Capital Video Corp. v. Commissioner

United States Court of Appeals
For the First Circuit

No. 02-1564

CAPITAL VIDEO CORPORATION; KENNETH GUARINO,

Petitioners, Appellants,

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent, Appellee.

APPEAL FROM THE UNITED STATES TAX COURT

[Hon. Stephen J. Swift, U.S. Tax Court Judge]

Before

Lynch, Circuit Judge,
Cyr, Senior Circuit Judge, and
Lipez, Circuit Judge.

Brian C. Newberry, with whom James P. Redding and Hinckley,
Allen & Snyder, LLP were on brief, for Appellants.

Judith A. Hagley, Attorney, Tax Division, with whom Eileen J.
O'Connor, Assistant Attorney General, and Gilbert S. Rothenberg,
Attorney, Tax Division, were on brief, for Appellee.

November 27, 2002
 LYNCH, Circuit Judge. This case raises the issue of the

deductibility of legal fees paid for a defense against criminal

charges as ordinary and necessary business expenses under Internal

Revenue Code § 162(a) (2000). The petitioners, a corporation and

the sole shareholder of that corporation, were sent tax deficiency

notices by the Internal Revenue Service (IRS) on April 24, 2000, in

the sum of $116,950.00 for the corporation and $312,874.00 for the

individual, plus penalties under I.R.C. § 6662. Both of the

deficiency notices stemmed from legal fees relating to the defense

of a federal criminal indictment against Kenneth Guarino. The

legal fees were paid and then deducted by the corporation, Capital

Video Corporation, and were not counted as income by Guarino, the

corporation's sole shareholder. Petitioners argue that the

criminal conduct was so related to the operation of the corporation

that the legal fees were a deductible corporate expense and

properly not included in Guarino's gross income. The tax court

disagreed, finding that the criminal charges were not sufficiently

related to the operation of the corporation. We affirm the ruling

of the tax court.

I.

These facts are derived from the joint stipulated facts

and from the exhibits, which were stipulated to be authentic.1 The

1
Some facts are taken from Guarino's plea agreement. Because
only the authenticity of the plea agreement has been stipulated to,
the parties dispute whether the facts detailed in the plea

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parties rested on only these facts and exhibits before the tax

court.

In 1979, Kenneth Guarino created and incorporated Capital

Video Corporation, located in Cranston, Rhode Island; Guarino was

the sole shareholder. Capital Video was a distributor of

pornographic videotapes. Guarino was associated with Natale

Richichi, a capo in the Gambino family of La Cosa Nostra, who dealt

directly with the bosses of both the Gambino and Patriarca families

and had influence with other factions of La Cosa Nostra. Guarino

was concerned that members of other organized crime families would

extort money from, or take over, his multimillion dollar business.

He also worried that organized crime would interfere with his other

business ventures, including a show at the Dunes Hotel and Casino

in Las Vegas, called "Night Dreams," and a precious metals business

in the New England area.

Guarino in 1979 began to pay "tribute" to Richichi to

fend off extortion attempts and to assist Guarino with other

business matters where Richichi's influence as a capo might benefit

Guarino. This included protection for the Night Dreams production

and the precious metals business in New England, and for influence

with various union officials. The payments averaged between eight

agreement are binding on the parties. This debate is inapposite,
because the only facts we derive from the plea agreement are used
against the petitioners, who urged that the plea agreement facts be
binding.

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and ten thousand dollars twice per month. The total amount of the

payments is in dispute, but between July 1985 and September 1995,

Guarino paid Richichi at least $1,728,000 in cash.

A substantial portion of Richichi's income came from

Guarino's payments, and Richichi was not otherwise lawfully

employed. Richichi worried that the IRS would become aware of and

attempt to tax his substantial income and assets. As a result,

Richichi and Guarino made arrangements to conceal the tribute

payments from the IRS. The payments were always made in cash.

