T.C. Memo. 2002-40
UNITED STATES TAX COURT
CAPITAL VIDEO CORPORATION, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
KENNETH GUARINO, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 4094-00, 4096-00. Filed February 11, 2002.
James P. Redding and Brian C. Newberry, for petitioners.
Michael P. Breton, for respondent.
MEMORANDUM OPINION
SWIFT, Judge: These cases are consolidated for trial,
briefing, and opinion. Respondent determined deficiencies in
petitioners’ Federal income taxes and accuracy-related penalties
as follows:
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Capital Video Corp.
Taxable Year Accuracy-Related Penalty
Ending Deficiency Sec. 6662(a)
Feb. 29, 1996 $116,950 $23,390
Kenneth Guarino
Accuracy-Related Penalty
Year Deficiency Sec. 6662(a)
1996 $312,874 $34,515
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.
After concessions, the primary issue for decision involves
whether petitioner Capital Video Corp. (Capital Video) may deduct
as ordinary and necessary business expenses $515,038 in legal
fees paid to defend its sole shareholder, petitioner Kenneth
Guarino (Guarino), against various criminal indictments.
Background
The facts of these cases were submitted fully stipulated
under Rule 122, and the stipulated facts are so found.
At the time the petitions were filed, Capital Video’s
principal place of business and Guarino’s primary residence were
located in Cranston, Rhode Island.
On February 27, 1979, Capital Video was incorporated, and
thereafter, Capital Video was engaged in the sale of pornographic
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videotapes and related products out of its office in Rhode
Island. Capital Video’s taxable year ended on the last day of
February.
During the 1980s and early 1990s, Capital Video and Guarino
made “tribute” payments to Natale Richichi (Richichi), a capo in
the Gambino crime family, in excess of $1,728,000 in exchange for
protection provided by the Gambino crime family to Capital Video
against extortion from other organized crime families.
Also, during these same years Guarino conspired with
Richichi to obstruct the Internal Revenue Service in the
assessment and collection of Richichi’s Federal income taxes
relating to the tribute payments Richichi received from Capital
Video and Guarino.
Guarino’s conspiracy and obstruction relating to the above
tribute payments included manipulating the accounting records of
Capital Video, skimming cash from peep show machines to provide
cash for the payments made to Richichi, and filing false Forms
1099 relating to the payments made to Richichi.
During 1992, 1994, and 1995, Guarino, Richichi, and other
individuals were indicted on various Federal criminal charges
relating to the above activities. Guarino was indicted in the
U.S. District Court for the District of Nevada and charged with
conspiracy to impede, impair, and obstruct the lawful functions
of the Internal Revenue Service and to evade the Federal income
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tax liabilities of Richichi under 18 U.S.C. sec. 371 (2000).
Guarino was also charged with conspiracy to bribe a union
official under 18 U.S.C. sec. 1954 (2000), with interstate
transportation of obscene material through use of a common
carrier under 18 U.S.C. sec. 1462 (2000), and with aiding and
abetting an offense against the United States under 18 U.S.C.
sec. 2 (2000).
On March 1, 1996, an election was made on behalf of Capital
Video with the Internal Revenue Service for Capital Video to be
taxed pursuant to subchapter S of the Internal Revenue Code.
On January 10, 1997, Guarino pled guilty to one count of the
above indictment against him relating to the conspiracy to
obstruct the lawful functions of the Internal Revenue Service and
to evade Richichi’s Federal income tax liabilities.
On April 25, 1997, pursuant to the plea agreement, Guarino
was sentenced to 16 months in prison, and he was fined $250,000.
As part of Guarino’s guilty plea, Guarino accepted the
Government’s allegation that he aided and abetted a fraud on the
Internal Revenue Service.
During calendar years 1995 and 1996, Capital Video paid
legal fees in the amounts of $250,034 and $517,038, respectively,
to provide legal representation for Guarino in connection with
the above criminal charges. Of the above $517,038 in legal fees
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paid by Capital Video in 1996, $423,101 was paid after
February 29, 1996, when Capital Video elected to be taxed as an
S corporation.
Capital Video was not named as a defendant in the above
criminal case, and Capital Video was not legally required to pay
the legal fees of Guarino.
For its taxable year ending February 29, 1996, Capital Video
timely filed its Federal Corporation Income Tax Return,
and Capital Video deducted thereon as ordinary and necessary
business expenses the $343,971 it had paid during its taxable
year ending February 29, 1996, as legal fees in connection with
the above criminal charges against Guarino.
For its short taxable year March 1 to December 31, 1996,
Capital Video timely filed its Federal Income Tax Return for an S
Corporation, and Capital Video deducted thereon as ordinary and
necessary business expenses the $423,101 it had paid during its
short taxable year as legal fees in connection with the above
criminal charges against Guarino.
On his 1996 individual Federal income tax return, Guarino
did not include in his reported income any portion of the
$343,971 in legal fees paid by Capital Video during its 1996
taxable year. Also (as a result of the $423,101 in deductions
claimed by Capital Video on its 1996 Federal Income Tax Return
for an S Corporation), Guarino’s share of the ordinary income of
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Capital for Cap Video for the period March 1 to December 31, 1996
(as reported on Guarino’s 1996 individual Federal income tax
return) was reduced by $423,101.
