DocketNumber: Docket No. 30825-09.
Citation Numbers: 104 T.C.M. 610, 2012 Tax Ct. Memo LEXIS 325, 2012 T.C. Memo. 324
Judges: HOLMES
Filed Date: 11/26/2012
Status: Non-Precedential
Modified Date: 4/17/2021
Decision will be entered under
HOLMES,
*325 She did not return home alive.
The coroner's report showed a massive amount of illegal drugs in her body and concluded that they were the likely cause of her death. Robinson's mother sued the boyfriend and his company for wrongful death. The parties settled. The company paid most of the $2.3 million settlement directly; the boyfriend contributed $250,000, which the company then reimbursed. The company then claimed the entire $2.3 million as a deduction, along with nearly $180,000 in related legal fees. The boyfriend's company is a corporation that elected long ago to have its income and deductions flow through to its owner's individual return. The parties have settled every other issue in the case, but the Commissioner is not willing to concede the deductibility of the settlement or the company's reimbursement *326 of the boyfriend's contribution.
James Cavanaugh is the CEO and sole shareholder of Dallas-based Jani-King International, Inc., which he founded in 1969 and has built into one of the most successful janitorial-services franchisors in the world. For the 2002 Thanksgiving holiday, Cavanaugh decided to rest from his entrepreneurial chores by going on a vacation to the Caribbean with Robinson. They traveled to Cavanaugh's villa in St. Maarten and were accompanied by Cavanaugh's *326 bodyguard, Ronald (Rock) Walker, 1 and Erika Fortner, another Jani-King employee. The parties agree that the trip was for pleasure and not to conduct or further any Jani-King business. On November 28, Robinson suffered fatal cardiac arrest after ingesting a large amount of cocaine.
In August 2003 Robinson's mother, Linda Robinson, sued both Cavanaugh and Jani-King in Texas state court. She sought damages for the wrongful death of her daughter, *327 but by the time she filed the final version of her complaint it had sprouted causes of action for negligence, assault and battery, conspiracy, premises liability, strict liability, strict products liability, negligence
The Jani-King board of directors called a special meeting in September 2004. *328 Cavanaugh insisted that the case was frivolous, but also said he was willing to contribute $250,000 to settle it. He then recused himself from the meeting to allow the board to discuss the matter. (Cavanaugh was only one of Jani-King's four directors, but he was its sole shareholder and had the power to remove any director for any reason.) Jani-King's lawyers agreed with Cavanaugh that both he and the corporation would likely win the case. The lawyers nevertheless warned that juries are unpredictable and Jani-King's reputation could be soiled if the case dragged on or became more notorious. According to the board minutes, the remaining directors were quite worried about losing the case, and worried even more that Jani-King franchisees would jump in for a second helping of litigation if they thought Robinson's suit would hurt their own businesses. As a corporate franchisor, Jani-King's income depends on a stream of royalties, so this is plausible, but we do note that the minutes don't elaborate the extent or specific *328 bases of the directors' anxiety. 3*329 The Board then approved a settlement of up to $5 million, in addition to Cavanaugh's contribution.
The case trudged forward until August 2005, when Linda Robinson settled it for $2.3 million payable over two years. 4*330 Cavanaugh contributed $250,000, which Jani-King promptly reimbursed; in the end he paid nothing in his individual capacity to settle the case. And Jani-King on its 2005 and 2006 tax returns deducted the settlement amount (including the amount it reimbursed Cavanaugh) along with its own attorney's fees as ordinary and necessary business expenses.
In 2009 Cavanaugh received a notice of deficiency that raised numerous issues. The parties settled them all, except for the disallowance of deductions for the settlement payments and legal fees relating to the Robinson suit and its settlement. That issue was headed for trial in Dallas (Cavanaugh resided in Texas*329 when he filed his petition) when the parties agreed to submit it for decision under
Their failure to settle these issues is entirely understandable. From Cavanaugh's perspective, it is an unfortunate fact of business life that corporations and prominent individuals get sued, sometimes on dubious facts and theories of liability. Settling such suits may be distasteful, but even a small chance of an enormous payout may justify a deal that protects assets from the uncertainty of litigation and protects a business reputation from scandal.
The Commissioner has a different view—he argues that however jumbled and wrinkly the legal topography created by the collision of Code, regulations, and caselaw may sometimes seem, it cannot possibly hide a crevice dark enough to successfully *331 shelter an argument that the price paid for the death of the boss's girlfriend is a deductible corporate business expense.
We must figure out two separate puzzles. We must first decide whether Jani-King can deduct its share of the settlement payments and the legal fees related to the lawsuit and settlement. Then we must decide if Jani-King can deduct Cavanaugh's $250,000 indemnification payment. We discuss each issue in turn.
Under • paid or incurred during the tax year, • "ordinary", • "necessary", and • a "business" expense.