While some of the funds were paid by Capital Video, these payments

were kept off of its accounting books. Some payments were hidden

by skimming funds from the profits of Capital Video's video booth

and peep show machines; Capital Video generated false Forms 1099 so

that it appeared that the skimmed profits were instead flowing to

Guarino and a nominee owner.2 Other funds from Capital Video were

reported as loans and dividends to nominee owners; Capital Video's

bookkeeper, Guarino's former mother-in-law, would write these loan

and dividend checks and cash them herself. Guarino also provided

Richichi with a Capital Video credit card, had Capital Video lease

Mercedes-Benz automobiles for him and for his daughter, and paid

for health insurance coverage for Richichi and his wife under

Capital Video's employee plan.

2
A "nominee owner" is someone who owns an asset merely on
paper, in order to disguise the true owner of property.

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 Apart from helping to hide the tribute payments from the

IRS, Guarino also helped Richichi hide other assets. For instance,

Guarino advised Richichi on the details of how to hide his

ownership of property in the Dominican Republic by using a

corporation and nominee owners. He also offered to help conceal

Richichi's interest in property more directly, though there were no

allegations that Guarino actually served in anything more than an

advisory capacity with regard to Richichi's other assets.

In October 1992, Guarino and Richichi, along with another

defendant, were indicted by a federal grand jury on one count of

conspiring to bribe an official of the stagehands union in

connection with Guarino's Las Vegas show. In August 1994, Guarino

and Richichi were indicted with three others in a superseding

indictment. Count One alleged a conspiracy to "defraud the United

States by impeding, impairing, obstructing, and defeating the

lawful government functions of the [IRS] in the ascertainment,

computation, assessment, and collection of federal income taxes

owed by" Richichi. Count Two reiterated the allegation of

conspiracy to bribe a union official. Finally, in August 1995

Guarino and Richichi were again indicted under a second superseding

indictment for both of these counts, and they were also each

separately indicted for several counts of interstate transportation

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of obscene material through the use of a common carrier, 18 U.S.C.

§ 1462, and aiding and abetting that crime under 18 U.S.C. § 2.3

In January 1997, Guarino, as part of a plea agreement,

pled guilty only to the charge of conspiracy to evade taxes. He was

sentenced to sixteen months in prison, eleven of which were served

in a halfway house, and fined $250,000.

Capital Video was a subchapter C corporation whose fiscal

year began on March 1. On March 1, 1996, Capital Video elected to

be treated instead as a subchapter S corporation. This change in

status meant, among other things, that its fiscal year needed to

match the calendar year. As a result, Capital Video's first fiscal

year as a subchapter S corporation was a short one, lasting from

March 1 to December 31, 1996.

During the calendar years 1995 and 1996, Capital Video,

out of its corporate funds, paid for all of the legal defense fees

for Guarino stemming from all of these criminal indictments.

Capital Video paid $250,034 in fees during calendar year 1995 and

$517,038 in fees during calendar year 1996, for a total of

$767,072. Of that amount, Capital Video spent $343,971 between

March 1, 1995 and February 29, 1996, when it was a C corporation.

For the C corporation fiscal year ending February 29, 1996, Capital

Video deducted as ordinary and necessary business expenses the

3
The obscenity charges did not stem from the operations of
Capital Video, which was an on-site video store, but instead
involved separate mail-order pornographic video businesses.

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$343,971 it had paid in legal fees for Guarino. Capital Video

spent the remaining $423,101 between March 1 and December 1, 1996;

it deducted this amount for its subchapter S corporation short

fiscal year. Guarino failed to report the payment of these legal

fees as income.

The IRS sent notices of deficiency to both Capital Video

and Guarino. For Capital Video, the IRS disallowed the full

$343,971 in legal fees that had been deducted as an ordinary and

necessary business expense for the C corporation fiscal year ending

February 29, 1996.4 For Guarino, the IRS assessed a tax deficiency

for his 1996 taxes. The IRS treated the entire $343,971 paid by

Capital Video when it was a subchapter C corporation as a

constructive dividend to Guarino. The IRS later conceded that

$250,034 of those fees, though deducted in the corporate fiscal

year ending February 1996, were actually paid in 1995; they

therefore could not be counted as personal income for Guarino for

1996. The remainder of the deducted amount, $93,936, was spent in

January and February of 1996, part of the 1996 tax year for

Guarino's personal tax purposes. For the legal fees paid by

4
Subchapter S corporations do not pay income tax; they
instead pass through all of their income to their shareholders
every year. See I.R.C. §§ 1363(a), 1366(a). Thus, the validity of
the deduction did not affect Capital Video’s taxes once it elected
S corporation status, but instead affected how much tax Guarino
paid on the corporate disbursements.

