Howard v. Commissioner , 22 B.T.A. 375 ( 1931 )

H. M. HOWARD, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Howard v. Commissioner

Docket No. 33271.

United States Board of Tax Appeals

22 B.T.A. 375; 1931 BTA LEXIS 2125;

February 26, 1931, Promulgated

---

A compromise payment to settle litigation and attorney fees paid in connection therewith, both growing out of and being incidental to petitioner's business dealings, are allowable deductions.

Frank J. Albus, Esq., for the petitioner.

W. Frank Gibbs, Esq., for the respondent.

---

VAN FOSSAN

This proceeding is brought to secure a redetermination of a deficiency of $38,678.13 in income taxes for the year 1923. The deficiency resulted from the disallowance by respondent of two deductions claimed by petitioner, - one for $90,000 paid to compromise and settle a lawsuit, and the other for $9,395.18 attorney fees paid by petitioner in connection with said litigation.

FINDINGS OF FACT.

About 1895 petitioner became associated with the Aetna Paper Company of Dayton, Ohio, and through this association became familiar with the entire industry of manufacturing paper. Some time prior to 1908 the petitioner became acquainted with Nathan Ebner, a dealer in rags for paper making. During 1918 it became known to petitioner that certain paper mill machinery could be purchased at a reasonable price from the receivers of a paper company in Denver, Colo., and at that time petitioner entered into negotiations with Ebner looking toward the purchase of this machinery and the establishment of a paper-manufacturing business. As a result of these negotiations a partnership agreement was drawn up between petitioner and Ebner in which it was agreed that they, as a partnership, would purchase the machinery and build a mill for the manufacture of paper. The agreement further provided that the liability of each partner should not exceed the sum of $35,000. After the machinery in question was purchased by petitioner and Ebner had contributed approximately $15,000 to the partnership funds, petitioner found that it would be impossible to build a mill for housing the machinery for the agreed sum of $70,000 provided in the partnership agreement. Upon being so advised by petitioner, Ebner indicated that he would not desire to increase his liability and it was decided by the partners that Ebner should withdraw his original investment and that taxpayer should have title to the machinery. A written agreement was entered into to this effect, Ebner executed a release to taxpayer, payments were made and the partnership dissolved.

After the dissolution of the partnership petitioner organized the Howard Paper Company, a corporation with capital stock of $500,000 with par value of $100 per share. Petitioner turned the machinery formerly owned by the partnership into the Howard Paper Company for its entire issue of capital stock and undertook the organization of the corporation and the securing of additional money for operation.

In April, 1909, petitioner agreed to contribute approximately 1,000 shares of the common stock of the Howard Paper Company to the corporation as surplus to be sold in order to obtain working capital. About 500 shares of the donated stock were sold to individuals at par. The remaining 500 shares of the stock were sold to Ebner for $25,000. The proceeds of the stock were turned over to the Howard Paper Company.

Shortly after acquiring the stock Ebner hypothecated his 500 shares with banks to secure loans. By November, 1916, Ebner owed the banks on account of such loans approximately $46,000. Payment being demanded by the banks, Ebner offered to sell to the petitioner his 500 shares of stock and the offer was accepted. By the terms of the agreement petitioner agreed, in consideration of the receipt of the 500 shares of stock, to satisfy the indebtedness of Ebner at the banks. This transaction was consummated and petitioner paid Ebner's indebtedness at the banks and received the stock.

On January 26, 1917, Ebner and petitioner agreed to a complete release of all liability on the part of the petitioner to Ebner in consideration of the waiving of a certain claim held by petitioner.

At about the same time that petitioner purchased Ebner's stock he also acquired stock of the Howard Paper Company held by other persons, paying par therefor.

From 1917 to 1920 petitioner and Ebner had no active business relations, but during November, 1920, Ebner filed a suit against the taxpayer, H. Maxwell Howard, William H. Clark, Lucius S. Howard and the Howard Paper Company, alleging misrepresentation and conspiracy in the conduct of the business of the corporation.

Answer of taxpayer was duly filed and the case came on for trial on October 15, 1923. Before trial was had the parties, through their respective attorneys, agreed upon a compromise settlement whereby petitioner Howard paid Ebner the sum of $90,000 in full settlement and discharge of any and all liability or obligation involved in said lawsuit or arising from their former relations.

Petitioner also paid attorneys' fees amounting to $9,395.18 in connection with legal services incident to the preparation for and settlement of the litigation. In his tax return for 1923 petitioner deducted both amounts as ordinary and necessary expenses, which items were disallowed by the Commissioner and added to the taxable income for said year.

OPINION.

VAN FOSSAN: We are of the opinion that petitioner should be sustained as to both deductions. The litigation, to terminate which petitioner made a compromise payment of $90,000, and the legal fees incident thereto, grew directly out of the business dealings between Howard and Ebner. The facts bring the case squarely within the ruling of the Supreme Court in Kornhauser v. United States,276 U.S. 145">276 U.S. 145. In that case attorney fees incurred incident to an accounting demanded by a former partner were allowed as a business expense. The Court rejected the suggestion that they were personal expenses and after referring to certain departmental rulings and F. Meyer & Brother Co.,4 B.T.A. 481">4 B.T.A. 481, where a legal expenditure made in defending a suit for an accounting and damages resulting from an alleged patent infringement was held deductible as a business expense, observed:

The basis of these holdings seems to be that where a suit or action against a taxpayer is directly connected with, or, as otherwise stated (Appeal of Backer,1 B.T.A. 214">1 B.T.A. 214, 216), proximately resulted from, his business, the expense incurred is a business expense within the meaning of section 214(a), subd. 1, of the act. These rulings seem to us to be sound and the principle upon which they rest covers the present case. If the expense had been incurred in an action to recover a fee from a client who refused to pay it, the character of the expenditure as a business expense would not be doubted. In the application of the act we are unable to perceive any real distinction between an expenditure for attorney's fees made to secure payment of the earnings of the business and a like expenditure to retain such earnings after their receipt. One is as directly connected with the business as the other.

Incidentally, it is noted that the notice of the deficiency in this@ case cites as an authority for the disallowance Treasury Decision 3964, which was a verbatim statement of the decision of the Court of Claims holding the legal expenses in the Kornhauser case to be personal expenses and not an allowable deduction. After the Supreme Court reversed the Court of Claims and held as above indicated, there was issued Treasury Decision 4222 quoting the Supreme Court's opinion and stating that Treasury Decision 3964 is reversed.

Though the Kornhauser case involved only legal fees, we believe the reasoning employed applies equally to the compromise payment made to settle the lawsuit. This expense grew directly out of, and proximately resulted from, the business dealings between the parties. It did not result in the acquisition of any capital assets. See Louisiana Jockey Club, Inc.,13 B.T.A. 752">13 B.T.A. 752; Superheater Co.,12 B.T.A. 5">12 B.T.A. 5; A. King Aitkin,12 B.T.A. 692">12 B.T.A. 692. Nor do we believe it important that petitioner, in his individual capacity, paid the entire sum though other persons were named as parties defendant. Petitioner was the real party in interest, the one who stood to suffer most. See E. L. Potter,20 B.T.A. 252">20 B.T.A. 252; and Edward A. Pierce,18 B.T.A. 447">18 B.T.A. 447.

Judgment will be entered under Rule 50.