George W. Guill v. Commissioner , 112 T.C. No. 22 ( 1999 )

112 T.C. No. 22
UNITED STATES TAX COURT
GEORGE W. GUILL, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 16796-97. Filed June 18, 1999.
P, an independent contractor, commenced a lawsuit
against D, alleging that D was liable to P for breach
of contract and conversion arising out of P's work for
D. As to the conversion claim, the jury awarded P
actual and punitive damages, together with interest and
costs. P received the award in 1992, and, from this
amount, P paid his attorneys their fees and the court
costs (collectively, legal costs). P deducted the
legal costs on his 1992 Schedule C, Profit or Loss From
Business, reporting that the costs arose out of his
sole-proprietor business, and he reported the actual
damages on that schedule as income from the business.
P did not include the punitive damages in his 1992
gross income. R determined that the legal costs were
deductible as a nonbusiness itemized deduction on
Schedule A, Itemized Deductions, and that the punitive
damages were reportable as nonbusiness income. R
concedes that the legal costs are a business expense to
the extent they are attributable to P's recovery of the
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actual damages. R asserts that the remaining legal
costs are a nonbusiness itemized deduction because they
are attributable to P's recovery of the punitive
damages. P and R agree that the punitive damages are
includable in P's business income if the legal costs
are a business expense.
Held: All of the legal costs are attributable to
P's trade or business; hence, the legal costs are all
deductible on Schedule C as a business expense.
Bobby Wayne Enlow, for petitioner.
Jeanne Gramling, for respondent.
OPINION
LARO, Judge: This case is before the Court fully
stipulated. See Rule 122. George W. Guill petitioned the Court
to redetermine deficiencies of $100,916 and $434 in his 1992 and
1993 Federal income tax, respectively. Following the parties'
concessions, the primary issue left to decide is whether all of
the attorney's fees and court costs (collectively, legal costs)
paid by petitioner in the successful prosecution of his claim of
conversion are expenses of his sole-proprietor business;
petitioner was awarded actual damages, punitive damages, costs,
and interest. We hold they are. Section references are to the
Internal Revenue Code in effect for 1992. Rule references are to
the Tax Court Rules of Practice and Procedure. Dollar amounts
are rounded to the nearest dollar.
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Background
All facts have been stipulated and are so found. The
stipulation of facts and exhibits submitted therewith are
incorporated herein by this reference. Petitioner resided in
Columbia, South Carolina, when he petitioned the Court.
Petitioner began working as an agent for Academy Life
Insurance Co. (Academy) in the late 1970's. He worked for it as
an independent contractor under a contract between the two.
Academy fired him in July 1986. When it did, it was
contractually obligated to pay him renewal commissions on
policies that he or an agent under his supervision had sold.
After his firing, Academy remitted to him reduced monthly
commissions. It also stopped sending to him the paperwork
documenting his commissions.
In September 1987, petitioner sued Academy for breach of
contract and conversion, praying in his complaint for an award of
actual and punitive damages. Petitioner alleged that Academy was
liable to him for: (1) An unlawful termination of contracts with
resulting failure to pay money due thereunder (breach of contract
and conversion), (2) unfair trade practices (also seeking treble
damages and attorney's fees), (3) a termination of resident
counselor status, (4) a failure to pay commissions, and (5) the
fraudulent filing of Federal tax forms reporting income not paid
to him. Following a jury trial, the U. S. District Court hearing
the case directed a verdict against Academy for breach of
contract and sent the issues of conversion and resulting damages
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to the jury. The judge instructed the jury as follows with
respect to punitive damages:
The plaintiffs [petitioner and the male taxpayer
in Whitley v. Commissioner, T.C. Memo. 1999-124] are
also seeking punitive damages in their conversion cause
of action.
The law permits the jury, under certain
circumstances, to award punitive damages in order to
punish a wrong-doer for some extraordinary misconduct,
and to serve as a warning not to engage in such conduct
in the future.
