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Business Tax

Court: lawsuit settlement payment was part corporate deduction, part employee expense

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

Ferguson, TC memo 2019-40

The Tax Court has held that, where a custom homebuilder conducted his business via several corporations and sole proprietorships, an amount paid by the homebuilder in settlement of a lawsuit with one of the businesses’ customers was 50% deductible by one of the corporations and was 50% an unreimbursed employee business expense.

Background.  The origin and character of a claim with respect to which an expense is incurred determines whether judgment and settlement payments are deductible. (Gilmore, (S Ct 1963) 11 AFTR 2d 758)

The Court of Appeals for the Eighth Circuit, to which an appeal in this case would lie, lists a number of factors to determine whether a bona fide loan exists, such as whether: (1) the corporation was so grossly undercapitalized that the loans were in fact needed for capital purposes and were actually intended to be risked capital rather than a loan, (2) the purported loans were made in proportion to equity holdings, (3) the repayment of the loan was predicated on the success of the venture, (4) there was a fixed date for payment of the note and a reasonable expectation of payment by that date, (5) the note was subordinated to other corporate debts, (6) third parties would have made the loan under the same conditions, (7) the claimed loan was secured by a mortgage or otherwise, (8) a provision was made for a sinking fund to retire the loan, (9) the person making the purported loan participated in the management of the corporation, and (10) the corporation had a large proportion of debt to equity. (J.S. Biritz Constr. Co. (CA 8 1967) 20 AFTR 2d 5891)

Facts.  The taxpayers were Mr. and Mrs. Ferguson. Mr. Ferguson was in the custom home building and construction business. He operated his business through several different entities that engaged in various stages of home design and construction.

One of Mr. Ferguson’s entities, RFI, was a C corporation of which Mr. Ferguson was the majority shareholder at all times. During the years at issue, Mr. Ferguson received a salary of $44,000 annually from RFI. RFI served as general contractor for Mr. Ferguson’s jobs.

A second entity, Pinnacle, was an S corporation of which Mr. Ferguson was also the majority shareholder. Pinnacle manufactured, supplied and installed cast stone.

Mr. Ferguson also had several other entities, one of which was a sole proprietorship.

RFI entered into a contract with a family (homeowners) to construct a home. RFI then subcontracted with several subcontractors. One of the subcontractors was Pinnacle, which was hired to produce, supply, and install the cast stone for the building.

The homeowners filed a lawsuit against RFI, Pinnacle and Mr. Ferguson regarding the construction. While the homeowners alleged various problems with the construction, their primary grievance pertained to the cast stone. The homeowners alleged that Pinnacle “improperly manufactured” the cast stone and, along with RFI, “improperly installed the defective cast stone.”

The lawsuit was settled. Mr. Ferguson paid cash which was drawn on his personal account. The homeowners agreed to release Mr. Ferguson, RFI and Pinnacle from their claims.

Pinnacle recorded the check payment on its books as a loan from Mr. Ferguson. No written loan documents were prepared, and no interest was accrued on the loan. Mr. Ferguson believed he could treat the payment as a loan to Pinnacle because he believed that the settlement was attributable to the defective cast stone.

IRS disallowed the settlement payment as a Pinnacle deduction; instead it treated the settlement payment as a unreimbursed employee business expense pertaining to Mr. Ferguson’s employment with RFI.

Positions of the parties.  The Fergusons contended that the settlement payment should be deducted on a Schedule C as an ordinary and necessary expense of a business activity other than employment.

In the alternative, the Fergusons argued that Pinnacle properly deducted the settlement payment and that they were entitled to their pro rata share of the deduction. According to the Fergusons, the homeowners’ lawsuit was attributable to Pinnacle, and the payment of the settlement by Mr. Ferguson should be treated as a loan or capital contribution to Pinnacle.

IRS countered that Pinnacle could not deduct any of the costs pertaining to the lawsuit because it did not pay or incur them. IRS further contended that the costs of the lawsuit were the responsibility of RFI. Accordingly, the Fergusons could deduct the settlement payment only as an unreimbursed employee business expense.

Court divides deduction into two parts.  The Court concluded that 50% of the deduction should be allowed to Pinnacle and that the other 50% was deductible as unreimbursed employee business expense. It considered several issues in arriving at this conclusion.

 Schedule C deduction.  IRS asserted that the settlement payment was RFI’s expense because RFI was responsible for the work that gave rise to the homeowners’ lawsuit. IRS argued that as an employee of RFI, Mr. Ferguson could deduct the settlement payment only as an unreimbursed employee business expense.

The Fergusons countered that RFI was not Mr. Ferguson’s only trade or business. According to the Fergusons, they could deduct the settlement payment on a Schedule C because Mr. Ferguson paid it to protect his business reputation and, by extension, his other businesses.

