IRS has privately ruled that legal expenses and restitution paid by an S corporation on behalf of its employee for his failure to timely inform the government of a client corporation's ongoing criminal activities were deductible under Code Sec. 162(a). The expenses arose as a proximate result of the employee's ordinary business activities and were paid by Taxpayer under an indemnification clause, and their deduction wasn't barred by Code Sec. 162(f).
Background. Under Code Sec. 162(a), a taxpayer can deduct all the ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business. However, no deduction is available for personal expenditures, capital expenditures, or fines or similar penalties paid to a government for the violation of any law. Generally, amounts paid to settle lawsuits are currently deductible if the acts which gave rise to the litigation were performed in the ordinary conduct of the taxpayer's business.
The origin of the claim test, first set forth by the Supreme Court in U.S. v. Gilmore, (S Ct 1963) 11 AFTR 2d 758, 372 U.S. 39, controls how to distinguish deductible business expenses from personal or capital expenditures. Under this test, the substance of the underlying claim or transaction out of which the expenditure in controversy arose governs whether an item is deductible, regardless of the motives of the payor making the payment or the consequences that may result from the failure to defeat the claim.
Facts. An indirect owner/employee of Taxpayer provided various operational services to an investment corporation on Taxpayer's behalf. While providing such services, the employee became aware that the investment corporation was engaging in fraudulent investment activities. Taxpayer subsequently ceased providing services to the investment corporation, and the employee later notified the Office of the U.S. Attorney of the corporation's fraudulent activities. The government's investigation showed that the investment corporation in fact defrauded numerous clients and that neither Taxpayer nor the employee participated in this scheme, but the government also determined that the employee's notification to the U.S. Attorney was untimely. The employee was charged with, and ultimately pled guilty to, misprison (i.e., failure to timely inform the government of an ongoing felony and the concealment of such felony). The employee received a prison sentence and was held jointly and severally liable with the investment corporation for restitution equal to the investment corporation clients' losses resulting from the misprison. These amounts were paid by Taxpayer under an indemnification clause. Taxpayer and its employee also incurred legal fees in the ensuing civil actions that were brought against them.
Deduction allowed. IRS concluded that Taxpayer was entitled to deduct the legal expenses and restitution as ordinary and necessary business expenses. Applying the origin of the claim test, IRS determined that the employee's delay in reporting the investment corporation's illegal activities arose from his provision of operational services to the investment corporation on Taxpayer's behalf. Taxpayer was contractually obligated to indemnify the employee since these operational services were within the employee's normal course of business activities, so the restitution payments were considered valid business expenses. IRS also determined that the restitution payments were compensatory in nature, so Taxpayer's deduction wasn't barred by Code Sec. 162(f). The legal fees were similarly deductible since they were connected to Taxpayer's business activities and incurred to protect its corporate assets.
References: For deduction of legal expenses, see FTC 2d/FIN ¶L-2902; United States Tax Reporter ¶1624.040; TaxDesk ¶305,004; TG ¶16163. For origin of the claim doctrine, see FTC 2d/FIN ¶L-2501; TaxDesk ¶305,001; TG ¶16161.