The Tax Court determined a taxpayer would be allowed a deduction for a portion of a settlement he paid to a customer that had filed a legal claim for problems with work performed by two corporations he controlled only as an employee business expense in Ferguson v. Commissioner, TC Memo 2019-40, rather than as an above the line business loss.  However, the portion of the loss allocable to the other corporation, which was an S corporation, would be treated as a contribution of capital giving rise to a deduction that would flow through to the taxpayer.

The opinion summarized the complaint of the customer as follows:

The homeowners alleged that Mr. Ferguson had misrepresented RFI’s and Pinnacle’s expertise in manufacturing and installing cast stone. The homeowners also alleged that Mr. Ferguson, in concert with Pinnacle and RFI, elected to use construction methods and materials that reasonable persons would not have employed.

The opinion goes on to describe the ultimate settlement:

In 2011 the lawsuit was settled. The homeowners, Mr. Ferguson, RFI, Pinnacle, and VFE were parties to the settlement agreement, which Mr. Ferguson signed in his individual capacity. As a part of the settlement, Mr. Ferguson transferred nine parcels of real estate to the homeowners. Mr. Ferguson also gave the homeowners a check, which was drawn on his personal bank account. In turn the homeowners agreed to release Mr. Ferguson, RFI, Pinnacle, and VFE from their claims.

RFI was a C corporation in which Mr. Ferguson held a majority interest that operated as the general contractor on custom homes that Mr. Ferguson built.  Mr. Ferguson was an employee of RFI.  Pinnacle was an S corporation of which Mr. Ferguson was also the majority shareholder which manufactured, supplied and installed cast stone.  VFE was another S corporation owned by Mr. Ferguson that sold the lots on which the homes were constructed.  He also operated a commercial construction business and a home remodeling business as sole proprietorships.

The taxpayer recorded the transactions as follows.

Pinnacle recorded the aggregate value of the check payment and the fair market value of the real estate transfer (collectively, settlement payment) on its books for 2011 as a loan from Mr. Ferguson. No written loan documents were prepared, and no interest was accrued on the loan. Mr. Ferguson believed he could treat these amounts as a loan to Pinnacle because he believed that the settlement was attributable to the defective cast stone. Pinnacle had no sales or gross receipts in 2012, and Mr. Ferguson shut it down later that year; he assumed Pinnacle’s liabilities regarding the recorded loan, essentially relieving Pinnacle of the obligation to repay him.

The taxpayer claimed these amounts as a deduction on Pinnacle’s S corporation tax return, with the losses flowing through to Mr. Ferguson’s individual income tax return.  The IRS contends that Pinnacle could not deduct the losses because it did not pay or incur them.  Rather, the IRS found that they were actually the liability of the C corporation and, as such, could only be deducted as an unreimbursed employee business expense.

The Tax Court opinion summarized the eventual positions of the parties as follows:

Respondent asserts that the settlement payment was RFI’s expense because RFI was responsible for the work that gave rise to the homeowners’ lawsuit. Respondent argues that as a statutory employee of RFI under section 3121(d)(1), Mr. Ferguson may deduct the settlement payment only as an unreimbursed employee business expense. Petitioners counter that RFI was not Mr. Ferguson’s only trade or business. According to petitioners, they may deduct the settlement payment on a Schedule C because Mr. Ferguson paid it to protect his business reputation and, by extension, his other businesses.

The Tax Court notes that the origin of the claim doctrine controls the deductibility of legal fees.  The key question was whether the loss arose from a business activity of Mr. Ferguson other than his employment by RFI.  That is important because employee business expenses are not deductible in arriving at adjusted income.[1]

The Court found that the claim clearly related to RFI and Pinnacle, not any Schedule C business of Mr. Ferguson:

The record establishes that the origin of the homeowners’ lawsuit stems from work performed by RFI and Pinnacle rather than a separate trade or business of Mr. Ferguson. While the homeowners’ complaint, amended complaint, and second amended complaint alleged various problems with the construction of the dwelling, the parties agree that the claims regarding the cast stone were the homeowners’ primary grievance. The cast stone work was performed and/or supervised by RFI and Pinnacle. RFI was the general contractor for the construction project and agreed to perform “all work necessary to complete the dwelling”. Pinnacle was subcontracted to produce, supply, and install cast stone for use in the construction.

While the homeowners also sued Mr. Ferguson in his individual capacity, he was not a party to the construction contract with the homeowners. Furthermore, the homeowners did not allege that Mr. Ferguson took any action in the construction of the dwelling other than as the face and controlling shareholder of RFI and Pinnacle.

The Court also found that there was no loan to Pinnacle:

Petitioners’ argument that Mr. Ferguson’s payment of the settlement was actually a loan to Pinnacle is not supported by the record. Petitioners cite Pinnacle’s treating the settlement payment as a loan on its books as evidence of a bona fide loan. However, no loan documents were prepared, and the record is devoid of any evidence of a fixed repayment date or repayment schedule. No interest or principal was paid or accrued on the purported loan, which Mr. Ferguson effectively canceled when he ended Pinnacle’s operations in 2012. Furthermore, Mr. Ferguson testified that Pinnacle had little chance of obtaining third-party financing on its own when he paid the settlement. This view was shared by Mr. Ferguson’s accountant, who acknowledged at trial that Pinnacle’s poor cash position made repayment unlikely.

On the basis of these facts, we find that Mr. Ferguson knew that Pinnacle would be unable to repay him when he funded the settlement. Accordingly, Mr. Ferguson did not intend to establish a creditor-debtor relationship with Pinnacle, and his payment of the settlement was not a loan to the S corporation.

Rather, the Tax Court found that Mr. Ferguson had made a capital contribution to Pinnacle.  The Court found both Pinnacle and RFI were responsible for the legal matter and thus decided to allocate the settlement between the two parties:

Because Mr. Ferguson personally funded the settlement payment, 50% of which was an expense of Pinnacle, we will deem 50% of the payment a capital contribution to Pinnacle. See Rink v. Commissioner, 51 T.C. at 751-752; Koree v. Commissioner, 40 T.C. at 966. Accordingly, Pinnacle may deduct 50% of the settlement payment for 2011, and petitioners are entitled to their pro rata share of any loss this deduction produces.

Because the remaining 50% was an expense of RFI, we would normally hold that this portion of the payment is not a deductible expense to petitioners but rather a capital contribution to the C corporation. See Rink v. Commissioner, 51 T.C. at 751-752; Koree v. Commissioner, 40 T.C. at 966. However, respondent has conceded that petitioners can deduct amounts paid on behalf of RFI as unreimbursed employee business expenses. On the basis of this concession, petitioners may deduct the remaining 50% of the settlement payment as an unreimbursed employee business expense.

[1] For the years in question, if the item is an unreimbursed employee business expense it would be a miscellaneous itemized deduction subject to a 2% of adjusted income limitation and not deductible in computing adjusted minimum taxable income.  For tax years 2018-2025 such an employee business would be wholly barred from deduction.