Taxpayer Avoids Penalty for Deducting Litigation Fees Involving Ex-Wife

(Parker Tax Publishing October 2021)

The Fifth Circuit affirmed a Tax Court decision which held that a taxpayer could not deduct as ordinary and necessary business expenses under Code Sec. 162 legal fees incurred in litigation against his ex-wife involving losses on his commodities brokerage account because such fees were more appropriately deductible as expenses incurred for the production of income under Code Sec. 212. The Fifth Circuit also vacated and remanded the Tax Court's decision holding the taxpayer liable for a penalty under Code Sec. 6662(a) after finding that the taxpayer reasonably relied upon an earlier stipulated Tax Court decision allowing him to deduct his commodities brokerage account losses as a Schedule C business losses. Ray v. Comm'r, 2021 PTC 292 (5th Cir. 2021).

Background

Ames and Christina Ray married in 1972 and moved to New York City in 1976. Christina pursued a career in the finance industry, developing mathematical models for commodities trading and authoring several books on risk management and options trading. Ames also worked for several financial institutions, but was never a commodities trader. In 1979, he developed a computer program that could analyze Securities and Exchange Commission filings, search for company information, and print financial statements, which he named "Firm Decisions." Ames licensed this software to Citibank and received income from Citibank for the software until 1986. Ames and Christina divorced in 1977, though they continued to live together until 1992. During that time, they maintained joint bank and credit card accounts and own shared assets. The Rays used a ledger system to track their joint and separate expenses, as well as financial transactions between them.

Over time, Christina incurred various debts to Ames, which the couple formalized in several written documents. In 1981, the Rays jointly purchased land in Sagaponack, New York with the intent of building a vacation home on the land. However, in 1984 Ames sold his share of the property to Christina for $350,000. Under a written agreement, Ames lent this amount to Christina in exchange for her agreement to make regular payments to him. Subsequently, when their Manhattan apartment was converted to a co-op around 1987, the Rays purchases shares in the co-op. In 1991, Ames sold his interest in the co-op shares to Christina in exchange for a note from Christina (i.e., 1991 promissory note) for $432,427, which covered the amounts Christina owed for both the Sagaponack property and the apartment.

Also in 1991, the Rays signed a document stating that Christina was solely liable for six different credit-card accounts in Ames's name due to her charges to those accounts. In 1993, Christina signed a document stating that she owed Ames $532,288 for (1) her default on the 1991 promissory note, (2) additional credit card debt that Ames paid on her behalf, (3) legal expenses incurred in connection with the enforcement of the note, and (4) interest due on these amounts. In 1993, Christina also signed a letter to Ames stating that she would provide him with notarized financial statements semiannually until the debt was paid in full. Under the agreement, Christina was liable for a $50 penalty for each day she was late in providing her financial statements to Ames. In 1994, Christina signed a letter summarizing her debts to Ames, which then totaled $590,222.

In May 1993, the Rays entered an agreement (i.e., the trading agreement) under which Christina would manage the trading of Ames's commodities brokerage account. The agreement provided that Christina would manage the account in her sole discretion and provide monthly reports to Ames in exchange for a 7 percent commission. Ames deposited $500,000 into his account so that Christina could trade his account pursuant to the trading agreement. By September 1993, the account's value had declined to $1,285. In a 1994 letter to Ames, Christina confirmed that she owed him $384,388 for the commodities trading losses plus interest. On his 1993 tax return, Ames deducted his losses under the trading agreement as a Schedule C business loss. The IRS disallowed the deduction and the case wound up in the Tax Court, where Ames and the IRS eventually reached a settlement, The agreement was entered by the Tax Court in 1997 as a stipulated decision under which Ames was allowed to deduct $374,102 as a Schedule C business loss labeled "Futures Trader."

