T.C. Memo. 1997-536
UNITED STATES TAX COURT
HAROLD LEVINSON ASSOCIATES, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 9575-95. Filed December 3, 1997.
Richard M. Gabor, for petitioner.
Gary W. Bornholdt, for respondent.
MEMORANDUM OPINION
RAUM, Judge: The Commissioner determined deficiencies in
petitioner's Federal income taxes for the taxable years ending
January 31, 1990, and January 31, 1991, in the amounts of
$179,860 and $1,349, respectively. The remaining issue for
consideration is whether an amount paid to settle a lawsuit is a
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deductible business expense under section 162(a)1 or a
nondeductible capital expenditure pursuant to section 263. This
case was submitted on the basis of a stipulation of facts.
Petitioner, Harold Levinson Associates, Inc., (petitioner)
is a New York State corporation whose principal place of business
when the petition in this case was filed was Plainview, New York.
During and throughout the fiscal year ended January 31, 1990,
Edward Berro and Rita Berro each owned 50 percent of petitioner's
common stock. Together, they owned all of the common stock in
petitioner during and throughout the taxable year ended January
31, 1990. The relationship of Edward and Rita Berro is not
disclosed in the record.
In or about November 1987, petitioner, Edward Berro, and
Rita Berro, entered into an option agreement with Mark Goldman
and Barry Feldman (the optionees), whereby each of the optionees
was granted an option to purchase 24.5 percent of the common
stock of petitioner at an agreed upon exercise price. In return,
the optionees made efforts to cause petitioner to become an
authorized cigarette stamping agent (New York Stamp Tax Agent) or
the equivalent thereof for the sale of cigarettes in the State of
New York. Once acquired, a New York Stamp Tax Agent license
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
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lasts indefinitely. Neither Mark Goldman nor Barry Feldman was
ever employed by petitioner.
Pursuant to the terms of the Option Agreement, the exercise
price for the option to purchase the 24.5-percent interest in
petitioner was to be determined by the tangible net worth of
petitioner on the exercise date of the option. The optionees had
the right to exercise the option for a period of 60 days after
the date on which petitioner became a New York Stamp Tax Agent.
The options granted pursuant to the Option Agreement were to
expire in or about April 1989, subject to extension for two
additional 3-month periods. On or about March 17, 1989, Mark
Goldman exercised his rights under the Option Agreement to extend
for two additional 3-month periods the terms of the Option
Agreement.
On or about September 13, 1989, petitioner was granted a
license as a New York Stamp Tax Agent. Petitioner's acquisition
of a New York Stamp Tax Agent license has resulted in a
substantial increase to petitioner's gross sales, as evidenced by
petitioner's Forms 1120 U.S. Corporation Income Tax Return for
the taxable years ended January 31, 1991, and January 31, 1992.
On or about October 23, 1989, Mark Goldman notified
petitioner, Edward Berro, and Rita Berro, of his intent to
exercise his rights under the Option Agreement. On or about
November 20, 1989, Goldman's request to exercise the option was
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rejected. In or about December 1989, Goldman filed a verified
complaint in the Supreme Court of the State of New York
initiating litigation (the litigation) against petitioner, Edward
Berro, and Rita Berro. The complaint alleged that petitioner and
the Berros failed to honor the terms of the Option Agreement.
Goldman sought specific performance under the terms of the Option
Agreement, requesting that petitioner and the Berros be ordered
to deliver the 24.5-percent equity interest in petitioner at the
agreed upon exercise price. He also sought monetary damages in
excess of $3 million.
On or about April 27, 1990, petitioner, Edward Berro, Rita
Berro, and Mark Goldman, entered into an agreement settling the
litigation. As stated in the settlement agreement, petitioner
concluded that it was impracticable and hazardous to the
continued viability of petitioner to permit Goldman to exercise
his option and become a shareholder in petitioner. Pursuant to
the terms of the settlement agreement, Mark Goldman is required
to release petitioner and the Berros from any claims asserted in
connection with the litigation. Petitioner is required to pay
Mark Goldman the sum of $1 million in annual payments of $83,200
in satisfaction of all claims asserted in connection with the
litigation.
