Fifth Circuit: Settlement Payments Relating to Death of S Corp Owner's Girlfriend Aren't Deductible

(Parker Tax Publishing April 2019)

The Fifth Circuit affirmed a Tax Court decision holding that an S corporation could not deduct as an ordinary and necessary business expense settlement payments made, in part by the S corporation and in part by its sole shareholder, to avoid liability arising from the death of the sole shareholder's girlfriend. The Fifth Circuit also upheld the Tax Court's holding that the S corporation's reimbursement payment to the sole shareholder for his portion of the settlement was also nondeductible. Cavanaugh v. Comm'r, 2019 PTC 109 (5th Cir. 2019).

Background

James Cavanaugh is the CEO and sole shareholder of Jani-King International, Inc., an S corporation and a commercial janitorial-services franchisor. In 2002, Cavanaugh and his girlfriend, Claire Robinson, traveled to Cavanaugh's residence in St. Maarten accompanied by Jani-King employees Ronald Walker (Cavanaugh's bodyguard) and Erika Fortner (Cavanaugh's employee and former girlfriend). On November 28, 2002, Robinson died at the residence, likely of a cocaine overdose.

Robinson's mother, Linda Robinson, sued Cavanaugh and Jani-King for wrongful death. She alleged that Robinson's death was caused by Jani-King employees acting in the course and scope of their employment. Robinson alleged that Cavanaugh, Walker, and Fortner facilitated her daughter's access to, and ingestion of, cocaine, causing her death.

Jani-King and Robinson settled the lawsuit for $2.3 million. Cavanaugh paid $250,000 toward the settlement and Jani-King paid the remainder. Jani-King reimbursed Cavanaugh in full for the $250,000, then deducted the settlement and reimbursement payments as ordinary and necessary business expenses under Code Sec. 162. The IRS denied the deductions. Despite having paid $2.3 million to ostensibly avoid protracted litigation and the attendant negative publicity, Cavanaugh decided to fight for the deductions. Before the Tax Court, he contested the IRS's determination that the expenses did not qualify as ordinary and necessary business expenses.

Tax Court Decision

The Tax Court held that Jani-King could not deduct the payments. The court applied the rule in U.S. v. Gilmore, 372 U.S. 39 (1963) that the origin and character of the claim determines whether a payment is deductible. Under Gilmore, if the claim arises in connection with a taxpayer's profit-seeking activities, related expenses may properly be characterized as business expenses. The Tax Court found that the lawsuit did not arise in connection with Jani-King's profit-seeking activities and were therefore not deductible. The Tax Court also found that Jani-King was not obligated to reimburse Cavanaugh, Cavanaugh was not unable to cover his part of the settlement, and the reimbursement was not an ordinary and necessary business expense.

Cavanaugh appealed to the Fifth Circuit, arguing that Gilmore did not apply because it did not address a situation where a corporation is directly named in the underlying suit. Cavanaugh said that the court must give significant weight to a corporation's direct exposure to a monetary judgment, rather than examining the origin of the claim. He also argued that, if Gilmore applied, Jani-King's employees' actions must have arisen from profit-seeking activities because Jani-King engaged only in profit-seeking activities. Cavanaugh contended that all expenses incurred in defending a lawsuit based on a theory of respondeat superior (i.e., a party has vicarious liability for the acts of its agents) are deductible, even if the lawsuit has no connection to the corporation's profit-seeking activities, because the nexus with the business is the allegation that the employee is acting within the course and scope of his employment. Cavanaugh also argued that the reimbursement payment was deductible because it was in Jani-King's best interests to settle the lawsuit. He also said that indemnification was obligatory under the company's bylaws.

Fifth Circuit's Analysis

The Fifth upheld the Tax Court's denial of the deductions. First, the court found that Gilmore was binding on it and declined to follow cases in other circuits that conflicted with it. The court found that under Gilmore, simply being named in the Robinson lawsuit was insufficient to prove that Jani-King's expenses were deductible business expenses.

Applying Gilmore, the Fifth Circuit found that even when an underlying lawsuit alleges that employees acted within the course and scope of their employment, the court must determine whether their activities arose from or were connected to the corporation's profit-seeking activities. The court noted that Cavanaugh did not argue that providing cocaine to Robinson was done with a profit-seeking motive, nor did he argue that the alleged actions arose from, or were proximately related to, any specific Jani-King business activity.

The court also rejected Cavanaugh's argument that the expenses were deducible because the lawsuit was founded on respondeat superior. The court found that Cavanaugh provided no legal support for the argument and it conflicted with Gilmore and other cases. The court said that it had to look not only at whether the employees were acting within the course and scope of their employment but also at the allegation that they provided cocaine leading to Robinson's death. The origin of the claim, the court said, was the employees' providing cocaine, not their employment at Jani-King.

As to the reimbursement payment, the court found that although Cavanaugh asserted Jani-King was legally obligated to indemnify him, he did not argue that the requirements of the bylaws' indemnification provision were met and therefore waived that argument. The court also noted that when a corporation voluntarily pays a controlling shareholder's expense, the payment may be deductible as an ordinary and necessary business expense to "protect or promote" the business, and is more likely to be deductible where the shareholder cannot pay the expense and the corporation is protecting its own interests. In this case, Cavanaugh did not argue that the reimbursement was necessary to protect Jani-King's business, nor did he contend he was unable to make the payment.

For a discussion of the deductibility of S corporation legal and settlement fees, see Parker Tax ¶31,945.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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