Shareholder legal fees.

With the increased number of legal problems corporate officers, directors and shareholders face, it's important to understand the correct tax treatment of legal fees a corporation pays on their behalf.

Kenneth Guarino created Capital Video Corp. to distribute pornographic videotapes. Because he was worried organized crime would try to take over the company or interfere with his other businesses, Guarino paid $1,728,000 in "tribute" to Natale Richichi, a known crime boss. The payment was to assure Richichi's help in avoiding any problems. Guarino helped Richichi hide the payment from the IRS and conceal other assets from the government. Both men were indicted for conspiracy and fraud. Capital Video paid and deducted $250,000 in 1996 and $517,000 in 1997 for Guarino's legal fees. The IRS denied the deductions and said the payments represented a constructive dividend to Guarino. The Tax Court ruled for the IRS and the taxpayer appealed.

Result. For the IRS. Legal fees to defend a business are deductible. Paying someone else's expenses generally is not. However, if a payment was to "promote" a taxpayer's business, then the fees are deductible. There is a two-part test CPAs can use to determine if such payments are deductible. First, the payment must have been made primarily to benefit the payor's business. Second, the expenses must be ordinary and necessary.

The IRS and the courts usually evaluate the second test using the origin of the claim doctrine. It looks to the factors that gave rise to the litigation and not the outcome. The fact an indispensable employee was involved and the business would have trouble surviving without him or her is immaterial. Applying the second test to this case, the taxpayer must prove the illegal activities arose in connection with, or proximately resulted from, the corporation's business activities, ignoring the effect of a conviction on the shareholder or the corporation.

The Tax Court found no evidence the payment or the conspiracy benefited the corporation. Therefore, it concluded the payments did not meet the deductibility tests. Since the taxpayer did not prove the finding of facts was clearly erroneous, the First Circuit Court of Appeals affirmed the Tax Court decision. The corporation was denied the deduction, and the taxpayer was forced to report a constructive dividend equal to the legal fees paid on his behalf.

The taxpayer's case was weakened substantially because he helped the codefendant hide income and assets from the IRS, actions that would not benefit the corporation. In addition the fact the tribute payments also concerned other businesses negated the conclusion the expenses were ordinary and necessary for the paying corporation. Before any shareholder legal fees are deductible, the company must show a lawsuit was the direct result of actions the shareholder took for the primary benefit of the paying corporation. The courts usually will rule that actions that benefit the shareholder or are not directly beneficial to the corporation don't promote its business. If a company cannot demonstrate an exclusive corporate business purpose, the deduction will be denied and the shareholder charged with receiving a constructive dividend.

* Capital Video Corp. v. Commissioner, CA-1.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accountancy and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

Uncle Sam Empties His Pockets

The U.S. government
refunded taxpayers $57.04
billion more in 2001 than it
did in 2000.

                      2001 Refunds     2000 Refunds
Type of tax          (in millions)    (in millions)

Individual income         $205,690         $157,837
Corporate income            37,941           30,382
Employment                   6,283            4,957
Excise                       1,948            1,802
Estate and gift                925              773
Total                     $252,787         $195,751

Source: IRS, www.ivs.gov.