In connection with the settlement of the litigation,
petitioner claimed a lawsuit settlement deduction in the amount
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of $529,000 on its Form 1120, U.S. Corporation Income Tax Return,
filed for the taxable year ended January 31, 1990. The $529,000
deduction claimed for that year represented the net present value
of the $1 million lawsuit settlement.2
On March 7, 1995, respondent issued petitioner a statutory
notice of deficiency asserting deficiencies in income tax for the
taxable years ended January 31, 1990, and January 31, 1991. The
deficiency for the taxable year ended January 31, 1990, is based
upon the disallowance of the $529,000 lawsuit settlement
deduction claimed on petitioner's return for that year.3 The
2
According to the stipulation of facts, the Berros
collectively owned 100 percent of the stock in petitioner "during
and throughout the taxable year ended January 31, 1990." Yet,
the Option Agreement provides that the optionees have the option
to purchase the stock "from the Company". Moreover, petitioner,
rather than the Berros, deducted the settlement amount on its
return. Thus, there is confusion in the record as to whether the
Berros or petitioner was to be the seller of the stock under the
Option Agreement. Further, what we have here is a troubling
obvious contradiction, particularly in view of provisions in the
Option Agreement contemplating a change in the number of shares
outstanding "in order that each Optionee [Gloldman and Feldman],
upon exercise of his Option shall be entitled to purchase that
number of shares of Common Stock necessary to acquire a 24.5%
equity" interest in petitioner. And the confusion is further
compounded by the fact that there are strong indications in the
record that there was actually a change in the number of shares
outstanding because of the situation concerning Feldman, the
other optionee. Indeed, the record shows that Feldman actually
acquired shares representing a 24.5-percent equity interest in
petitioner.
3
Since respondent's present theory for disallowing the
settlement deduction was raised in the Amendment to Answer to
Amended Petition, respondent bears the burden of proof with
respect to that theory. Rule 142(a). However, the point was not
(continued...)
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deficiency for the taxable year ended January 31, 1991, is based
upon the disallowance of a $3,967 insurance deduction claimed on
petitioner's return for that year. Petitioner concedes the
deficiency determination for the taxable year ended January 31,
1991, in the amount of $1,349.
Section 162(a) allows as a deduction "all the ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on any trade or business". But section 263(a) prohibits
deductions for "Any amount paid out * * * for permanent
improvements or betterments made to increase the value of any
property or estate." Section 1.263(a)-2(c), Income Tax Regs.,
provides examples of capital expenditures, including "The cost of
defending or perfecting title to property."
In United States v. Gilmore, 372 U.S. 39 (1963), the Supreme
Court held that whether litigation expenses are "business" or
"personal" is determined by looking to "the origin and character
of the claim with respect to which an expense [is] incurred".
Id. at 49. This doctrine was amplified in Anchor Coupling Co. v.
United States, 427 F.2d 429, 433 (7th Cir. 1970), cert. denied
401 U.S. 908 (1971):
Taxpayer argues that Gilmore is inapplicable because we
are asked here to determine whether a settlement
constitutes an ordinary and necessary business expense
3
(...continued)
argued on brief, and nothing appears to turn on the burden of
proof in this factually fully stipulated case.
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or a capital outlay and not whether a payment is a
deductible business expense. We disagree. Although
the two questions are admittedly different,
substantially the same problems arise in each
determination. Thus in both cases the court must
determine the tax consequences of monetary outlays made
in connection with contesting a claim on the taxpayer's
assets. * * *
To determine the origin of the claim, the Court must consider
"the issues involved, the nature and objectives of the
litigation, the defenses asserted, the purpose for which the
claimed deductions were expended, the background of the
litigation, and all facts pertaining to the controversy." Boagni
v. Commissioner, 59 T.C. 708, 713 (1973)); Saltzman v.
Commissioner, T.C. Memo. 1994-641.
United States v. Wheeler, 311 F.2d 60 (5th Cir. 1962), is
instructive here. The taxpayer owned controlling stock interests
in 3 corporations. He first entered into negotiations to sell
the stock to an individual named Cage, but upon learning
(mistakenly) that Cage had lost interest, the taxpayer entered
into a sales agreement with Ainsworth. Id. at 61. After signing
the latter contract, the taxpayer discovered that Cage was still
interested in purchasing the stock. The taxpayer also feared
that "Ainsworth would probably 'bleed' the corporate assets" dry.
To prevent that, the taxpayer refused to sell his stock.
Ainsworth sued, alleging breach of contract and requesting
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specific performance. Id. at 62. The taxpayer paid roughly
$57,000 to settle the litigation. Id. at 61.
The Fifth Circuit determined that the origin of the proposed
deduction was the suit for specific performance, which revolved
around the title to the stock. Id. at 63. The court concluded
that the settlement payments the taxpayer made were capital
expenditures. Id. at 64; see Von Hafften v. Commissioner, 76
T.C. 831 (1981).
The origin of the claim in the present case was the dispute
over title to 24.5 percent of petitioner's stock. Mark Goldman
agreed to use his best efforts to cause petitioner to become a
New York Stamp Tax Agent. In exchange, he was granted an option
to purchase 24.5 percent of petitioner's stock. Petitioner
acquired a Stamp Tax Agent license in September 1989. In a
timely manner, Mark Goldman gave notice that he intended to
exercise his option. His request was rejected.
In response, Goldman filed suit in the Supreme Court of the
State of New York. In his verified complaint, he alleged:
13. Plaintiff Goldman is ready, willing and able to tender
the purchase price for the common shares of stock as set
forth in the Option Agreement pursuant to paragraph 6
thereof.
14. The shares of stock in the Company are unique in that
they represent an interest in a Company possessing a New
York Stamp Tax Agents [sic] License.
