The taxpayers in the case of Garcia v. Commissioner, TC Summary Op. 2018-38, recognized that expenses related to litigation that arose from an investment in stock in Randgold & Exploration Co., Ltd. (R&E) they had made would only be deductible as IRC §212 expenses. They also recognized that a deduction under that provision would be a miscellaneous itemized deduction subject to the 2% floor imposed on all such deductions in the year in question and not deductible at all in computing their alternative minimum tax liability.

The taxpayers also were aware that if such expenses were an ordinary and necessary trade or business under IRC §162 that was incurred in the trade or business other than that of being an employee, the entire amount of the expense would be deductible in computing their adjusted gross income. As well, the entire amount would also reduce their alternative minimum taxable income.

So, they decided they could come up with a strategy to move those expenses from the “bad” §212 category to the “good” §162 category. Their strategy involved creating a new S corporation (JGx5 Enterprises). The S corporation held four rental properties they moved into the corporation along with they added one “special” right.

The Garcias took the following action via a notation in “Special Minutes” for their new S corporation per the facts recited in the opinion:

The other document, captioned “Special Minutes”, states that petitioners “assign their litigation rights for any investment made by John and Jamie Garcia to JGX5 Enterprises.” It also states that “the business of JGX5 is to make investments, including the funding of litigation costs * * * [i]n exchange for * * * a[n] ownership interest in the litigation recovery, if any.” The document further states that “this memo is to provide further clarity that Randgold & Exploration litigation funding is being done through JGX5 Enterprises and that JGX5 Enterprises will earn a fair return on its investment for funding such litigation.” The document states: “RESOLVED, that JGX5 accepts litigation and the costs thereof in return for a reasonable assignment of shares necessary to cover the costs of litigation and provide for a reasonable recovery.”

The Garcias had entered into an agreement with a consortium of minority shareholders of R&E to fund litigation in South Africa (where R&E was located) to obtain an award of damages from R&E and a third party for corporate fraud. That agreement provided the Garcias with the right to a percentage of any ultimate recovery obtained by the consortium. Under the agreement, the Garcias would from time to time be faced with “capital calls” to send funds to the consortium to pay for the legal battle.

Despite the claim that they had transferred the rights to JGx5, the facts section of the opinion noted they did not take action to transfer the stock or, apparently, notify the consortium that JGx5 was now a party to the litigation:

None of the R&E stock was ever actually assigned to JGx5 and, as previously stated, petitioners remained the registered owners of the R&E stock at all relevant times. JGx5 never submitted an application to intervene in the R&E litigation, and none of the legal documents relating to the R&E litigation refers to JGx5.

Having executed the “Special Minutes” they treated amounts paid for all of 2012 as ordinary and necessary business expenses of the S corporation and on their 2012 S corporation return they claimed a deduction for legal and professional fees of $76,630 as part of an ordinary business loss of the S corporation.

When the IRS examined their return, they denied the trade or business loss of $76,630 as a deduction, rather allowing an itemized deduction of $64,180. Ultimately this change resulted in an additional tax due of over $27,000 for 2012 as well the assessment of an accuracy related penalty.

The only question before the Court was whether these expenses were truly trade or business expenses of the S corporation, or rather investment related expenses of the shareholders deductible as miscellaneous itemized deductions.

There were three payments made towards the legal expenses in 2012. Two of them, made in February and June of that year, were not paid from corporate funds, but rather were paid directly by the shareholders to the consortium. The taxpayers claimed, as noted in another section of the “Special Minutes”, that these payments were loans to the S corporation.

The Tax Court did not accept the view that these were truly loans to the S corporation. As the Court noted:

Neither payment could fairly be characterized as a “transfer into” JGx5 under the terms of the “Special Minutes”, and there is no objective evidence of a bona fide expectation of repayment. In any event, the February 1, 2012, payment was made nine days before JGx5 was even incorporated.

As we’ve noted in previous articles, merely calling something a loan doesn’t make it so. In particular, most often the taxpayer has no intent whatsoever of repaying such “loans” which is fatal to the position—real lenders expect to be repaid their loans.

If the S corporation didn’t pay the payment, it can’t deduct it. But they did make one final payment directly out of the S corporation. However, in this case the Court still noted that, despite the corporation making the payment, it still wasn’t really an expense of the corporation:

We assign little significance to the “Special Minutes” that petitioners signed in 2012, purportedly assigning the litigation and costs to JGx5. Transfers between a corporation and its sole shareholders are subject to heightened scrutiny, and the labels attached to such transfers mean little if not supported by other objective evidence. E.g., Boatner v. Commissioner, T.C. Memo. 1997-379, aff’d without published opinion, 164 F.3d 629 (9th Cir. 1998). The record contains no objective evidence to suggest that this paperwork altered in any way petitioners’ relationship to the consortium or their personal obligation to the consortium for the legal expenses in question. Indeed, all the evidence shows that the consortium continued to invoice petitioners, and not JGx5, for payment of petitioners’ commitment even after the year at issue. JGx5 never submitted an application to intervene in the R&E litigation, and none of the legal documents relating to the R&E litigation refers to JGx5.

The Court ultimately decides that none of the deduction is properly a “trade or business” deduction of the S corporation’s “litigation funding” business.

Advisers should expect to be confronted with clients who want to set up structures like the one that failed in this case, especially now that the §212 investment related expenses are simply not deductible at all following the passage of the Tax Cuts and Jobs Act. As always, the clients will claim that “their buddy’s CPA” said this was fine and the buddy is claiming such expenses on his/her return.

Here’s the hitch—pure and simply it’s not at all fine. The position is, at best, an “audit lottery” position where the only way the position “works” is if the IRS never looks at it. And, frankly, we also know that there will be other variants of schemes that also will claim to convert §212 expenses into trade and business expenses, most of which will be built on similarly shaky foundations.

At the end of the day, simply putting an S corporation shell around expenses not related to a true trade or business will not magically transform the expenses from nondeductible §212 expenses into deductible §162 trade or business expenses. These expenses have to meet very specific criteria to make their way onto the front page of the Form 1120S.