It's section 162's last requirement—that the deduction be a "business", in contrast to a "personal", expense—that is the key issue. In the context of legal expenses and costs, the question usually turns on the "origin and character of the *331 claim" underlying the legal controversy.
Cavanaugh's first argument is that
In
The company settled and deducted its share of the settlement and legal fees. The Fourth Circuit agreed *333 that it could, because the company was named in the suit and the company had "direct exposure to the risk of a monetary judgment."
And Cavanaugh is also correct that *334 we ourselves have cited
This carries us back to
The Supreme Court also told us to focus on origins and not consequences in cases where the question wasn't whether an expense was deductible, but whether an expense was deductible or had to be capitalized. In
We synthesized these holdings in
We've often cited
We have elsewhere called the test a "totality of the circumstances" test or looked at the "circumstances out of which the litigation arose."
The deductibility of Jani-King's portion of the settlement and its legal fees turns both on what the "claim" was and whether its "origin" lay in Jani-King's business.
Neither party disputes the "claim" here: Linda Robinson's *340 suit against Jani-King and Cavanaugh. They differ markedly, however, about the origin of that claim. Cavanaugh argues that its origin is Linda Robinson's contention that Jani-King killed Robinson by negligently allowing its employees to provide illegal drugs to her. The Commissioner disagrees and sees the origin of the claim simply as Robinson's death.
We agree with Cavanaugh that the Commissioner's view is one link too far down the chain
But just because we find that the origin of Linda Robinson's claim lay in the conduct of the Jani-King employees doesn't mean that Jani-King may deduct the settlement costs and legal expenses. We must also identify whether this conduct arose from Jani-King's profit-seeking activities.
The Commissioner argues that the parties stipulated that the trip to St. Maarten involved no business conduct, and that this fact alone means that he should win. Cavanaugh argues that tort claims against company employees are nearly certain to arise in business today, and that this makes them proximately related to undertaking business operations. But Cavanaugh cites no authority to support such a broad assertion.
Cavanaugh could have tried to analogize to cases that he and the Commissioner cite for other propositions, and where we allowed deductions for the costs of litigation. *342 • *339 • • • • •
Each of these cases, however, involves using property actively employed in the company's
Jani-King is a franchisor *343 of cleaning businesses. Even if Jani-King employees gave Robinson the drugs that killed her, Cavanaugh hasn't shown how those actions arose from, furthered, or used property directly employed in, Jani-King's franchising business. That makes this case a lot like
That court reasoned *344 that none of the telephone company's actions involved its "profit-making activities."
In this case, Jani-King employees were engaged in non-profit-seeking activities that did not arise from or further Jani-King's business, and were far from any company property. 7*345 We therefore hold that Jani-King's settlement costs and legal fees are personal costs and not deductible.
Rock Walker's conduct might present a closer question. Jani-King employed him as a bodyguard, and it's conceivable that Jani-King determined his security duties furthered its business objectives.
We *347 therefore conclude that none of the Jani-King employees' conduct that Thanksgiving weekend, whether proven or alleged, arose from Jani-King's profit-*343 seeking activities. Jani-King, therefore, cannot deduct the settlement costs or legal fees.
Cavanaugh agreed to contribute $250,000 to the settlement payment from his personal funds. Jani-King reimbursed *348 him in full for this amount, and then deducted the payment as an ordinary and necessary business expense. We must figure out if this deduction is appropriate, 10 either because Jani-King was legally obliged to reimburse Cavanaugh, or as a voluntary payment with a sufficient business purpose.
A corporation's payment of its own contractual obligations—even indemnification obligations—is generally an ordinary and necessary payment.
But we don't have to explain very much about the general rule about required reimbursements or its exceptions, because in this case we don't even think the reimbursement was required. Article 9 of the bylaws requires indemnification of any current or former "Director, officer or employee" of Jani-King for "any and all liability and reasonable expense" stemming from "any claim, action, suit or proceeding"—but only where that person became involved in the controversy "by reason of being or having been such a Director, officer or employee." It also *345 conditions indemnification on the person having acted in "good faith" and in his "reasonable" belief that he acted in accordance with Jani-King's best interests at the time.
If a person meets these requirements, and is "wholly successful" in his defense, he is entitled to indemnification as a "matter of right." If he is only partially successful in the controversy, his indemnification is discretionary upon either the Board's or independent legal counsel's determining that he has otherwise *350 met the remaining standards. Cavanaugh submitted no evidence that either of these determinations was made, hasn't argued that he was "wholly successful" in his defense of the Robinson suit, and didn't explain how he met the remaining requirements for indemnification. Given this lack of proof, we find that Jani-King wasn't required to reimburse Cavanaugh for his portion of the settlement costs, and
Even a taxpayer's voluntary payments may sometimes be deductible, however, if made to protect or promote his business.