Thus, if you find that the plaintiffs have shown
by a preponderance of the evidence, that the defendant
converted the plaintiffs' money with malice, ill will,
a conscious indifference to the rights of others, or a
reckless disregard for the rights of others, you may
award the plaintiffs punitive damages.
If you so find, it becomes your right to award
punitive damages in such an amount as you unanimously
agree to be proper in light of the character of the
wrong committed, the punishment which should be
applied, and the ability of the defendant to pay.
The jury found against Academy on the conversion claim and
awarded petitioner $51,499 in actual damages for unpaid
commissions and $250,000 in punitive damages, together with
"interest thereon at the rate of 8.85 per cent and his costs of
action". The jury's verdict was affirmed upon appeal.
Academy paid $371,542 to petitioner in 1992, and, from that
amount, he paid his attorneys the legal costs, which consisted of
$148,617 in attorney's fees and $3,279 in court costs.
Petitioner included the actual damages in income on his Schedule
C, Profit or Loss From Business, and he claimed on that schedule
a deduction for the legal costs. Petitioner did not report any
of the punitive damages on his 1992 Federal income tax return.
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Respondent issued petitioner a notice of deficiency that
reflects respondent's determination that the $250,000 in punitive
damages is includable in petitioner's 1992 gross income as "Other
Income" and that he must deduct the legal costs on Schedule A,
Itemized Deductions, as a miscellaneous deduction. Respondent's
determination as to the punitive damages and the legal costs
resulted in certain other "mechanical" adjustments, one of which
was the applicability of the alternative minimum tax.
Discussion
In a case of first impression, we must decide whether the
litigation costs attributable to an independent contractor's
recovery of punitive damages are deductible on Schedule C as a
business expense or on Schedule A as a nonbusiness itemized
deduction.1 Petitioner also contests respondent's determination
that petitioner did not receive the punitive damages on account
of a personal injury. We recently held that the punitive damages
received by Mr. Whitley, petitioner's coplaintiff in the Academy
lawsuit, were includable in Mr. Whitley's gross income. See
Whitley v. Commissioner, T.C. Memo. 1999-124. We relied mainly
on O'Gilvie v. United States, 519 U.S. 79 (1996), Commissioner v.
Schleier, 515 U.S. 323 (1995), and United States v. Burke,
504 U.S. 229 (1992), concluding that punitive damages received
under South Carolina law are not excludable from gross income
1
Respondent concedes that the litigation costs attributable
to the actual damages are deductible on Schedule C as a business
expense.
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under section 104(a)(2). We apply the reasoning in Whitley and
hold the same here.
As to the primary issue, section 162(a) governs the
deductibility of litigation costs as a business expense.
Section 162(a) allows an individual to deduct all of the ordinary
and necessary expenses of carrying on his or her trade or
business. Section 212 governs the deductibility of litigation
costs as an itemized deduction, when the costs are incurred as a
nonbusiness profit-seeking expense. Section 212 allows an
individual to deduct all of the ordinary and necessary expenses
paid or incurred in: (1) Producing income, (2) managing,
conserving, or maintaining property held for the production of
income, or (3) determining, collecting, or refunding a tax.
Sections 162(a) and 212 are considered in pari materia, except
for the fact that the income-producing activity of the former
section is a trade or business whereas the income-producing
activity of the latter section is a pursuit of investing or other
profitmaking that lacks the regularity and continuity of a
business. See Woodward v. Commissioner, 397 U.S. 572, 575 n.3
(1970); United States v. Gilmore, 372 U.S. 39, 44-45 (1963);
Bingham's Trust v. Commissioner, 325 U.S. 365, 374-375 (1945).
A deduction of litigation costs under section 162(a) may be
more desirable to an individual than is a deduction under section
212. The primary advantage to a deduction under section 162(a),
vis-a-vis a deduction under section 212, rests on each
deduction's effect on gross income and adjusted gross income.