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Capital Video once it elected S corporation status, the IRS

increased Guarino’s 1996 taxable ordinary income by $423,101.

Capital Video and Guarino sued in the U.S. Tax Court,

arguing that the conspiracy to evade payment of taxes was directly

related to the tribute payments, which were themselves made to

protect and promote Capital Video’s business. Therefore, they

argued, the legal fees were properly deductible by Capital Video as

ordinary and necessary business expenses and should not be included

in Guarino’s taxable income. The tax court ruled for the IRS,

finding that the petitioners had not established that the

conspiracy charge was sufficiently related to the protection and

promotion of Capital Video, though it refused to apply I.R.C.

§ 6662 penalties. Capital Video Corp. v. Comm'r, Nos. 4094-00,

4096-00, 2002 Tax Ct. Memo LEXIS 42, *9-*10, *15 (Feb. 11, 2002).

This appeal timely followed.

II.

We review decisions of the tax court "in the same manner

and to the same extent as decisions of the district courts in civil

actions tried without a jury." I.R.C. § 7482(a)(1); see State

Police Ass’n v. Comm'r, 125 F.3d 1, 5 (1st Cir. 1997). The tax

court's legal interpretations are reviewed de novo. Alexander v.

IRS, 72 F.3d 938, 941 (1st Cir. 1995). We will overturn its

factual findings only if they are clearly erroneous. Filios v.

Comm'r, 224 F.3d 16, 21 (1st Cir. 2000). The clear error standard

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of review extends to factual findings "based on inferences from

stipulated facts." Medchem, Inc. v. Comm'r, 295 F.3d 118, 122 (1st

Cir. 2002). A trial court’s finding is clearly erroneous when

"although there is evidence to support it, the reviewing court on

the entire evidence is left with the definite and firm conviction

that a mistake has been committed." Comm'r v. Duberstein, 363 U.S.

278, 291 (1960) (quoting United States v. United States Gypsum Co.,

333 U.S. 364, 395 (1948)).

III.

A. Deduction by Capital Video

1. The Legal Standard

The burden of proof is generally on the taxpayer to

demonstrate that the IRS's nondeductibility determination is in

error. U.S. Tax Ct. R. 142(a); United States v. Janis, 428 U.S.

433, 440 (1976). Once "a taxpayer introduces credible evidence

with respect to any factual issue," the burden shifts to the IRS on

that issue. I.R.C. § 7491(a)(1).

Section 162(a) of the Internal Revenue Code permits the

deduction of "all the ordinary and necessary expenses paid or

incurred during the taxable year in carrying on any trade or

business." Id. § 162(a). To qualify as a § 162(a) deduction, an

expense must "(1) be 'paid or incurred during the taxable year,'

(2) be for 'carrying on any trade or business,' (3) be an

'expense,' (4) be a 'necessary' expense, and (5) be an 'ordinary'

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expense." Comm'r v. Lincoln Sav. & Loan Ass'n, 403 U.S. 345, 352

(1971). The phrase "ordinary and necessary" has a specialized

definition in tax law. The term "necessary" imposes "only the

minimal requirement that the expense be 'appropriate and helpful'

for 'the development of the [taxpayer's] business.'" Comm'r v.

Tellier, 383 U.S. 687, 689 (1966) (quoting Welch v. Helvering, 290

U.S. 111, 113 (1933)). Moreover, an expense need not be recurring

in order to be considered ordinary under § 162(a):

Ordinary in this context does not mean that the payments must
be habitual or normal in the sense that the same taxpayer will
have to make them often. A lawsuit affecting the safety of a
business may happen once in a lifetime. The counsel fees may
be so heavy that repetition is unlikely. None the less, the
expense is an ordinary one because we know from experience
that payments for such a purpose, whether the amount is large
or small, are the common and accepted means of defense against
attack.

