Paul L. Caron

Monday, July 23, 2018

Lesson From The Tax Court: Origin Of The Claim Test For §162

Tax Court (2017)Last week’s post involved taxpayers whose tax troubles arose from events related to the Great Recession. Those troubles resulted in litigation and a lesson about how the Tax Court applies an “origin of the claim” test in evaluating claimed §104(a)(2) exclusions.

This week’s post also involves a taxpayer whose life took a downturn during the Great Recession. Only this week we look at the more traditional application of the “origin of the claim” test when taxpayers seek to deduct litigation expenses. In Sky M. Lucas v. Commissioner, T.C. Mem.o 2018-80 (June 11, 2018) the IRS sent Mr. Lucas an NOD asserting a tax deficiency of $1.7 million for 2010. Part of that deficiency was due to the disallowance of about $3 million in legal and professional fees related to Mr. Lucas’ divorce litigation.  The multi-year litigation was a fight over some $47 million.  No wonder it was expensive. In the end, Mr. Lucas got to keep most of that.  Mr. Lucas thought he could deduct his litigation costs.  For a great lesson in how the Tax Court applied the origin of the claim test to deny him the deduction, see below the fold.

The Law
Lucas is an opinion written by Judge Vasquez. He does a really nice job of summarizing the law. I can no better. So let’s read how he frames the law concerning deductibility of litigation expenses.

“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. [It allows deduction when the costs are incurred in]: (1) producing income, (2) managing, conserving, or maintaining property held for the production of income, or (3) determining, collecting, or refunding any 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 profit-making that lacks the regularity and continuity of a business. No deduction is allowed with respect to personal, living, or family expenses. Sec. 262.”

So it comes down to that classic tension in the tax code: was the expense for business or investment purposes or was it a personal expense? As we saw in last week’s post, this is a question of causality. What caused the expense?  Last week we were looking to see whether damages were received "because of" physical injury.  Here, we look to see whether the expense was incurred because of a profit-seeking activity.

In the context of divorce litigation the seminal case remains United States v. Gilmore, 372 U.S. 39 (1963). The taxpayer there was Mr. Gilmore. He and his wife engaged in what the Supreme Court characterized as a “bitterly fought divorce.”

Now, for those of you who were adults in 1963---or else have watched Mad Men---you know that in those days divorce carried a nontrivial social stigma.  That stigma both came from, and was reflected in, the law of divorce.  If you wanted a divorce you needed to show your spouse was a bad spouse, such as by showing your spouse was cruel or adulterous.  It would be seven years after the Gilmore case before California became the first state to allow no-fault divorces.   Couples who simply wanted to call it quits, therefore, had to kind of fake the adultery or cruelty part.

Mr. Gilmore’s wife wasn't faking.  She really took after him and, as part of her case, sought ownership of his interests in three franchised General Motors dealerships.  That was hitting him in the pocketbook because he made all his (very good) money from salaries and dividends arising from those three GM franchises.  The trial court found, as a matter of fact, that Mr. Gilmore’s overriding concern in the divorce litigation was “to protect these assets against the claims of his wife.” 372 U.S. at 41. It should be pretty obvious why. If his wife got her hands on the stock interests, she would fire him! Not to mention that her “sensational and reputation-damaging charges of marital infidelity” (372 U.S. at 42) would make GM cancel his franchises.

Mr. Gilmore won the divorce war and, thankful for the preservation of his assets, deducted his litigation costs.  He argued that since his motivation was to protect his livelihood, these expenses were ordinary and necessary for either §162 or §212 purposes.  The Court of Claims agreed, saying that since the result of him losing the divorce would affect Mr. Gilmore's assets, the costs associated with the protection of income-producing assets could be deducted.

The Supreme Court disagreed.  The Court synthesized the case law into this rule: “the origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test of whether the expense was "business" or "personal," and hence whether it is deductible or not.” 372 at 49. This is the original “origin of the claim” test.

Applying that principle to the case before it, the Supreme Court found that even though Mr. Gilmore was trying to preserve his property, the reason the property was in danger in the first place was because of a divorce claim. The origin of that claim, said the Court, “stemmed entirely from the marital relationship, and not, under any tenable view of things, from income-producing activity.” 372 U.S. at 51.