In respondent’s notice of deficiency mailed to Capital Video
for Capital Video’s taxable year ending February 29, 1996,
respondent disallowed the full $343,971 claimed ordinary and
necessary business deduction relating to Guarino’s legal fees.
In respondent’s notice of deficiency mailed to Guarino for
1996, respondent: (1) Treated the full $343,971 in legal fees of
Guarino that Capital Video paid during Capital Video’s taxable
year ending February 29, 1996, as a constructive taxable dividend
to Guarino, and (2) increased by $423,101 Guarino’s share of
Capital Video’s taxable ordinary income for the period March 1 to
December 31, 1996. Both of respondent’s adjustments mentioned in
this paragraph resulted in increases to Guarino’s taxable income
for 1996 in the full amounts of those adjustments.
Prior to trial, respondent conceded that $250,034 of the
above legal fees relating to Guarino that were deducted on
Capital Video’s tax return for its taxable year ending
February 29, 1996, was paid by Capital Video in 1995 and
therefore that $250,034 should not be charged to Guarino as
taxable dividend income for 1996. As a result of respondent’s
concession (of the $343,971 in total claimed legal fees that
respondent treated as a constructive dividend taxable to Guarino
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for 1996) only $93,936 remains in issue as an adjustment to
Guarino’s income for 1996. The table below summarizes the
adjustments respondent made that are still in dispute:
Capital Video Guarino
Year Ending Calendar Year
Adjustment 2/29/96 12/31/96 1996
Legal fees disallowed $343,971 $423,101
Dividend income $ 93,936
Subchapter S income 423,101
Discussion
Capital Video’s Claimed Deduction of Guarino’s Legal Fees
Generally, taxpayers may not deduct expenses of another
person and may not deduct expenses that are personal in nature.
Deputy v. du Pont, 308 U.S. 488, 494 (1940); Johnson v.
Commissioner, 72 T.C. 340, 348 (1979).
Where expenses of another are paid in order to protect a
taxpayer’s business, the taxpayer, in limited circumstances, may
be allowed to deduct the expenses. Lohrke v. Commissioner, 48
T.C. 679, 684-685 (1967). Also, legal fees paid relating to
criminal charges against a taxpayer may be deductible where the
alleged criminal activity sufficiently relates to the taxpayer’s
business. Commissioner v. Heininger, 320 U.S. 467, 474 (1943).
The origin of the criminal charges to which the legal fees
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relate, rather than the potential consequences of a conviction on
the underlying charges, generally will control whether the legal
fees qualify as business expenses. United States v. Gilmore, 372
U.S. 39, 48 (1963).
In Lohrke v. Commissioner, supra, we adopted a two-prong
test for analyzing whether a taxpayer may deduct legal expenses
of another. First, we analyzed whether the purpose or motive of
the taxpayer in paying another person’s legal expenses was to
protect or promote the taxpayer’s business, and second, we
analyzed whether the expenses constituted ordinary and necessary
business expenses of the taxpayer’s business.
In their arguments herein, petitioners argue that the motive
or purpose of Capital Video in making the “tribute” payments to
Richichi was to protect and promote the business of Capital
Video, that Guarino’s conspiracy to evade the income taxes of
Richichi (the charge to which Guarino pled guilty) was directly
related to the “tribute” payments and to the related protection
from extortion that Capital Video received, and therefore that
Guarino’s legal fees relating to the conspiracy charge should
qualify as deductible business expenses of Capital Video.1
Respondent argues that petitioners have not established that
Guarino’s conspiracy to evade Richichi’s income taxes was
1
Petitioners make no argument that the legal fees in dispute
related to the various criminal charges against Guarino that were
dropped as part of the plea agreement.
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sufficiently related to the protection of Capital Video’s
business. Respondent contends that therefore the legal fees paid
by Capital Video relating to the conspiracy do not qualify as
business deductions of Capital Video. We agree with respondent.
We emphasize that the legal fees in dispute were paid to
cover the legal fees of Guarino in connection with his criminal
conspiracy activities relating to Richichi’s income tax
liabilities. They were not paid as part of the “tribute”
payments to obtain protection from Richichi. There is no
evidence herein 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. In fact, the
legal fees in dispute were paid by Capital Video years after the
protection was provided by Richichi and years after the
conspiracy between Guarino and Richichi occurred.
Apart from whether the tribute payments made by Capital
Video to Richichi were made to protect the business of Capital
Video, petitioners have not established that Guarino’s
participation in the conspiracy to avoid Richichi’s income taxes
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.
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The legal fees paid by Capital Video in its taxable year
ending February 29, 1996 ($343,971), and in its short taxable
year ending December 31, 1996 ($423,101), to defend Guarino
against the conspiracy charge are not deductible as business
expenses of Capital Video.
