Sky M. Lucas v. Commissioner

T.C. Memo. 2018-80UNITED STATES TAX COURT
SKY M. LUCAS, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 24111-16. Filed June 11, 2018.
Kevin Noel Kemp, for petitioner.
Rose E. Gole and Gennady Zilberman, for respondent.
MEMORANDUM OPINION
VASQUEZ, Judge: In this case, respondent determined a deficiency in
petitioner’s Federal income tax of $1,760,709 for 2010.
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[*2] After concessions,1 the remaining issue for decision is whether petitioner is
entitled to a deduction for legal and professional fees for the 2010 and 2011 tax
years.2
Background
The parties submitted this case fully stipulated under Rule 122.3 Our
findings of fact consist of the stipulated facts and facts drawn from the stipulated
exhibits. The stipulation of facts, the supplemental stipulation of facts, and the
attached exhibits are incorporated herein by this reference. Petitioner resided in
New Hampshire at the time the petition was filed.
1
The parties filed two stipulations of settled issues, in which they made
several concessions for 2010 and for several years not in issue. See infra note 2.
Because it is unclear how these concessions will affect the calculation of the 2010
deficiency, we will require a Rule 155 computation.
2
The notice of deficiency makes adjustments to petitioner’s returns for tax
years 2009, 2010, 2011, and 2012 but determines a deficiency only for 2010.
Because respondent’s adjustments have not resulted in any deficiencies for 2009,
2011, or 2012, we do not have jurisdiction over those years. See Martz v.
Commissioner, 77 T.C. 749 (1981). However, part of petitioner’s 2010 deficiency
is attributable to adjustments to petitioner’s 2011 net operating loss. We may
compute the correct tax liability for a year not in issue when such a computation is
necessary to determine the correct tax liability for a year that has been placed in
issue. Lone Manor Farms, Inc. v. Commissioner, 61 T.C. 436, 440 (1974), aff’d,
510 F.2d 970 (3d Cir. 1975).
3
Unless otherwise indicated, all section references are to the Internal
Revenue Code in effect for the year in issue, and all Rule references are to the Tax
Court Rules of Practice and Procedure.
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[*3] I. Vicis Capital, LLC
Petitioner formed Vicis Capital, LLC (Vicis), with two other partners in
2004; each partner owned a one-third interest. Vicis was an investment adviser for
several funds (Vicis Funds) including Vicis Capital International Fund
(International Fund). The Vicis Funds paid Vicis a management fee of 1.5% of
assets under management per annum. Vicis also received performance fees equal
to 20% of profits earned by the Vicis Funds during the year. Between February
2005 and December 2008, Vicis’ assets under management grew from
approximately $290 million to approximately $5.6 billion.
Under its advisory agreement with the International Fund, Vicis could elect
to defer all or a portion of the management and performance fees payable by the
International Fund for payment in subsequent years. If Vicis elected to defer
management or performance fees, the deferred fees were invested in the
International Fund portfolio, and the amount of the deferred fees ultimately
distributed would depend on the performance of the portfolio from deferral until
distribution. Vicis elected to defer a portion of its International Fund performance
fees for each of 2006, 2007, and 2008.
Vicis’ fortunes changed after the onset of the 2008 financial crisis. From
December 2008 through September 2009, investors in the Vicis Funds requested
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[*4] approximately $3 billion in redemptions. Vicis began liquidating its portfolio
in September 2009, and Vicis’ principals decided to wind down operations in
January 2010. Vicis’ deferred payment plan with the International Fund
terminated in February 2010, and the deferred performance fees were distributed
to Vicis. As of September 27, 2010, the Vicis convertible portfolio was
completely liquidated.
II. Petitioner’s Divorce
Petitioner and his former wife, Margaret Lucas, were married on July 2,
1994. Ms. Lucas filed for divorce on January 28, 2008. Between the date of the
divorce filing and the date the divorce was granted, petitioner received
$48,723,169 in distributions from Vicis.4 While the divorce action was pending,
petitioner was not involved with any business or employment activity other than
Vicis.
The largest issue in the divorce was the valuation and equitable distribution
of petitioner’s interest in Vicis including the nearly $47 million in distributions
4
The parties to the divorce stipulated that $2 million of this amount
constituted a loan from Vicis; net distributions totaled $46,723,169.