The Facts of Lucas
Mr. Lucas co-founded a high-flying investment fund called Vicis Capital, LLC (not to be confused with the company called Vicis that invented an improved football helmet). During it’s heyday, Vicis had over $5.6 billion under management and Mr. Lucas was very, very well compensated, part of which he stashed into a deferred compensation arrangement.

When the economy went south in 2008, investors made a run on the fund forcing about $3 billion in redemptions. According to the Tax Court opinion “Vicis’ principals decided to wind down operations in January 2010.”   More than the bad economy may have been at work, however.  A couple of them (but not Mr. Lucas) were under federal investigation at that time, with one of them eventually paying the SEC a multi-million dollar fine.

Mr. Lucas’ personal life also went south in 2008 when his wife of 13.5 years filed for divorce in January. It appears the divorce was finalized in 2011. In the meantime, there was plenty of money for Mr. Lucas. He received almost $47 million from Vicis during that time period---some as salary and compensation in 2008 and 2009 and some as part of the windup in 2010.  And some of the $47 million was payment of the deferred compensation.

A big chunk of the divorce litigation concerned how much, if any, of that $47 million was a marital asset subject to equitable distribution. In 2011 the Florida state court overseeing the divorce decided that about $4.7 million was deferred compensation from years where the parties were married and so needed to be allocated.  The rest was non-marital assets not subject to distribution. The Florida court also found that although Mr. Lucas’ interest in Vicis as of 2011 was zero, it had been about $5 million in January 2008.  The court then found that the total marital estate to be distributed was valued at about $15 million and the court made a distribution based on that.  She got their Florida home and $6.6 million cash to boot.

The good news for Mr. Lucas was that he got to keep most of that $47 million he received from Vicis between 2008 and 2010. The bad news was that the litigation cost him about $3 million in costs and attorneys fees.  Like Mr. Gilmore, Mr. Lucas decided to take that as a deduction because, like Mr. Gilmore, he had been trying to protect his assets in the divorce litigation. And, like Mr. Gilmore, Mr. Lucas lost.  Apparently his return preparer had not read Gilmore

After explaining the applicable law Judge Vasquez had no difficulty in finding that “but for her marriage to petitioner, Ms. Lucas would have no claim to petitioner’s interest in Vicis.” Echoing almost word-for-word the Supreme Court’s language in Gilmore, Judge Vanquez found that “Ms. Lucas’ claim to the Vicis distributions stemmed entirely from her marriage to petitioner.”

The Lesson
It is very difficult to deduct the costs of divorce. That is because the divorce claim is inevitably tied to the marriage relationship and marriage is deemed by society to be something other than a transaction entered into for profit, although we all probably know couples who behave otherwise. It is for that reason that Treasury Regulation §1.262-1(b)(7) provides “Generally, attorney’s fees and other costs paid in connection with a divorce, separation, or decree for support are not deductible by either the husband or the wife.”

But it is not impossible to deduct some costs in the context of a divorce. The trick is to identify the non-personal “claim” that you can then tie your costs to. In Liberty Vending, Inc. v. Commissioner, T.C. Memo. 1998-177, for instance, Mr. Pulous was laid up in the hospital for heart problems. When he got out, he discovered his wife had filed for divorce and obtained a court order giving her possession of his video arcade businesses. She had used the court order to fire employees and basically shut down the operations, running up creditor bills. So he (and his company Liberty Vending) filed a variety of claims to get back his businesses and get them back running. He had to do that through the divorce court. The Tax Court allowed him to deduct the portion of attorneys fees related to those particular claims finding that they stemmed from his profit-seeking activities rather than his marriage, even though the claims were asserted in a divorce case.

If Mr. Poulos, however, had simply been defending his ownership in Liberty Vending during the divorce proceeding against the claims of his wife, and had not been trying to stave off his soon-to-be ex-wife’s attempts to interfere in the business, then that would be like Gilmore and Lucas, just part of the divorce claim. No deduction. As it was, however, his wife’s active interference required him to assert claims to get back control of the business.

Coda: Curiously, Vicis appears to still be in existence, although inactive, at least according to Bloomberg and Brightscope websites.

Bryan Camp has not yet been divorced from his position as the George H. Mahon Professor of Law at Texas Tech University School of Law.

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