Ames brought four lawsuits against Christina for the amounts she owed him in connection with the Sagaponack property purchase, the Manhattan apartment purchase, the credit card debt, the late financial statements, and the losses under the trading agreement. On his 2014 tax return, Ames reported a negative amount as "other income" of $238,937 for legal fees and costs he incurred relating to these lawsuits. He did not file a Schedule C with his 2014 tax return. The IRS disallowed the deduction and imposed a 20 percent penalty under Code Sec. 6662(a). Ames took his case to the Tax Court, arguing that his legal expenses were deductible either as ordinary and necessary business expenses under Code Sec. 162(a) or as expenses for the production of income under Code Sec. 212. The Tax Court held that none of the legal expenses were deductible under Code Sec. 162(a) but that the portion of his legal expenses relating to the trading agreement losses could be deducted under Code Sec. 212 as expenses for the production of income. The legal expenses relating to Ames's efforts to recover his losses on the two real estate loans, the credit card debt, and the late financial statements were, however, all held to be nondeductible personal expenses. The Tax Court also upheld the penalty under Code Sec. 6662(a), which it calculated as 20 percent of (1) the difference in the amounts Ames would be allowed to deduct for legal expenses for the trading agreement losses if they were deductible under Code Sec. 162(a) rather than Code Sec. 212, and (2) Ames's deduction of his legal expenses relating to litigation to recover on his ex-wife's indebtedness.

Ames appealed to the Fifth Circuit. He argued that his legal expenses relating to the trading agreement venture should be deductible under Code Sec. 162(a) because the venture was an extension of his earlier computer programming business. He asserted that the venture was a collaboration with Christina and that he regularly and continuously engaged in writing and creating financial software programs from 1976 through the end of his collaboration with his ex-wife. Regarding the legal expenses relating to his litigation to recover on Christina's indebtedness, Ames argued that the expenses were deductible under Code Sec. 212 because the debt instruments were interest-bearing, income-producing assets. Ames also asserted a defense of reasonable cause and good faith against the imposition of the understatement penalty, arguing that he reasonably relied on the 1997 stipulated Tax Court decision in deducting his legal expenses under Code Sec. 162(a).

Analysis

The Fifth Circuit affirmed the Tax Court's holding that Ames's legal expenses relating to the trading agreement losses were not deductible under Code Sec. 162(a) but were deductible under Code Sec. 212. The Fifth Circuit also affirmed the Tax Court's holding that Ames's legal expenses to recover on Christina's debts were not deductible under Code Sec. 212. The Fifth Circuit vacated and remanded the Tax Court's imposition of the penalty after finding that Ames was entitled to a reasonable cause and good faith defense for the understatement.

The Fifth Circuit determined that Ames failed to establish a link between the trading agreement venture and his earlier computer programming business. The court found that there was no evidence that the computer programs used in the trading agreement venture were related to Ames's earlier computer programming business or were developed by Ames. The court further found that, although Ames claimed to have collaborated with his ex-wife on the trading agreement venture, nothing in the record showed that he engaged in the trading agreement venture with continuity and regularity. The court also noted that under the trading agreement, Ames disclaimed any right to be actively involved in the trading aspect of the purported business and gave Christina sole discretion to trade his commodities account. Thus, the Fifth Circuit found no error in the Tax Court's conclusion that Ames failed to prove that the origin of the claims underlying Ames's litigation to recoup his trading agreement losses was related to his engagement in a trade or business within the meaning of Code Sec. 162(a).

Next, the Fifth Circuit held that Ames's legal expenses incurred in litigating to recover on his ex-wife's indebtedness were not deductible under Code Sec. 212 as expenses for the production of income because Ames failed to show that they were made in furtherance of a bona fide profit objective. The court explained that legal fees are considered personal expenses and thus are not deductible if the claims underlying the lawsuit are personal in nature. With respect to the Sagaponack property and the Manhattan apartment, the court found that both were used by the Rays for personal residential purposes rather than as investment properties. Likewise, the court found that Ames entered into the agreements with Christina regarding her personal charges to his credit card accounts and the late financial statements in order to further separate their finances and to obtain assurance that his debts would be repaid.

The Fifth Circuit held that Ames had a good faith and reasonable cause defense with regard to the penalty attributable to the difference in the amounts Ames would be allowed to deduct for legal expenses for the trading agreement losses under Code Sec. 162(a) rather than Code Sec. 212. The court reasoned that, given the IRS's prior position regarding the trading agreement venture, and considering the particular facts and circumstances, it was reasonable for Ames to have relied upon the stipulated decision in assessing whether his legal expenses could be deducted as a Schedule C business loss.

For a discussion of the rules for deducting legal fees, see Parker Tax ¶80,185. For a discussion of the reasonable cause and good faith defense to penalties, see Parker Tax ¶262,127.

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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