Constructive Dividend to Guarino
A constructive dividend to a shareholder of a corporation
may occur where the corporation “confers an economic benefit on
* * * [the] shareholder without the expectation of repayment
* * * even though neither the corporation nor the shareholder
intended a dividend.” Magnon v. Commissioner, 73 T.C. 980,
993-994 (1980). Not every payment by a corporation, however,
which incidentally confers an economic benefit on a shareholder
is treated as a constructive dividend. Hood v. Commissioner, 115
T.C. 172 (2000). Generally, the test of whether a payment is to
be treated as a constructive dividend to a shareholder is whether
the payment primarily benefited the shareholder and whether the
payment was made for a valid business purpose of the corporation.
Loftin & Woodard, Inc. v. United States, 577 F.2d 1206, 1214 (5th
Cir. 1978).
As we have held, petitioners have not established that
Capital Video made the payments of Guarino’s legal fees in
connection with the business of Capital Video. Capital Video had
no obligation to make such payments. The payment by Capital
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Video of Guarino’s legal fees conferred a significant economic
benefit upon Guarino, Capital Video’s sole shareholder, without
an expectation of repayment and was not necessary for the
business of Capital Video (i.e., the payment of the legal fees
was not necessary for Capital Video to receive Richichi’s
protection from extortion).
We conclude that the payment by Capital Video of the $93,936
in Guarino’s legal fees should be treated as a constructive
dividend to Guarino. As to the $423,101 in legal fees of Capital
Video that are disallowed herein as deductible business expenses
of Capital Video for its short taxable year ending December 31,
1996, such adjustment mechanically 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.
If respondent’s income adjustments against Guarino are
sustained herein, as we have done, then Guarino argues that for
1996 he should be entitled to additional miscellaneous itemized
business expense deductions (subject to the percentage
limitations applicable thereto) in the amount of the constructive
dividend and the additional income of Capital Video, as an S
corporation, that is to be charged to Guarino. The apparent
basis for Guarino’s argument is that if he is to be charged with
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a constructive dividend and with additional income from Capital
Video relating to the legal fees Capital Video paid, he should be
deemed to have incurred the legal fees, and the legal fees should
be treated as his miscellaneous business expenses.
The analysis herein to the effect that the legal fees in
dispute do not constitute ordinary and necessary business
expenses of Capital Video also applies to Guarino’s argument that
the legal fees should be deductible ordinary and necessary
business expenses to him. Guarino has not shown a sufficient
business nexus to the legal fees for the fees to qualify as
ordinary and necessary business expenses to him.2 We reject
Guarino’s argument as to his entitlement to miscellaneous
itemized business expense deductions relating to the legal fees
paid by Capital Video.
Sec. 6662 Penalties
Under section 6662, a penalty of 20 percent is imposed on
any portion of an understatement of tax attributable to
negligence or to disregard of the rules or regulations. For
purposes of section 6662(a), negligence constitutes a failure to
make a reasonable attempt to comply with the Internal Revenue
Code. Sec. 6662(c).
2
Petitioners make no argument that respondent has the burden
of proof under sec. 7491.
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Petitioners cite Jack’s Maint. Contractors, Inc. v.
Commissioner, T.C. Memo. 1981-349, revd. per curiam 703 F.2d 154
(5th Cir. 1983), and Hood v. Commissioner, 115 T.C. 172 (2000),
as substantial authority for petitioners’ treatment of the legal
fees paid by Capital Video.
In Jack’s Maint. Contractors, Inc. v. Commissioner, supra,
we allowed a corporate taxpayer a deduction for its payment of
legal expenses of its shareholder relating to the shareholder’s
indictment for criminal tax evasion. Reversing, the Court of
Appeals for the Fifth Circuit held that the legal fees were not
deductible because the legal fees were personal in nature and did
not qualify as an ordinary and necessary business expense of the
corporation.
In Hood v. Commissioner, supra, we followed the Court of
Appeals for the Fifth Circuit’s reversal of Jack’s Maint.
Contractors, Inc. v. Commissioner, supra, and we disallowed a
corporation a deduction for legal fees the corporation had paid
relating to an indictment of its sole shareholder for tax
evasion.
Significant to the penalties involved in these cases is the
fact that in Hood, decided in 2000, we declined to impose the
accuracy-related penalty for negligence. We stated as follows:
Given that * * * [the taxpayer’s] reporting position
was consistent with our holding in Jack’s Maintenance
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Contractors, Inc. v. Commissioner, supra, we find there
was no negligence or disregard of rules or regulations
on the part of * * * [the taxpayer]. [Id. at 183.]
We believe that for the same reason, petitioners herein
should be relieved of the section 6662 penalties. Petitioners’
tax returns for the years in dispute were filed prior to our
opinion in Hood v. Commissioner, supra, which was filed in the
year 2000, and petitioners’ tax return preparer would have had
access to the same authority that the taxpayers in Hood had
access to. In light of our holding in Hood v. Commissioner,
supra, we do not impose upon petitioners herein the accuracy-
related penalties relating to the disallowed legal fees paid by
Capital Video and relating to the additional dividend and income
adjustments made against Guarino. We so hold.
To reflect the foregoing,
Decisions will be entered
under Rule 155.