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Goldman sought specific performance, requesting that petitioner
and the Berros be required to deliver the 24.5-percent equity
interest in petitioner at the agreed upon exercise price. He
also sought monetary damages in excess of $3 million.
Petitioner, the Berros, and Goldman reached a settlement in
April 1990. Goldman agreed to release all claims against
petitioner and the Berros and dismiss the litigation with
prejudice. In return, petitioner was required to pay Goldman
$1 million in annual installments of $83,200.
The issue involved in the Goldman litigation was the
ownership of the stock for which Goldman was willing to pay. The
litigation was a suit for specific performance for title to the
stock. The damages were based on the injury Goldman suffered
because he was denied access to the stock. Petitioner and the
Berros protected their ownership of the stock by removing
Goldman's claim through the $1 million settlement. As a whole,
it is clear that the initial litigation was a dispute over title
to 24.5 percent of petitioner's stock. Since the settlement
amount was paid to defend and perfect title to stock, it is a
capital expenditure and thus nondeductible. As indicated in
supra note 2, we are troubled by the question as to whose stock
(petitioner's or the Berros') is involved in light of the
possible contradictory state of the record. But in view of the
explicit statement in the Option Agreement that the optionees
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would have the right to purchase stock "from the company", and
the fact that no issue has been raised by either party in that
connection, we address the issue as though the stock of
petitioner is involved just as the parties themselves have done.
Petitioner contends that the settlement amount represents
lost compensation deductible under section 162(a). According to
petitioner, Goldman saw the stock as a symbol of the accompanying
employment contract and compensation it entailed. Petitioner
asserts that since petitioner is a closely-held corporation and
does not pay dividends, Goldman wanted the stock only to the
extent it would provide compensation. Correspondingly,
petitioner argues, petitioner would have been entitled to a
compensation deduction for any amounts paid to Goldman.
Petitioner characterizes Goldman in its brief as an employee
seeking lost compensation analogous to back pay.
The flaw in this argument is its assumption that Goldman was
an employee of petitioner. Petitioner stipulated that Goldman
was never employed by petitioner. The record does not articulate
Goldman's intentions. It seems a reasonable inference that
Goldman pursued the stock sale because the stock represented not
only future earnings, as petitioner alleges, but also control.
Had he been able to purchase the stock, Goldman would have owned
a significant minority of the corporation. Such control,
arguably, may have been his goal. Whatever his intentions, it is
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clear that the stock, and not simply money, was what he desired
and pursued. The cases petitioner relies on, which involve
amounts received upon cancellation of employment contracts, do
not apply to the current situation.
Petitioner also contends that the outcome is controlled by
section 83. Section 83(a) provides:
(a) General Rule.--If, in connection with the
performance of services, property is transferred to any
person other than the person for whom such services are
performed, the excess of--
(1) the fair market value of such property * * *
at the first time the rights of the person having the
beneficial interest in such property are transferable
or are not subject to a substantial risk of forfeiture,
whichever occurs earlier, over
(2) the amount (if any) paid for such property,
shall be included in the gross income of the person who
performed such services * * *
Section 83(h) gives a corresponding deduction under section
162(a) "to the person for whom were performed the services in
connection with which such property was transferred".
Section 83 is not applicable here. First, section 1.83-
6(a)(4), Income Tax Regs., provides that the deduction under
section 83(h) does not apply to capital expenditures. We held
above that the origin of the claim for which the settlement
amount was paid was capital in nature. Thus, section 83(h) is
inapplicable.
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Second, section 83 does not apply to "the transfer of an
option without a readily ascertainable fair market value". Sec.
83(e)(3). Section 1.83-7(b), Income Tax Regs., provides that
where an option is not actively traded on an established market,
the option does not have a readily ascertainable fair market
value unless the taxpayer can demonstrate all of the following:
(i) The option is transferable by the optionee;
(ii) The option is exercisable immediately in full by the
optionee;
(iii) The option or the property subject to the option is
not subject to any restriction or condition * * * which has
a significant effect upon the fair market value of the
option; and
(iv) The fair market value of the option privilege is
readily ascertainable in accordance with paragraph (b)(3) of
this section.
The option in this case fails the first two conditions. The
Option Agreement states that "The Options are not transferable
and are exercisable only by the Optionee, during his lifetime."
The option was also not exercisable immediately in full by
Goldman. The Option Agreement provides that the Optionees can
exercise the options for 60 days, but only "after the date on
which Company has become a New York Tax Stamp Agent". In view of
petitioner's obvious failure to satisfy the first two conditions,
we need not even consider whether the third or fourth conditions
have been met.
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Petitioner paid the settlement amount to protect or retain
title to its 24.5 percent of petitioner's stock. That payment
was a capital expenditure. The Commissioner's disallowance of
the business expense deduction claimed by petitioner is
sustained.
Decision will be entered
under Rule 155.