Legal Fees Incurred for Criminal Defense Were Deductible Business Expenses

(Parker Tax Publishing September 2024)

The Tax Court held that a taxpayer who incurred $365,735 in legal expenses defending himself against a criminal indictment for wire fraud and money laundering was allowed to deduct the expenses as ordinary and necessary business expenses under Code Sec. 162(a) because they were incurred in the defense of a criminal case involving two entities directed by the taxpayer. The court found that although there was some doubt as to whether one of the entities was a legitimate business, the charges against the taxpayer involved transactions that were made between the entities and the taxpayer and therefore, the origin of the legal fees stemmed from the taxpayer's profit-seeking activities. Chang v. Comm'r, T.C. Summary 2024-18.

Background

Jonathan Chang and Wei-Lin Chang were members of Home of Christ 4 Church (HOC4) in Saratoga, California. Around 2001 Jonathan became an elder at HOC4 and took on financial responsibilities which included managing donations and donors. At the time, Jonathan worked at VIA Technologies, Inc., and served as a board director at S3 Graphics, Inc. (S3 Graphics).

In 2004 Jonathan helped set up two entities. HOC Associates, Inc. (HOCA Inc.), was incorporated for the purpose of "Christ-centered ministries, church purposes, [to] administer and support religious activities, seminary activities, evangelical missions and Christian services." The Changs were appointed directors of HOCA Inc. in 2005. HOCA Inc. was granted tax-exempt status under Code Sec. 501(c)(3).

HOC Associates, LLC (HOCA LLC), was formed as a for-profit limited liability company and engaged in the business of "strategic planning and development," which included the acquisition of rental property and the receipt of rental income. Jonathan was the sole member of HOCA LLC. S3 Graphics lent HOCA LLC $3 million. HOCA LLC's offices were at Jonathan's home. Jonathan maintained the records of the business. He did not have a real estate license.

In 2016, Jonathan Chang was indicted and charged with multiple counts including conspiracy to commit wire fraud, wire fraud, conspiracy to commit money laundering, and money laundering. The charges involved transactions to and from HOCA Inc., HOCA LLC, and Jonathan's personal account. In 2019, a jury found Jonathan guilty of four counts of wire fraud and three counts of money laundering.

Jonathan retained legal representation to assist him in the criminal case. During 2019 the Changs incurred legal expenses of $365,735. This included attorney fees, expert witness fees, translator fees, and other miscellaneous expenses. The fees were paid from the Changs' personal account, not from the HOCA Inc. account or HOCA LLC account.

The Changs filed Form 1040, U.S. Individual Income Tax Return, for the year at issue. The Changs reported on HOCA LLC's Schedule C, total legal and professional services expenses of $367,429 for 2019. In a 2021 notice of deficiency, the IRS determined a deficiency and disallowed all of the reported legal and professional expenses for the year at issue. The Changes took their case to the Tax Court.

Deductibility of Legal Fees as Business Expenses

Code Sec. 162(a) allows a deduction for all ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business. An ordinary and necessary expense is one which is appropriate and helpful to the taxpayer's business and results from an activity that is common and accepted practice in the business. A taxpayer claiming a deduction must show that a reported business expense was incurred primarily for business rather than personal reasons and that there was a proximate relationship between the expense and the business. Code Sec. 262(a) provides that no deduction is allowed for personal, living, or family expenses.

Under U.S. v. Gilmore, 372 U.S. 39 (S. Ct. 1963), the deductibility of legal fees depends on the origin and character of the claim for which the expenses were incurred and whether the claim bears a sufficient nexus to the taxpayer's business or income producing activities. The Supreme Court stated that "the origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test." If the claim arises "in connection with the taxpayer's profit-seeking activities," the fees are deductible; if not, they are not deductible. In Comm'r v. Tellier, 383 U.S. 687 (S. Ct. 1966), the Supreme Court held that public policy does not prohibit the deduction of legal fees relating to criminal activity so long as the legal fees are an ordinary and necessary expense of a trade or business.

The Changs maintained that the legal fees were a deductible business expense because they were incurred in the defense of a criminal case involving HOCA Inc. and HOCA LLC and their activities. Consequentially, the Changs contended that the legal fees were an ordinary and necessary expense to defend the HOCA entities in litigation. Jonathan testified that the business purpose of HOCA LLC was "strategic planning and development" which involved purchasing rental properties and receiving rental income, among other activities. Jonathan also testified and produced documents indicating that HOCA LLC, HOCA Inc., HOC4, and S3 Graphics were involved in various financial arrangements. These arrangements included purchasing real estate, collecting rental income, and paying interest on a loan.

The IRS asserted that HOCA LLC did not engage in a trade or business, as demonstrated by the lack of gross receipts for the year at issue, and therefore was not a legitimate business. According to the IRS, the Changs were not entitled to deduct legal fees under Code Sec. 162 as the legal fees did not have a proximate relationship to a trade or business. Instead, the IRS argued that the legal expenses were of a personal rather than a business nature. The IRS asserted that the criminal charges were distinguishable from the business of HOCA LLC as the charges arose from Jonathan's embezzlement of funds. While the funds acquired by Jonathan were deposited and used by HOCA LLC, the IRS contended that HOCA LLC activities did not give rise to the criminal charges. Rather, the IRS believed that Jonathan's personal activities in his role as an elder of the church originated the criminal charges.

The IRS further argued that the legal fees were personal because they were paid from the Changs' personal account rather than a business account. In response, the Changs testified that their attorneys requested payment be made from a personal account and produced a retainer agreement that provides that the payments be made from sources that have no connection to the criminal charges.

Analysis

The Tax Court held that the Changs were entitled to deduct their legal fees. The court found that the origin of the fees stemmed from Jonathan's business activities as the director of the HOCA entities. While those activities had some relevance to Jonathan's position as an elder, the court determined that they were ultimately profit-seeking activities.

After reviewing the criminal proceedings, the court said there was some doubt as to whether HOCA LLC was a legitimate business. In the court's view, the criminal conviction supported allegations that Jonathan conspired and participated in wire fraud and money laundering. The court noted that those charges involved transactions that were made between the HOCA entities and Jonathan. Therefore, it appeared to the court that Jonathan's plans to commit wire fraud and money laundering in addition to those transactions between Jonathan and the HOCA entities gave rise to the claim originating the legal fees at issue.

The court found that under Tellier, although seemingly against public policy, legal fees relating to criminal activity may be deducted as ordinary and necessary expenses of a trade or business. The court concluded that at least part of Jonathan's business activities in HOCA LLC were to defraud donors and others for his personal financial benefit. Accordingly, the court held that the Changs were entitled to deduct legal and professional expenses for the year at issue.

For a discussion of the deductibility of legal expenses, see Parker Tax ¶90,150.

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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