Magazine article The CPA Journal

Legal Costs to Recover Punitive Damages Are a Deductible Business Expense

Magazine article The CPA Journal

Legal Costs to Recover Punitive Damages Are a Deductible Business Expense

Article excerpt

By Peter C Barton, JD CPA, and Clayton R.Sager, PhD, University of Wisconsin-Whitewater

In Guill v. Commissioner, the Tax Court recently ruled that legal costs to recover taxable punitive damages were deductible as an IRC section 162(a) business expense rather than as a miscellaneous itemized deduction under IRC section 212, thereby avoiding an alternate minimum tax (AMT) problem. This issue is timely because the Y2K bill passed by Congress in July 1999 allows punitive damages.

In 1989, Congress amended IRC section 104(a) to tax punitive damages where no physical injury is involved. For cases before the 1989 amendment, in O'Gilvie v. US., 519 U.S. 79 (1996), the Supreme Court ruled that punitive damages to punish the defendant and deter wrongdoing are taxable. In 1996, Congress amended section 104(a)(2) to tax all punitive damages. Ordinary and necessary expenses of carrying on a trade or business are deductible on Schedule C under section 162(a). IRC section 212 allows deductions for nonbusiness expenses of income-producing activities that lack the regularity and continuity of a business. Section 212(1) expenses for the production or collection of income are Schedule A miscellaneous itemized deductions (MIDs) under IRC section 63(d) and IRC section 67. MIDs are deductible only in excess of 2% of AGI, and they are not deductible at all for the AMT.

Guill, an independent contractor insurance agent, worked for Academy Life Insurance for several years. Guill alleged that, after firing him in 1986, Academy did not pay him all of the renewal commissions he had earned. He sued for breach of contract, conversion, unfair trade practices, failure to pay commissions, and overstatement of income reported to the IRS. A U.S. district court jury awarded Guill $51,499 in actual damages and $250,000 in punitive damages on the conversion claim, plus interest.

Guill reported the actual damages on his 1992 Schedule C; however, he did not report the punitive damages. …

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