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. …