Welch, 290 U.S. at 114. To be deductible as ordinary and

necessary, an expense must be "directly connected with" or have

"proximately resulted from" business activity. Kornhauser v.

United States, 276 U.S. 145, 153 (1928). Whether an expenditure is

ordinary and necessary is usually a question of fact. Comm'r v.

Heininger, 320 U.S. 467, 475 (1943).

Legal fees paid to defend the business interests of a

taxpayer may normally be deducted under § 162(a). Tellier, 383

U.S. at 690. Public policy does not prohibit the deduction of

legal fees relating to criminal activity so long as the legal fees

are an ordinary and necessary expense of a trade or business. Id.

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at 694-95; Heininger, 320 U.S. at 474. However, the payment of

another taxpayer's expenses generally is not deductible as a

business expense. Welch, 290 U.S. at 114. This principle extends

to legal fees, which a taxpayer usually cannot deduct as a business

expense if the fees are for legal services provided to another. J.

Gordon Turnbull, Inc. v. Comm'r, 41 T.C. 358, 378 (1963), aff'd,

373 F.2d 87 (5th Cir. 1967).

This general rule, like many such rules, has a limited

exception. If the taxpayer pays the expenses of another in order

to promote the paying taxpayer's business interests, the payment

may sometimes be deductible as an ordinary and necessary business

expense. See Gould v. Comm'r, 64 T.C. 132, 134-35 (1975). The

relevant test is that of Lohrke v. Commissioner, 48 T.C. 679

(1967), which the parties agree applies. The test is twofold:

First, the tax court must "ascertain the purpose or motive which

cause[d] the taxpayer to pay the obligations of the other person."

Id. at 688. To meet this prong, the expense must have been made

primarily to benefit the taxpayer's business; any benefit conferred

on the party whose expenses are being paid must be only incidental.

AMW Invs., Inc. v. Comm'r, No. 3901-94, 1996 Tax Ct. Memo LEXIS

255, at *13-*14 (May 22, 1996). Second, the tax court "must then

judge whether it is an ordinary and necessary expense of the

[taxpayer's] trade or business; that is, is it an appropriate

expenditure for the furtherance or promotion of that trade or

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business? If so, the expense is deductible by the individual

paying it." Lohrke, 48 T.C. at 688.

The second prong of this test, as applied to legal

expenses, reflects the focus on the origin of the subject of

litigation, and not on the consequences to the taxpayer. United

States v. Gilmore, 372 U.S. 39, 48 (1963) ("[T]he characterization,

as 'business' or 'personal,' of the litigation costs of resisting

a claim depends on whether or not the claim arises in connection

with the taxpayer's profit-seeking activities. It does not depend

on the consequences that might result . . . .") (emphasis in

original). A corporation may not pay the legal expenses of an

indispensable employee merely on the rationale that the employee

may otherwise lose his case and be imprisoned, with disastrous

results to the corporation. Jack's Maint. Contractors, Inc. v.

Comm'r, 703 F.2d 154, 156-57 (5th Cir. 1983) (per curiam).

Were the contrary rule adopted, businesses could deduct

all manner of personal expenses paid on behalf of indispensable

employees as long as the expenses were necessary to keep them

employed; such a rule "would be far too broad." Id. at 157; see

also Cummins Diesel Sales, Inc. v. United States, 207 F. Supp. 746,

748-49 (D. Or. 1962), aff'd, 321 F.2d 503 (9th Cir. 1963) (denying

a corporate deduction for the wages of a nurse whose care was

necessary to the principal officer and shareholder of the

corporation). In order to prevent this small exception from

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throwing open the floodgates of corporate deduction, the second

prong of the Lohrke test requires that the expense arise in

connection with the business activities of the taxpayer paying the

expense. See Lohrke, 48 T.C. at 688; see also Gilmore, 372 U.S. at

48; Kornhauser, 276 U.S. at 153.

