Legal Fees Relating to Status of Investment Fund Distributions in Divorce Were Not Deductible Business Expenses

(Parker Tax Publishing July 2018)

The Tax Court held legal fees that a taxpayer incurred in a divorce proceeding to defend his ownership of investment fund distributions, which he received after his former wife had filed for divorce but before the date the divorce was granted, were not deductible as expenses related to a business or income producing activity. The Tax Court applied the "origin of the claim" test under U.S. v. Gilmore, 372 U.S. 39 (1963) and found that the fees were personal and nondeductible because the former wife's claim to the distributions originated entirely from the marriage. Lucas v. Comm'r, T.C. Memo. 2018-80.

Background

Sky Lucas formed Vicis Capital, LLC with two other partners in 2004. Vicis was an investment adviser for several funds including Vicis Capital International Fund (International Fund). The funds paid Vicis a management fee of 1.5 percent of assets under management (AUM) per year, as well as a performance fee equal to 20 percent of profits earned by the funds during the year. From 2005 to 2008, Vicis's AUM grew from approximately $290 million to $5.6 billion.

Under its agreement with International Fund, Vicis could elect to defer payment of the management and performance fees. If Vicis elect to defer the payments, they were invested in the International Fund portfolio. Vicis elected to defer a portion of its International Fund performance fees for 2006-2008.

Vicis began liquidating its portfolio in September 2009, after investors requested some $3 billion in redemptions as a result of the 2008 financial crisis. Vicis's deferred payment plan with the International Fund terminated in February 2010 and the deferred fees were distributed to Vicis. As of September 2010, the Vicis convertible portfolio was completely liquidated.

Lucas and his former wife, Margaret, were married in 1994. Ms. Lucas filed for divorce in January 2008. Between the date of the divorce filing and the date the divorce was granted, Mr. Lucas received approximately $47 million in distributions from Vicis. The largest issue in the divorce was the valuation and equitable distribution of Mr. Lucas's interest in Vicis, including the $47 million in distributions. Ms. Lucas argued that the distributions were part of the marital estate even though Mr. Lucas received them after she had filed for divorce. The divorce court determined that only around $4.7 million represented deferred compensation attributable to Mr. Lucas's predivorce earnings and was therefore a marital asset.

Mr. Lucas paid several million dollars of legal and professional fees in the divorce. He hired a law firm to represent him as well as a consulting group as an expert witness on the Vicis valuation issue. On his 2010 Schedule A, Itemized Deductions, Mr. Lucas deducted approximately $1.3 million in legal fees. For 2011 he deducted $1.6 million in fees on his Schedule E, Supplemental Income and Loss. In 2016, the IRS sent Mr. Lucas a notice of deficiency disallowing the legal fee deductions. Mr. Lucas petitioned the Tax Court to review the notice of deficiency.

Analysis

Litigation costs may be deductible as a business expense under Code Sec. 162(a) or as costs incurred in producing income under Code Sec. 212. Under Code Sec. 262, no deduction is allowed for personal, living or family expenses.

Observation: Taxpayers generally prefer the Code Sec. 162(a) trade or business expense deduction over the Code Sec. 212 deduction. A trade or business expense is subtracted in full from gross income, while a deduction under Code Sec. 212 is subtracted from adjusted gross income and is subject to certain floor limitations in Code Sec. 67(a). A Code Sec. 212 deduction may also be limited if the alternative minimum tax applies. However, it should be noted that, for years beginning after 2017 and before 2026, no miscellaneous itemized deductions are available to individuals as a result of the Tax Cuts and Jobs Act of 2017.

Under U.S. v. Gilmore, 372 U.S. 39 (1963), the deductibility of legal fees depends on whether the underlying claim arose in connection with the taxpayer's profit seeking or personal activities. Under this "origin of the claim" test, the Supreme Court held that legal expenses paid to defeat claims arising from a marital relationship were personal and nondeductible. The Gilmore test has been described as a but-for test; if the claim could not have existed but for the marriage relationship, the expense of defending it is a personal expense and not deductible.

Legal expenses arising from a divorce are deductible in some cases. A limited exception in the regulations under Code Sec. 262 applies for divorce-related legal fees incurred in collecting taxable alimony income. The Tax Court in Hahn v. Comm'r, T.C. Memo. 1976-113 allowed a deduction under Code Sec. 212 for legal fees a former spouse incurred to secure income from jointly owned property over which the other spouse had taken possession. In Liberty Vending, Inc. v. Comm'r, T.C. Memo. 1998-177 (1998), the Tax Court allowed a taxpayer to deduct legal fees incurred to resist actions by an ex-spouse that interfered with the taxpayer's business activities.

Mr. Lucas argued that he was entitled to deduct his legal and professional expenses under Code Sec. 162(a) or Code Sec. 212 because the fees were paid to defend a claim for profits earned in his business or income producing activity. He contended that the facts in his case were similar to those in Hahn, where the Tax Court found the expenses to be deductible. The IRS responded that the fees were nondeductible personal expenses under Code Sec. 262.

Tax Court's Decision

The Tax Court held that Mr. Lucas's legal and professional fees were nondeductible personal expenses. The court reasoned that but for the marriage, Ms. Lucas would have had no claim to Mr. Lucas's interest in Vicis. The court further found that Hahn did not apply because, while the fees in that case were business connected, Mr. Lucas's legal fees had no connection to Vicis's investment advisory business. Rather, they were incurred defending his ownership and distributions from equitable distribution in the divorce.

Mr. Lucas failed to demonstrate that the expenses were otherwise deductible, in the Tax Court's view. The court concluded that Mr. Lucas was neither pursuing alimony nor resisting an attempt to interfere with his ongoing business activities as in Liberty Vending. The court found that Mr. Lucas engaged in little trade or business activity in 2010 or 2011, as Vicis began liquidating in 2009 and thereafter he engaged in no business activity other than a limited management role with Vicis. Mr. Lucas did not, in the view of the Tax Court, establish that Ms. Lucas's claim related to the winding down of Vicis, or that the fees incurred to defeat her claim were ordinary and necessary to his trade or business.

For a discussion of the deductibility of legal fees, see Parker Tax ¶80,185.

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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