The Court said that the question was whether and to what extent the homeowners’ lawsuit arose from, or was proximately related to, a business activity of Mr. Ferguson other than his employment with RFI. The record established that the origin of the homeowners’ lawsuit stemmed from work performed by RFI and Pinnacle rather than a separate trade or business of Mr. Ferguson. While the homeowners’ complaint alleged various problems with the construction of the dwelling, the parties agreed that the claims regarding the cast stone were the homeowners’ primary grievance. The cast stone work was performed and/or supervised by RFI and Pinnacle.

While the homeowners also sued Mr. Ferguson in his individual capacity, he was not a party to the construction contract with the homeowners. Furthermore, the homeowners did not allege that Mr. Ferguson took any action in the construction of the dwelling other than as the face and controlling shareholder of RFI and Pinnacle.

The Court said that it recognized that Mr. Ferguson had a separate home remodeling business that generated substantial Schedule C income for 2011, and “we do not doubt that he was indeed concerned about the consequences of an unfavorable judgment on this and other business ventures.” However, the Court said that it was bound by the origin-of-the-claim rule to look at the origin of the underlying claim and not the consequences. In this case, the origin of the claims was the work performed by RFI and Pinnacle. Accordingly, the Fergusons could not deduct the settlement payment on a Schedule C.

Loan to Pinnacle.  The Fergusons argued that Mr. Ferguson intended the settlement payment to be a loan to Pinnacle, because Pinnacle was responsible for the work that gave rise to the homeowners’ claims, and that Pinnacle should be treated as having paid the settlement.

The Court disagreed. The Fergusons cited Pinnacle’s treating the settlement payment as a loan on its books as evidence of a bona fide loan. However, no loan documents were prepared, and the record was devoid of any evidence of a fixed repayment date or repayment schedule. No interest or principal was paid or accrued on the purported loan, which Mr. Ferguson effectively canceled when he ended Pinnacle’s operations in 2012. Mr. Ferguson’s accountant acknowledged at trial that Pinnacle’s poor cash position made repayment unlikely.

The Court concluded that Mr. Ferguson knew that Pinnacle would be unable to repay him when he funded the settlement. Accordingly, Mr. Ferguson did not intend to establish a creditor-debtor relationship with Pinnacle, and his payment of the settlement was not a loan to the S corporation.

Deemed capital contribution to Pinnacle.  The Fergusons argued that, even if Mr. Ferguson’s payment of the settlement was not a loan, the payment was nevertheless attributable to Pinnacle’s trade or business and deductible by Pinnacle as an ordinary and necessary business expense. According to the Fergusons, Mr. Ferguson’s payment of the settlement was a contribution to the capital of Pinnacle if it was not a loan.

IRS acknowledged that a shareholder’s payment of corporate expenses may be deemed a capital contribution in appropriate circumstances.

…RFI or Pinnacle.  IRS then argued that, whether or not Mr. Ferguson’s payment of the settlement was a contribution to the capital of Pinnacle, the settlement costs were solely attributable to RFI. In support of this argument, IRS contended that (i) RFI was the general contractor on and bore the ultimate responsibility for the construction project that gave rise to the homeowners’ lawsuit, (ii) Pinnacle was not a party to RFI’s and the homeowners’ contract, and (iii) the allegations in the homeowners’ lawsuit addressed RFI’s decisions to use defective materials and RFI’s inadequate installation of the materials.

The Court disagreed. It said that, while IRS argued that Pinnacle played no role in the installation of the cast stone, the record indicated otherwise. The parties stipulated that Pinnacle subcontracted with RFI to “produce, supply, and install cast stone” for use in the construction of the homeowners’ home. The homeowners’ complaint alleged that Pinnacle, along with RFI, “improperly installed the defective cast stone.”

Furthermore, Pinnacle’s interests were accounted for in the settlement agreement. Pinnacle was a party thereto and was released by the homeowners from all claims pertaining to the construction project at issue.

The Court then allocated 50% of the settlement payment to RFI and 50% to Pinnacle. Because Mr. Ferguson personally funded the settlement payment, 50% of which was an expense of Pinnacle, it deemed 50% of the payment a capital contribution to Pinnacle. Accordingly, Pinnacle could deduct 50% of the settlement payment.

The Court then said that, because the remaining 50% was an expense of RFI, it would normally hold that this portion of the payment is not a deductible expense to the Fergusons but rather a capital contribution to the C corporation.  However, the Court said, IRS had conceded that the Fergusons could deduct amounts paid on behalf of RFI as unreimbursed employee business expenses. On the basis of this concession, the Court held that the Fergusons could deduct the remaining 50% of the settlement payment as an unreimbursed employee business expense.

References: For the “origin-of-the-claim” rule, see FTC 2d/FIN ¶L-2501United States Tax Reporter ¶ 1624.040.

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