2. Factual Analysis

The taxpayers concede that the tax court articulated the

correct principles of law, but argue that these principles were

incorrectly applied to the facts. The tax court found that there

was insufficient evidence under the "ordinary and necessary" second

prong of the Lohrke test. It found no evidence "that indicates

that Richichi would not have provided the protection to Capital

Video if Guarino had not participated in the conspiracy relating to

Richichi's taxes and if Capital Video had not paid Guarino's legal

fees." Capital Video, 2002 Tax Ct. Memo LEXIS 42, at *10.

Therefore, the petitioners had "not established that Guarino's

participation in the conspiracy . . . and Capital Video's payment

of the legal fees in dispute had a sufficient business relationship

with the protection or promotion of Capital Video's business." Id.

For Capital Video to deduct the legal fees paid for

Guarino's criminal defense, it is not enough to argue that its

business would be in danger if Guarino were convicted of the crimes

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of which he was accused.5 It is not enough for Capital Video to

argue that its decision to pay for Guarino's legal fees was made

primarily for business reasons. When, as here, the corporation

pays the legal expenses of a sole shareholder, it may be difficult

to disentangle the motive of the business from that of the

shareholder. Instead, Capital Video must also prove that the

origin of the expense, here Guarino's criminal conspiracy activity,

arose in connection with, or proximately resulted from, Capital

Video's business activities. Gilmore, 372 U.S. at 48.

There is no clear error in the tax court's factual

finding that the petitioners failed to establish that the expense

was an ordinary and necessary one. Simply put, the petitioners

presented no evidence that the criminal charge, the conspiracy to

avoid paying Richichi's taxes (even ignoring the other charges),

was sufficiently related to Capital Video. No one testified, for

example, that the protection Richichi offered would not be provided

had Guarino not helped to hide the tribute payments, or that such

tax conspiracies are an integral part of tribute payments to

organized crime networks. There was nothing in the record that

required the tax court to make a finding that the conspiracy was

related to the promotion of Capital Video's business. The burden

of proof is on the taxpayer; had the petitioners introduced

5
In fact, the sales and resulting profits of Capital Video
actually increased while Guarino was incarcerated.

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credible evidence on this point, the burden would have been shifted

to the IRS, I.R.C. § 7491(a), but no such evidence was introduced.

The petitioners maintain that even though there was no

direct evidence requiring a contrary conclusion, it was clear error

for the tax court to refuse to make a "common-sense inference" that

the tax conspiracy was a necessary part of the tribute payment

scheme. They argue that the underlying payment of protection was

an ordinary and necessary expense of Capital Video and that a crime

necessarily carries with it a cover-up, and so the cover-up must

also be an ordinary and necessary expense. There were more than

adequate grounds to refuse to make such an inference.

We hold6 there was a fatal lack of evidence regarding the

relationship between the tribute payments, the tax conspiracy, and

Capital Video. While Capital Video may have benefitted from

Richichi's protection, there was no evidence presented as to what

services Richichi provided Capital Video. It is impossible to

ascertain from the record whether Capital Video was a primary or

even a significant beneficiary of the services, if any, exchanged

6
As background, we note that the indictments accused Guarino
of four means of engaging in criminal misconduct, only one of which
referenced or involved Capital Video in any way. The other three
involved other pornography distribution enterprises and Guarino's
Las Vegas show. The legal fees were paid to lawyers who were
defending Guarino against all of these charges. The mere fact that
Guarino pled guilty to only the conspiracy charge of the second
superseding indictment, which described conduct linked to Capital
Video as well as other conduct, does not transform the legal fees
paid to resolve all of these criminal indictments into expenses
deductible by Capital Video.

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for the tribute payments. Furthermore, no evidence was introduced

that the effectiveness of the tribute payments depended on the

resulting tax conspiracy. In light of these gaps in the evidence,

the taxpayers did not show that the tribute payments were ordinary

and necessary expenses of Capital Video. Even if the tax court did

make an inference linking the tribute payments to the conspiracy

charge, as the petitioners request, that inference itself would not

result in a finding that the legal fees were deductible, because

the tribute payments themselves are not clearly linked to the

business of Capital Video. We cannot say the tax court committed

clear error in rejecting the hypothesis that the tribute payments,

as to Capital Video, necessitated the cover up which resulted in

one of the criminal charges in the absence of evidence of this

relationship.

