Litigation costs must be "attributable to a trade or business carried on by the taxpayer" to be deductible as a business expense.

The ascertainment of a claim's origin and character is a factual determination that must be made on the basis of the facts and circumstances of the litigation. The most important factor to consider is the circumstances out of which the litigation arose. In passing on this factor, the fact finder must take into account, among other things, the allegations set forth in the complaint, the issues that arise from the pleadings, the litigation's background, nature and purpose and the facts surrounding the controversy.

G's legal costs, which the parties agree are ordinary and necessary expenses, bear the required nexus to his sole proprietor insurance business to meet the requirements for deductibility under Sec. 162(a). As a matter of fact, G's lawsuit against A arose entirely from his insurance business. Each cause of action G alleged in the lawsuit was spawned entirely from the fact that, after A fired him, it failed to honor the terms of their working agreement by not paying him the commissions to which he was entitled under their agreement. But for the agreement, and the fact that A breached the agreement by unilaterally terminating its obligation to pay commissions to G, the instant lawsuit, as it was framed, would never have arisen, and G would never have incurred (or paid) any of the legal costs.

The IRS devotes much time in its opening brief to apportioning G's legal costs between his business and nonbusiness activities, spending little time arguing that apportionment of the legal costs is appropriate. As we understand this argument on apportionment, G must apportion his legal costs because he has not proven that he incurred 100% of the costs in his insurance business. We disagree. After reviewing the record, we are persuaded that all of G's legal costs were attributable to his insurance business and, more importantly, that all of the costs were connected to claims that arose in that business. G's complaint, for example, attests to the fact that each of his claims, and not simply his claim of conversion, arose from the sole proprietor insurance business.

We consider it both ordinary and necessary from a business standpoint for G to have filed the lawsuit against A and for him to have sought any and all damages to which he was entitled on account of A's breach of contract and related conversion. The mere fact that G sought and was paid punitive damages to punish A for its misconduct and to serve as a warning not to engage in such conduct in the future does not change the fact that G's legal costs were all attributable to his business activity. Pursuant to state law, the jury in the A lawsuit awarded G both actual and punitive damages on his conversion claim. The fact that G received two different types of damages on his single claim of conversion does not mean that the claims are bifurcated solely for purposes of applying the Federal income tax laws. Contrary to the Service's position in this case, the various types of damages that G received on his conversion claim do not dictate whether his legal costs must be apportioned between his business and nonbusiness activities. An allocation of litigation costs, if and when applicable, rests on the origin of the claims relating to those expenses.

When appropriate, litigation costs must be apportioned between business and personal claims, and business litigation costs are nondeductible to the extent they constitute capital expenditures. This principle of allocation does not apply to our decision here. First, G's legal costs were all attributable to claims that originated in his business activity, the primary claim being that of conversion. Second, in contrast to cases in which each of the underlying claims could have resulted in an award of damages regardless of an award of damages on any other claim, under state law, G's award of punitive damages could not have been made in isolation.

George W. Guill, 112 TC No. 22

REFLECTIONS: This decision means that the punitive damage award is includable in G's self-employment income and is subject to self-employment tax.

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