Taxpayers Improperly Deducted Legal Fees Related to Former Employment as Negative "Other Income"

(Parker Tax Publishing February 2017)

The Tax Court held that a taxpayer's legal fees should not have been reported as negative "Other Income", but instead as miscellaneous itemized deductions subject to the 2 percent of AGI floor. Sas v. Comm'r; T.C. Summary 2017-2.

Background

In 2008, Seattle Bank hired Ellen Sas as president and chief executive officer. In July 2010, they paid Ms. Sas a change-of-control bonus of $612,000. In September 2010, the bank terminated Sas' employment, and two months later sued her for breach of fiduciary duty and attempted to recover the entire bonus. In January 2011, Sas countersued, claiming employment discrimination.

The lawsuit was settled in May 2011, with the bank and Sas paying each other nothing and agreeing to release all claims against each other. Ms. Sas paid $25,000 and $55,798 in legal expenses associated with this lawsuit in 2010 and 2011, respectively.

During 2010 and 2011, Sas and her spouse Roger Jones maintained an accounting and consulting business ("accounting business"), although the record was unclear on who owned the business and Sas' role in the business. Sas and Jones filed a Schedule C with their 2010 Form 1040, reporting Jones as the sole proprietor. For the 2011 tax year, they reported no Schedule C income but did report $293,385 of income from the accounting business on Schedule E.

On their Forms 1040 for 2010 and 2011, the couple reported negative amounts of "Other Income" of $25,000 and $55,798, respectively, for the legal fees paid to settle the Seattle Bank lawsuit. The IRS disallowed the negative Other Income, but allowed the amounts as miscellaneous itemized deductions subject to the 2 percent of adjusted gross income (AGI) floor in Code Sec. 67(a). This treatment reduced the deductible amounts to $4,525 and $50,579 for 2010 and 2011, respectively. The taxpayers timely petitioned the Tax Court for redetermination.

Analysis

At trial, the taxpayers did not press their claim that the legal fees were deductible as negative Other Income. Instead, they argued that the legal fees were fully deductible under either Code Sec. 62(a)(20) because they were paid in connection with an action involving a claim of unlawful discrimination, or Code Sec. 162 as ordinary and necessary expenses of their accounting business. The IRS argued that the legal fees were deductible on Schedule A as miscellaneous itemized deductions under Code Sec. 67(a).

Code Sec. 62(a)(20) allows a deduction for legal fees and court costs in connection with any action involving a claim of unlawful discrimination as defined in Code Sec. 62(e). Code Sec. 62(e) defines "unlawful discrimination" to include a number of specific federal statutes, federal whistleblower statutes, and any federal, state, or local law "providing for the enforcement of civil rights, or regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law."

However, the deduction under Code Sec. 62(a)(20) cannot exceed the amount includible in the taxpayer's gross income for the tax year on account of the judgment or settlement (whether by suit or agreement and whether as a lump sum or periodic payments). The taxpayers attempted to get around this limitation by arguing that Sas included the bonus as income when it was received and was able to retain the bonus because of her countersuit. By this thinking, her bonus was included in the couple's gross income on account of a judgment or settlement relating to her action.

In rejecting this argument, the Tax Court noted that Sas' bonus was received and includible in gross income because of her employment with Seattle Bank, and under the terms of the settlement agreement, neither party received any amount includible in gross income. Therefore, the gross income limitation on the amount of the deduction was zero under Code Sec. 62(a)(20).

The taxpayers argued, in the alternative, that the legal fees were deductible as ordinary and necessary business expenses under Code Sec. 162. Citing the Supreme Court in U.S. v. Gilmore, 372 U.S. 39 (1963), the Tax Court stated that the deductibility of legal fees under Code Sec. 162 depends on -

(1) the origin and character of the claim for which the legal fees were incurred; and

(2) whether that claim bears a sufficient nexus to the taxpayer's business or income-producing activities.

There taxpayers did not argue that Sas' claim was rooted in their accounting business, but rather that the lawsuit would have an adverse effect on Sas' professional reputation which in turn could damage the reputation of the accounting business.

The Tax Court addressed a similar contention in Test v. Comm'r, T.C. Memo. 2000-362, which was affirmed by the Ninth Circuit. In that case, the taxpayer pursued legal claims related to her employment with the University of California, San Francisco, in part because she feared harm to her reputation which in turn would harm a business she operated independently of her position at the university. The Tax Court looked to the origin of the claim and disregarded the taxpayer's motives. Because the claim originated in her employment with the university and not her involvement in the separate business, the legal fees were properly treated as miscellaneous itemized deductions on Schedule A.

While acknowledging that the clawback of Sas' bonus may have harmed her professional reputation and the taxpayers' accounting business, the court focused on the origin of the claim and not the potential consequences of a win or loss. The court noted that Sas' claims arose from her status as a former employee of Seattle Bank, and she hired an attorney because Seattle Bank was attempting to claw back the bonus she received in connection with her employment at the bank. Therefore, taxpayers could not deduct the legal fees as ordinary and necessary business expenses of their business under Code Sec. 162.

Accordingly, the court sustained the IRS's position that the fees were deductible only as miscellaneous itemized deductions subject to the 2 percent floor.

For additional discussion on deducting 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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