In sum, the tax court did not commit clear error by

refusing to find that the payment of legal fees was an ordinary and

necessary business expense by Capital Video. The deductions do not

meet the second prong of the Lohrke test. Accordingly, we need not

reach the question of the motive for the payments under Lohrke's

first prong.

B. Income to Guarino

Once the tax court determined that the $423,101 in legal

fees paid by Capital Video after it became a subchapter S

corporation were not deductible, "such adjustment mechanically

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results in additional income to Guarino in that same amount as a

result of the corresponding increase in Guarino's share of the

income of Capital Video, as an S corporation." Capital Video, 2002

Tax Ct. Memo LEXIS 42, at *12. Subchapter S corporations do not

retain profits or losses but instead pass them to their

shareholders every year. See I.R.C. § 1366(a). Once it is

determined that the legal fees were not deductible business

expenses, Capital Video's S corporation taxable income is increased

by $423,101. Guarino, as the sole shareholder, must pay taxes on

that amount as personal income. This result depends not on whether

that money was spent for his benefit; instead, it flows directly

from the pass-through nature of S corporation status.

The tax court also concluded that the $93,936 in legal

fees paid during calendar year 1996 while Capital Video was a

subchapter C corporation should be construed as a constructive

dividend to Guarino, and that he thus owed tax on that amount as

well. Capital Video, 2002 Tax Ct. Memo LEXIS 42, at *11-*12; see

Hadley v. Comm'r, 36 F.2d 543, 545 (D.C. Cir. 1929); Hood v.

Comm'r, 115 T.C. 172, 180 (2000); Magnon v. Comm'r, 73 T.C. 980,

993-94 (1980). Guarino has not challenged this holding on appeal;

he disputes the finding of a constructive dividend solely by

arguing that the legal expenses were deductible by Capital Video.

Because we find otherwise, that portion spent by Capital Video as

a subchapter C corporation constitutes a constructive dividend and

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is therefore taxable to Guarino as ordinary income. I.R.C.

§ 61(a)(7).

C. Miscellaneous Itemized Deductions

Finally, Guarino argues that he should be able to deduct

the legal expenses as miscellaneous itemized business expense

deductions under I.R.C. § 162(a). He claims that if the legal fees

paid by Capital Video are to be taxable to him, then those legal

fees should be considered to have been paid by him directly;

moreover, he argues, once the legal fees are treated as his

expense, he should be able to deduct them as a business expense.

The tax court held that Guarino had not shown that the legal

expenses were sufficiently related to a trade or business. Capital

Video, 2002 Tax Ct. Memo LEXIS 42, at *13. There was no clear

error in this holding.

Section 162(a) permits deductions by individuals as well

as by corporations for "ordinary and necessary expenses paid or

incurred . . . in carrying on any trade or business." I.R.C.

§ 162(a). Individuals may deduct legal expenses under § 162(a) if

they are sufficiently related to the taxpayer's business. Tellier,

383 U.S. at 689. The appropriate test is whether the "origin and

character of the claim with respect to which an expense was

incurred" is business or personal. Gilmore, 372 U.S. at 49.

To meet the ordinary and necessary § 162(a) standard for

deductibility from his personal taxes, Guarino need not show that

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the criminal activity originated with Capital Video; the

relationships with his other business ventures, including the

precious metals business and the Las Vegas show which were also

protected and aided by Richichi, are also relevant. Ultimately,

however, Guarino did not show that the legal defense fees were

ordinary and necessary business expenses, even considering the

entirety of his business enterprises. The failings are similar to

those set forth in the analysis of Capital Video's deduction.

Guarino did not show a link between the protection of the

businesses and the tax conspiracy in which he engaged; there was no

evidence that the latter was an integral part of securing the

former. Moreover, the indictment alleged, and the plea agreement

acknowledged, conduct beyond merely hiding the tribute payments

from the government. There was no clear error in the finding that

the legal fees are not deductible by Guarino under § 162(a).

The judgment of the tax court against both Capital Video

and Guarino is affirmed.

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