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[*5] made to petitioner.5 Ms. Lucas argued that the distributions were part of the
marital estate even though petitioner received them after she had filed for divorce.
A final divorce hearing was held from April 18 through 21, 2011. The
Family Division of the Circuit Court of Pinellas County, Florida (circuit court),
determined that Vicis was without a fair market value at the time of the trial and
valued petitioner’s interest in Vicis at $5,095,000 as of the divorce filing date.
The circuit court found that, of the nearly $47 million in distributions,
approximately $4.7 million represented deferred compensation attributable to
petitioner’s predivorce earnings and was a marital asset subject to equitable
distribution. The circuit court held that the remaining amount of the distributions
was a nonmarital asset and therefore not subject to equitable distribution. After
determining that the total marital estate was worth $15,522,158, the circuit court
awarded Ms. Lucas their Belleair, Florida, property and an equalizing cash
payment of $6,676,412.
As a result of these proceedings, petitioner paid several million dollars of
legal and professional fees.6 On his 2010 Schedule A, Itemized Deductions,
5
Neither Vicis nor the International Fund were parties to the divorce suit.
6
Petitioner hired a law firm to represent him in the divorce. He also hired a
consulting group and an expert witness to help resolve the valuation issues
(continued...)
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[*6] petitioner deducted legal and professional fees of $1,337,158. For 2011
petitioner deducted legal and professional fees of $1,644,261 on his Schedule E,
Supplemental Income and Loss. The parties have stipulated that these amounts
were incurred by petitioner with respect to issues related to Vicis in the divorce.
On August 12, 2016, respondent timely issued a statutory notice of
deficiency for 2010. Respondent determined a deficiency of $1,760,709,
disallowing, in part, deductions for petitioner’s nonbusiness bad debts and
miscellaneous itemized deductions. Respondent also disallowed, in part,
petitioner’s claimed deduction for Schedule E expenses for 2011. Petitioner
timely petitioned this Court.
Discussion
I. Burden of Proof
As a general rule, the Commissioner’s determination of a taxpayer’s liability
in a notice of deficiency is presumed correct, and the taxpayer bears the burden of
proving that the determination is incorrect.7 Rule 142(a); Welch v. Helvering, 290
6
(...continued)
concerning his interest in Vicis.
7
Petitioner does not contend that the burden of proof should be shifted to
respondent pursuant to sec. 7491(a), and there is no justification on this record for
doing so. See Higbee v. Commissioner, 116 T.C. 438, 442-443 (2001).
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[*7] U.S. 111, 115 (1933). Deductions are a matter of legislative grace, and the
taxpayer ordinarily bears the burden of proving entitlement to any deduction
claimed. Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992);
New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).
II. Deductions for Legal and Professional Fees
Petitioner claimed deductions for legal and professional fees for both 2010
and 2011. Petitioner argues that he is entitled to deductions for these fees under
section 162(a) because they were paid to defend a claim for profits earned in his
trade or business. Petitioner implicitly argues that he is entitled to these
deductions under section 212 if section 162 does not apply.
Respondent contends that petitioner cannot claim deductions for the legal
and professional fees under either section 162(a) or section 212 because they are
nondeductible personal expenses under section 262. For the following reasons,
we sustain respondent’s determination.
Section 162(a) governs the deductibility of litigation costs as a business
expense. Section 162(a) allows an individual to deduct all of the ordinary and
necessary expenses of carrying on his or her trade or business. Section 212
governs the deductibility of litigation costs as an itemized deduction, when the
costs are incurred as a nonbusiness profit-seeking expense. Section 212 allows an
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[*8] individual to deduct all of the ordinary and necessary expenses paid or
incurred in: (1) producing income, (2) managing, conserving, or maintaining
property held for the production of income, or (3) determining, collecting, or
refunding any tax. Sections 162(a) and 212 are considered in pari materia, except
for the fact that the income-producing activity of the former section is a trade or
business whereas the income-producing activity of the latter section is a pursuit of
investing or other profit-making that lacks the regularity and continuity of a
business.8 See Woodward v. Commissioner, 397 U.S. 572, 575 n.3 (1970); United
States v. Gilmore, 372 U.S. 39, 44-45 (1963); Bingham’s Tr. v. Commissioner,
325 U.S. 365, 374-375 (1945). No deduction is allowed with respect to personal,
living, or family expenses. Sec. 262.
