Thursday, July 7, 2011

CEO Could Deduct Legal Fees Incurred In Defending Against Suit By Disgruntled Investor

Ramig, TC Memo 2011-147

The Tax Court has concluded that a chief executive officer (CEO), who was also a board member and minority shareholder, could deduct legal fees in defending against charges that he made misrepresentations to an investor in the company. The legal fees were deductible under Code Sec. 162 as the ordinary and necessary expenses of his business of rendering services to his company as an employee.

Background. Under Code Sec. 162(a), a taxpayer is allowed to deduct ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business. The performance of services as an employee can be a trade or business for purposes of Code Sec. 162. (Biehl v. Comm., (2002) 118 TC 467, affirmed (CA 9 2003) 92 AFTR 2d 2003-7280)

The Supreme Court has said that a taxpayer can deduct litigation expenses incurred in defending a lawsuit if the suit arises in connection with or proximately results from the taxpayer's business. (U.S. v. Gilmore, (S Ct 1963) 11 AFTR 2d 758) Whether legal fees incurred in defending a lawsuit arose from a taxpayer's business depends on whether the underlying legal claim originated from that business (i.e., the origin of the claim test). If the legal claim arose from the taxpayer's business, the legal fees are deductible regardless of whether the taxpayer was still conducting that business when the fees were incurred. (Ostrom, (1981) 77 TC 608)

Facts. John Ramig, an attorney and entrepreneur, with several others formed shoeS4Work, a business that used the internet to sell safety footwear. Ramig was CEO, a board member, and a minority shareholder.

Unfortunately, shoeS4Work was unable to raise enough capital and never achieved profitability. It stopped operations and liquidated most of its tangible assets.

Shortly before shoeS4Work shut down, an investor, Jeannie Lay, and her wholly owned company, Hecate, LLC, sued shoeS4Work. Her complaint named Ramig, shoeS4Work, and five other members of its board of directors as codefendants. Lay alleged that Ramig made misrepresentations to persuade her to invest in shoeS4Work and that its board failed to adequately supervise Ramig. Eventually, Ramig won the suit but incurred over $13,000 in legal fees in 2004 and 2005.

Parties' positions.
Ramig claimed that he was entitled to deduct the legal fees that he incurred to defend himself from the lawsuit as ordinary and necessary business expenses. On the other hand, IRS argued that the suit was against Ramig personally—not as CEO of shoeS4Work—and that the expenses of defending the suit were therefore unrelated to the conduct of a trade or business.

Court's conclusion. The Tax Court held that Ramig was entitled to deduct the legal fees under Code Sec. 162(a). The Court found that the claim against Ramig arose from his business of performing services for shoeS4Work as an employee. The complaint alleged that he, as CEO of shoeS4Work, made misrepresentations and omitted facts about the company to persuade Lay to buy shares. It further alleged that the other board members were liable because they failed to properly supervise his activities.

In reaching this conclusion, the Court looked to the Ostrom case. There, a taxpayer's legal expenses in defending a claim were held to be deductible because they arose from his misrepresentations of the company's financial status made while performing his duties as the company's president and general manager. Similarly, the Tax Court found that Ramig's expenses were deductible under Code Sec. 162 as expenses of his business of rendering services to shoeS4Work as an employee.

References: For deduction of legal expenses, see FTC 2d/FIN ¶L-2902; United States Tax Reporter ¶1624.040; TaxDesk ¶305,004; TG ¶16163. For the origin of the claim doctrine, see FTC 2d/FIN ¶L-2501; TaxDesk ¶305,001; TG ¶16161.

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