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A deduction under section 162(a) is subtracted in full from gross
income to arrive at adjusted gross income. A deduction under
section 212 is subtracted from adjusted gross income to arrive at
taxable income and is subject to certain floor limitations in
section 67(a). The benefit from a deduction of litigation costs
under section 212 may also be limited by application of the
alternative minimum tax. See sec. 56(b); see also Benci-Woodward
v. Commissioner, T.C. Memo. 1998-395.
Whether an ordinary and necessary litigation expense is
deductible under section 162(a) or section 212 depends on the
origin and character of the claim for which the expense was
incurred and whether the claim bears a sufficient nexus to the
taxpayer's business. See Woodward v. Commissioner, supra; United
States v. Gilmore, supra at 44-45; see also Peckham v.
Commissioner, 327 F.2d 855, 856 (4th Cir. 1964), affg. 40 T.C.
315 (1963). Ordinary and necessary litigation costs are
generally deductible under section 162(a) when the matter giving
rise to the costs arises from, or is proximately related to, a
business activity. See Woodward v. Commissioner, supra;
Kornhauser v. United States, 276 U.S. 145, 153 (1928).
Litigation costs must be "attributable to a trade or business
carried on by the taxpayer" in order to be deductible as a
business expense. Sec. 62(a)(1).
The ascertainment of a claim's origin and character is a
factual determination that must be made on the basis of the facts
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and circumstances of the litigation. See United States v.
Gilmore, supra at 47-49. The most important factor to consider
is the circumstances out of which the litigation arose. See
Boagni v. Commissioner, 59 T.C. 708 (1973). In passing on this
factor, the fact finder must take into account, among other
things, the allegations set forth in the complaint, the issues
which arise from the pleadings, the litigation's background,
nature, and purpose, and the facts surrounding the controversy.
See id. at 713.
Petitioner's legal costs, which the parties agree are
"ordinary" and "necessary" expenses, bear the required nexus to
his sole-proprietor insurance business to meet the requirements
for deductibility under section 162(a). As a matter of fact,
petitioner's lawsuit against Academy arose entirely from his
insurance business. Each cause of action petitioner alleged in
the lawsuit was spawned entirely from the fact that, after
Academy fired him, it failed to honor the terms of their working
agreement by not paying him the commissions to which he was
entitled under their agreement. But for the agreement, and the
fact that Academy breached the agreement by unilaterally
terminating its obligation to pay commissions to petitioner, the
instant lawsuit, as it was framed, would never have arisen, and
petitioner would never have incurred (or paid) any of the legal
costs.
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Respondent devotes much time in his opening brief to his
proffered method of apportioning petitioner's legal costs between
his business and nonbusiness activities, spending little time
arguing that apportionment of the legal costs is appropriate. As
we understand respondent's argument on apportionment, petitioner
must apportion his legal costs because, respondent asserts,
petitioner has not proven that he incurred 100 percent of the
costs in his insurance business. We disagree. After reviewing
the record, which includes 19 stipulations and 9 exhibits, we are
persuaded by more than a preponderance of the evidence that all
of petitioner's legal costs were attributable to his insurance
business and, more importantly, that all of the costs were
connected to claims which arose in that business. Petitioner's
complaint, for example, attests to the fact that each of his
claims, and not simply his claim of conversion, arose from the
sole-proprietor insurance business.