In
Like the taxpayers in
But this isn't the only reason the payment is nondeductible. Quite apart from Cavanaugh's ability to pay is that
Capital Video, his corporation, paid all his legal fees and costs, and then tried to deduct these expenses. The First Circuit agreed with this Court and the Commissioner that they weren't deductible. Capital Video's reliance on its own business judgment in paying the expenses was not enough; what was necessary was that the "origin of the expense * * * arose in connection with, or proximately resulted from, Capital Video's business activities" and that Capital Video hadn't shown that its shareholder's tax conspiracy was a necessary part of the mob tribute scheme or of Capital Video's business.
Cavanaugh's portion of the settlement arose from *354 his personal, not his business, activities that fateful Thanksgiving holiday. Jani-King's $250,000 deduction also fails under
*349 This would normally be enough, but the Commissioner does make one more argument that's worth some mention. He correctly points out that we noted in
*350 For an S corporation that does have accumulated earnings and profits, a shareholder distribution is more complicated. The amount of a distribution that exceeds the corporation's accumulated adjustment account (AAA) is a dividend—but only to the extent it does not exceed the S corporation's accumulated E&P.
When Jani-King reimbursed Cavanaugh $250,000 in 2005 its reported AAA was nearly $6.4 million. But the Commissioner introduced no evidence of Jani-King's accumulated E&P or Cavanaugh's basis in his Jani-King stock, which leaves us with no grounds to decide if the distribution is a constructive dividend.
*351 The Commissioner bears the burden of proof *356 on this issue. 14 The parties settled numerous other issues, so
1. Though Walker's various "security" duties appear to be wholly focused on Cavanaugh, Walker was technically employed by Jani-King. Cavanaugh provides us no evidence regarding Walker's duties for Jani-King, and but the faintest sketch of what Walker did for him personally.↩
2. Over the course of amending her complaint, Linda Robinson detailed her daughter's relationship with Cavanaugh. She alleged that Cavanaugh preyed on young women, including Robinson's older sister, plied them with drugs, controlled their every move, and forced them to participate in diverse debauchery—helped along by his "vice man" Rock Walker and other Jani-King employees.↩
3. Cavanaugh introduced no other evidence regarding Jani-King's fear of being sued by its franchisees for publicity fallout from the Robinson litigation.
4. Jani-King is an S corporation, and so doesn't pay taxes itself.
5. Much of the caselaw in this area arises, like
6. This makes sense: Since the underlying suit settled, the facts that could have made Jani-King liable never got established, and no factfinder ever passed on the merits of Robinson's claims. To reach the unestablished merits of a case in our Court punishes those parties who settle rather than litigate, which isn't in anyone's interest. Robinson's claims aren't frivolous on their face: Under Texas law, the crucial issue of whether Cavanaugh, Walker, and Fortner were acting within the scope of their employment is a jury question.
7. We withhold judgment on facts similar to those in
8. We also have no factual basis in the settlement agreement (or any other document) to allocate a portion of the settlement only to Walker's conduct, which is what we would have to do to sustain the deduction because of his actions alone.↩
9. Cavanaugh hasn't argued that he can deduct the expenses personally.
10. Cavanaugh could have argued that the payment should be deductible by Jani-King as salary compensation to him, but he hasn't.
11. Since
12.
13. Under Subchapter C of the Code, the net income of a C corporation is taxed first at the corporate level, and a second time at the individual level when the corporation's shareholders receive distributions of those profits in the form of dividends.↩
14. He raised this issue for the first time in his brief. And it's an issue whose proof would require new evidence—whether a constructive dividend exists requires proof of Jani-King's accumulated earnings and profits and Cavanaugh's basis in his Jani-King stock. This makes it a new "matter", in contrast to a new "theory", which is simply a new argument about existing evidence.
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H. H. Helgerson and D. F. Helgerson v. United States of ... , 426 F.2d 1293 ( 1970 )
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Jack's Maintenance Contractors, Inc. v. Commissioner of ... , 703 F.2d 154 ( 1983 )
Prentiss M. Brown, Jr., and Margaret D. Brown v. United ... , 526 F.2d 135 ( 1975 )
loftin-and-woodard-inc-k-c-loftin-and-marie-loftin-e-a-woodard-and , 577 F.2d 1206 ( 1978 )
Welch v. Helvering , 54 S. Ct. 8 ( 1933 )
Lykes v. United States , 72 S. Ct. 585 ( 1952 )
United States v. Gilmore , 83 S. Ct. 623 ( 1963 )
Commissioner v. Tellier , 86 S. Ct. 1118 ( 1966 )
Woodward v. Commissioner , 90 S. Ct. 1302 ( 1970 )
Commissioner v. Lincoln Savings & Loan Ass'n , 91 S. Ct. 1893 ( 1971 )