In Gilmore, 372 U.S. at 48, the Supreme Court held that whether legal fees
are deductible expenses or nondeductible personal expenses depends upon
8
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 to a
deduction under sec. 162(a), vis-a-vis a deduction under sec. 212, rests on each
deduction’s effect on gross income and adjusted gross income. A deduction under
sec. 162(a) is subtracted in full from gross income to arrive at adjusted gross
income. A deduction under sec. 212 is subtracted from adjusted gross income 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. Guill v. Commissioner, 112 T.C.
325, 328-329 (1999); see also sec. 56(b); Benci-Woodward v. Commissioner, T.C.
Memo. 1998-395.
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[*9] whether the claim arises in connection with the taxpayer’s profit-seeking
activities or his personal activities. Under this “origin of the claim” test, the Court
held that legal expenses paid to defeat claims arising from a marital relationship
were personal and nondeductible. Id. at 51-52. The Court noted that it is
irrelevant whether the taxpayer’s income-producing property would be affected by
the outcome of the divorce proceeding. See id. at 48. For ascertaining the source
of claims giving rise to legal expenses, we apply a “but for” test. See Fleischman
v. Commissioner, 45 T.C. 439, 446 (1966). If the claim could not have existed but
for the marriage relationship, the expense of defending it is a personal expense and
not deductible. See id.To be sure, a deduction for legal expenses is not necessarily precluded
because the taxpayer’s underlying claim arose in a divorce action. Barry v.
Commissioner, T.C. Memo. 2017-237. The regulations provide a limited
exception under section 212 for divorce-related legal fees incurred for the
production or collection of taxable alimony income. See Wild v. Commissioner,
42 T.C. 706, 710-711 (1964); sec. 1.262-1(b)(7), Income Tax Regs. The legal
costs of securing rights to other forms of income are also deductible. See Hahn v.
Commissioner, T.C. Memo. 1976-113 (allowing a section 212 deduction for legal
fees relating to obtaining possession of, and income rights to, a corporation
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[*10] already owned by the taxpayer). A taxpayer may also deduct legal fees
incurred to resist actions by the taxpayer’s ex-spouse that interfere with the
business activities of the taxpayer’s corporation. See Liberty Vending, Inc. v.
Commissioner, T.C. Memo. 1998-177.
On the record before us, it is clear that but for her marriage to petitioner,
Ms. Lucas would have no claim to petitioner’s interest in Vicis. Ms. Lucas’ claim
to the Vicis distributions stemmed entirely from her marriage to petitioner. Thus,
under Gilmore, the legal and professional fees paid by petitioner are personal and
not deductible.
Petitioner argues that facts in this case are similar to those in Hahn, in which
we held that the taxpayer’s legal fees were deductible. We disagree. In Hahn, the
taxpayer’s deductible legal fees were incurred securing income from jointly owned
property over which her ex-husband had taken possession. As we explained in
Barry v. Commissioner, T.C. Memo. 2017-237, the Hahn taxpayer’s deductible
legal fees were business connected. In contrast petitioner’s legal fees had no
connection to Vicis’ investment advisory business. They were incurred defending
petitioner’s Vicis ownership and distributions from equitable distribution in a
divorce action.
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[*11] Petitioner has not demonstrated that the expenses are otherwise deductible
under section 162(a) or section 212. In the divorce action at issue, petitioner was
neither pursuing alimony from Ms. Lucas nor resisting an attempt to interfere with
his ongoing business activities. Cf. Liberty Vending, Inc. v. Commissioner, T.C.
Memo. 1998-177; sec. 1.262-1(b)(7), Income Tax Regs. Furthermore, petitioner
engaged in little trade or business activity during 2010 and 2011. Vicis began
liquidating its portfolio in September 2009 and thereafter petitioner was not
engaged in any business activity other than a limited management role with Vicis.
Petitioner has not established that Ms. Lucas’ claim related to the winding down
of Vicis. Nor has petitioner established that the fees he incurred to defeat her
claim were “ordinary and necessary” to his trade or business. We therefore sustain
respondent’s disallowance of petitioner’s deductions for legal and professional
fees for 2010 and 2011.
In reaching all of our holdings herein, we have considered all arguments
made by the parties, and to the extent not mentioned above, we find them to be
irrelevant or without merit.
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[*12] To reflect the foregoing,
Decision will be entered
under Rule 155.