We consider it both ordinary and necessary from a business
standpoint for petitioner to have filed the lawsuit against
Academy and for him to have sought any and all damages to which
he was entitled on account of Academy's breach of contract and
related conversion. The mere fact that petitioner sought and was
paid punitive damages to punish Academy for its "extraordinary
misconduct, and to serve as a warning [to it and to other
persons] not to engage in such conduct in the future" does not
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change the fact that petitioner's legal costs were all
attributable to his business activity. Pursuant to South
Carolina law, see Oxford Fin. Cos. v. Burgess, 402 S.E.2d 480,
482 (S.C. 1991); Rhode v. Ray Waits Motors, Inc., 74 S.E.2d 823,
825 (S.C. 1953); see also Sherrill White Constr., Inc. v. South
Carolina Natl. Bank, 713 F.2d 1047, 1051-1052 (4th Cir. 1983),
and the judge's instructions, the jury in the Academy lawsuit
awarded petitioner both actual and punitive damages on his
conversion claim.2 The fact that petitioner received two
different types of damages on his single claim of conversion does
not mean, as respondent would have us hold, that the claim is
bifurcated into two claims solely for purposes of applying the
Federal income tax laws. Contrary to respondent's position in
this case, the various types of damages which petitioner received
on his conversion claim do not dictate whether his legal costs
must be apportioned between his business and nonbusiness
2
We recognize that South Carolina law does not provide that
punitive damages are awarded in every case in which a tortfeasor
is held liable for an act of conversion. See Sherrill White
Constr., Inc. v. South Carolina Natl. Bank, 713 F.2d 1047,
1051-1052 (4th Cir. 1983) ("in order to recover punitive damages
[under South Carolina law] there must be more than mere
conversion. There must be malice, ill will, a conscious
indifference to the rights of others, or a reckless disregard
thereof."; citations and quotation marks omitted). The fact that
the converter's degree of culpability enters into an award of
punitive damages under South Carolina law, however, does not
change the fact that the origin and character of a claim for
punitive damage under that law is an act of conversion, which, in
this case, stems from petitioner's business activity.
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activities. An allocation of litigation costs, if and when
applicable, rests on the origin of the claims relating to those
expenses. See Woodward v. Commissioner, 397 U.S. at 577-578;
United States v. Gilmore, 372 U.S. at 44-45; see also Peckham v.
Commissioner, 327 F.2d at 856.
We recognize that, when appropriate, litigation costs must
be apportioned between business and personal claims, and that
business litigation costs are nondeductible to the extent that
they constitute capital expenditures. See, e.g., Kurkjian v.
Commissioner, 65 T.C. 862 (1976) (deduction disallowed for
portion of attorney's fees attributable to personal matters);
Buddy Schoellkopf Prods., Inc. v. Commissioner, 65 T.C. 640, 646-
647 (1975) (deduction disallowed for portion of attorney fees
attributable to acquisition of intangible assets); Merians v.
Commissioner, 60 T.C. 187 (1973) (deduction disallowed for
portion of attorney's fees attributable to personal matters); see
also Boagni v. Commissioner, supra, (recognizing that litigation
costs can be characterized as both deductible and nondeductible
when the litigation is rooted in situations giving rise to both
types of expenditures). This principle of allocation is
inapposite to our decision herein for two main reasons. First,
petitioner's legal costs were all attributable to claims which
originated in his business activity, the primary claim being that
of conversion. Second, in contrast to cases where each of the
underlying claims could have resulted in an award of damages
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regardless of an award of damages on any other claim,
petitioner's award of punitive damages could not have been made
in isolation. As South Carolina's highest court has stated:
"Punitive damages may be awarded [under South Carolina law] only
upon a finding of actual damages." Dowling v. Home Buyers
Warranty Corp., 428 S.E.2d 709, 711 (S.C. 1993); see also Gamble
v. Stevenson, 406 S.E.2d 350 (S.C. 1991).
We hold that petitioner may deduct the legal costs under
section 162(a).3 In reaching our holdings herein, we have
considered all arguments by the parties, and, to the extent not
addressed above, find them to be meritless or irrelevant. To
reflect the foregoing,
Decision will be entered
under Rule 155.
3
The parties agree that our holding on this issue means
that the punitive damage award is includable in petitioner's
self-employment income and that it is subject to self-employment
tax. See secs. 1401 and 1402.