Attorney-at-Law

WELL-SETTLED – NO DEDUCTION – PART DEUX

In Uncategorized on 11/27/2012 at 18:04

Once again, litigation settlement costs aren’t deductible, according to The Great Dissenter, a/k/a The Judge Who Writes Like a Human Being, Mark V. Holmes, in James A. Cavanaugh, Jr., 2012 T. C. Memo. 324, filed 11/26/12.

Big Jim was a heavy cleanup hitter, having founded and operated Jani-King International, Inc., a Sub S that was one of the world’s leading janitorial-services franchisors. To take a break from cleaning up, Big Jim, his bodyguard Rock Walker, and a Jani-King employee named Erica Fortner (job title unclear), took a Thanksgiving holiday at Big Jim’s villa on St. Maarten, strictly for fun (as everyone stipulates).

Unfortunately, Big Jim brings along 27-year-old Ms. Colony Anne (Claire) Robinson. Unhappily, their holiday in the sun is marred by the death of Ms. Colony Anne (Claire), whose death is caused by an overdose of cocaine.

Momma Robinson sues all and sundry, claiming Big Jim and his employees provided the drugs that killed her baby.

Fearing that his corporation’s good name and his own would wind up in the trash, with the Texas jurors acting as the janitors,  Big Jim’s Sub S, echoing the words of Paul Simon, says “so here’s to you Mrs. Robinson”, forking over $2.3 million to Momma Robinson, of which Big Jim kicks in $250K, but gets reimbursed by his Sub S. Oh, and Big Jim’s Sub S also claims $180K in legal fees it paid to its own lawyers to get it out of the case.

Judge Holmes cuts to the chase: “From Cavanaugh’s perspective, it is an unfortunate fact of business life that corporations and prominent individuals get sued, sometimes on dubious facts and theories of liability. Settling such suits may be distasteful, but even a small chance of an enormous payout may justify a deal that protects assets from the uncertainty of litigation and protects a business reputation from scandal.

“The Commissioner has a different view–he argues that however jumbled and wrinkly the legal topography created by the collision of Code, regulations, and caselaw may sometimes seem, it cannot possibly hide a crevice dark enough to successfully shelter an argument that the price paid for the death of the boss’s girlfriend is a deductible corporate business expense.” 2012 T. C. Memo. 324, at p. 6.

The issue is origin versus consequences. Did the claim that the parties settled arise out of business operations, that is, out of the use of business premises, business property, business equipment or in furtherance of a business purpose? Or was the origin of the claim a personal, nonbusiness matter?

While damage to reputation is certainly a concern, “(O)ur Court has never held that naming a company as defendant in a lawsuit ipso facto makes legal fees or settlement costs into business expenses.” 2012 T. C. Memo. 324, at p. 10.

And Tax Court doesn’t consider the merits of the claim that was settled; to do so would punish those who settle, and that would be a bad result; judges want settlements. The claim was that Jani-King’s employees, Big Jim, Rock and Erica Fortner plied poor Colony Anne (Claire) with blow, causing her death, and both the employees and the employer (respondeat superior) are liable.

But the analysis doesn’t end there. They may be employees, but were they engaged in business activities? No. “The Commissioner argues that the parties stipulated that the trip to St. Maarten involved no business conduct, and that this fact alone means that he should win. Cavanaugh argues that tort claims against company employees are nearly certain to arise in business today, and that this makes them proximately related to undertaking business operations. But Cavanaugh cites no authority to support such a broad assertion.” 2012 T. C. Memo. 324, at p. 15.

What cases there are that would sustain Big Jim’s deduction all involve use of business property or business activity, for profit; and going to St. Maarten was none of the above.

Big Jim might argue that Rock was acting for the Sub S in the course of the St. Maarten’s trip, but the evidence is too scanty to say what Rock was doing.

To sum up, here’s part of a Judge Holmes footnote that says it all: “If the Jani-King employees had been attending a conference in St. Maarten or if they had given Robinson the drugs that killed her back in Dallas, at Jani King’s offices, and during business hours, our analysis might be different.” 2012 T. C. Memo. 324, at p. 18, footnote 7, last sentence.

And while his Sub S by-laws provided for indemnification and reimbursement of an officer of Jani-King, when made party to litigation, those benefits are limited to litigation in the indemnitee’s capacity as officer or director, acting in good faith and in the best interests of Jani-King, and Jani-King’s Board and counsel must so find. No evidence of this, so no deduction for the reimbursement to Big Jim of the $250K. And if the $250K is treated as a voluntary payment by the Sub S, it still needs a business purpose, and we don’t have that here.

Finally, IRS wants to claim the $250K is a constructive dividend to Big Jim. But that involves us in all the Sub S E&P, AAA and basis computations. “For an S corporation that does have accumulated earnings and profits, a shareholder distribution is more complicated. The amount of a distribution that exceeds the corporation’s accumulated adjustment account (AAA) is a dividend– but only to the extent it does not exceed the S corporation’s accumulated E&P. See sec. 1368(c)(2). The portion of the distribution that doesn’t exceed the AAA is taxable only to the extent it is greater than the shareholder’s basis in his stock. See sec. 1368(c)(1).

“When Jani-King reimbursed Cavanaugh $250,000 in 2005 its reported AAA was nearly $6.4 million. But the Commissioner introduced no evidence of Jani- King’s accumulated E&P or Cavanaugh’s basis in his Jani-King stock, which leaves us with no grounds to decide if the distribution is a constructive dividend.” 2012 T. C. Memo. 324, at p. 27.

See my blogpost “Well-Settled – No Deduction”, 11/7/2012.

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  1. Jim was a wannabe Hugh Hefner. Erika and Claire were his girlfriends and neither worked for Jani King. I know firsthand that he fed them drugs. He fed me drugs too and I stayed at his house on Star Island in South Beach. I eventually saw that I was on a path to destruction and left in the middle of the night. I later called to check on Colony and he told me she died. I was so saddened. I’ve never forgiven Jim and his actions should come to light. He is not a good person.

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  2. I was Jim Cavanaugh’s executive personal consultant from 2003 to late 2007… I know everything that goes on at hibiscus island and st. Maarten… As I was the executive oversight for these properties, his personal life and the girls… Talk about tax evasion… Would love to talk now… As I am no longer under a separation agreement from Jim or Jani-King. Zhayes1@live.com

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