T.C. Summary Opinion 2018-38
UNITED STATES TAX COURT
JOHN A. GARCIA AND JAMIE GARCIA, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 498-17S. Filed August 7, 2018.
Solis Cooperson, for petitioners.
Sheri A. Wight, for respondent.
SUMMARY OPINION
THORNTON, Judge: This case was heard pursuant to the provisions of
section 7463 of the Internal Revenue Code in effect when the petition was filed.1
1
Unless otherwise indicated all section references are to the Internal
Revenue Code in effect for the year at issue, and all Rule references are to the Tax
Court Rules of Practice and Procedure. Monetary amounts are rounded to the
(continued...)
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Pursuant to section 7463(b), the decision to be entered is not reviewable by any
other court, and this opinion shall not be treated as precedent for any other case.
Respondent determined a $27,017 deficiency and a $5,403 accuracy-related
penalty with respect to petitioners’ 2012 Federal income tax. The issues for
decision are: (1) whether legal and professional fees paid in 2012 are properly
deductible as ordinary and necessary business expenses of petitioners’ wholly
owned S corporation and (2) whether petitioners are liable for the accuracy-related
penalty pursuant to section 6662(a).2
Background
The parties have stipulated some facts, which we incorporate by this
reference. When they petitioned the Court, petitioners resided in California.
Shareholder Litigation
In 2005 petitioners purchased 498,900 shares of stock in Randgold &
Exploration Co., Ltd. (R&E), a South African exploration and gold mining
investment company. At all relevant times petitioners have been the registered
owners of the R&E shares.
1
(...continued)
nearest dollar.
2
The parties filed a stipulation of settled issues resolving all other issues.
-3-
At some point R&E shareholders discovered that Investec Bank, Ltd.
(Investec), an international specialist bank, had engaged in a fraudulent scheme
involving R&E stock, which ultimately devalued R&E shares. Sometime before
2012 a consortium of minority shareholders (consortium) instituted litigation in a
South African court against R&E and Investec for corporate fraud (litigation).3
The purpose of the litigation was to secure judgment in favor of the R&E minority
shareholders and recover their investments.
In return for a promised percentage of any ultimate recovery, petitioners
agreed to finance a portion of the consortium’s legal and related expenses. During
2012 their commitment totaled at least 500,000 rand.4 During 2012 the
consortium made “capital calls”, whereby it invoiced petitioners and other
consortium members for their agreed-upon contributions to fund the litigation. In
response to these capital calls, on February 1, 2012, petitioners wired $39,609
from their personal brokerage account with Fidelity Investments (Fidelity account)
3
A group of shareholders that included Mr. Garcia commenced the R&E
litigation as early as 2005, and a second group was formed shortly thereafter to
represent a broader group of shareholders. On March 28, 2011, “the applicants”
(ostensibly including petitioners) instituted legal proceedings in a South African
court, seeking an order to require Investec to purchase the applicants’ R&E shares
for a certain price.
4
In subsequent years petitioners’ commitment increased to at least 850,000
rand.
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to Anglorand Securities, Ltd. (Anglorand), another plaintiff in the litigation. At
the then-current exchange rate, this payment satisfied 300,000 of their total
500,000 rand commitment to the consortium. The remaining 200,000 rand of the
commitment was satisfied by two subsequent, roughly equal payments of U.S.
dollars, viz, on June 13, 2012, petitioners wired $12,321 from their Fidelity
account to Anglorand, and on December 20, 2012, JGx5 Enterprises (JGx5),
petitioners’ wholly owned subchapter S corporation, wired $12,250 from its
corporate bank account to Anglorand.
At some unspecified time Mr. Garcia entered into a written agreement with
Mankadan Investments (identified in the record as one of the “workers” in the
consortium) to provide professional services to the consortium in return for an
extra percentage of any recovery.
Creation of Subchapter S Corporation, JGx5
On February 9, 2012, JGx5 was incorporated in the State of California with
Mr. Garcia as the sole shareholder. During 2012 JGx5 owned four rental
properties described as single-family residences. During 2012 three of these
properties were rented and the fourth was in the process of being rehabbed or
refurbished. The four rental properties were in southern California. During 2012
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JGx5 managed these properties but did not otherwise engage in property
management services to third parties.
On February 28, 2012, petitioners signed two documents, each captioned
“SPECIAL MINUTES OF JGX5 ENTERPRISES”.5 One of these documents
states in part:
A) money transfers into JGx5 Enterprises from John & Jamie Garcia
will be deemed loans to the Corporation[,] B) costs incurred by John
& Jamie Garcia associated with the assignment of assets or otherwise
transferred to JGx5 Enterprises shall be treated as a loan to JGx5
Enterprises whereas such costs shall not be in excess of such costs
incurred up until the time of the transfer, C) money transfers out of
JGx5 Enterprises to John & Jamie Garcia will be deemed repayment
of loans or in the event such loans have been repaid such money
transfers out of JGx5 enterprises will be considered a [sic] income
distribution or otherwise * * *.
This document states that any loans are noninterest bearing and are for a term of
the “greater of 20 years or Perpetual Term”.
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 * * *
5
Although the parties have stipulated that Mr. Garcia was the sole
shareholder of JGx5 during 2012, Mrs. Garcia signed each of these documents as
“Shareholder”.
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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.”
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.
Tax Returns
On its 2012 Form 1120S, U.S. Income Tax Return for an S Corporation,
JGx5 listed its business activity code as 531110, which corresponds to “Lessors of
Residential Buildings & Dwellings (including equity REITs)”. On the 2012 Form
1120S JGx5 claimed a deduction for legal and professional fees of $76,630 and
reported an ordinary business loss of $133,952.
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On their 2012 Form 1040, U.S. Individual Income Tax Return, petitioners
reported wages of $429,222 earned by Mr. Garcia from his employment as a
financial analyst for ADP Totalsource and claimed a $138,067 loss on Schedule E,
Supplemental Income and Loss. The Schedule E loss included the $133,952
ordinary business loss reported by JGx5. Petitioners’ 2012 Form 1040 reported
total tax of $100,661.
By notice of deficiency respondent disallowed $72,780 of the legal and
professional fees deduction claimed by JGx5.6 Respondent also determined that
petitioners were liable for the section 6662(a) accuracy-related penalty.
Discussion
I. Deductibility of Legal Expenses
The Commissioner’s determinations in a notice of deficiency are generally
presumed correct, and the taxpayer bears the burden of proving those
determinations erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115
(1933). Deductions are allowed as a matter of legislative grace, and the taxpayer
bears the burden of proving entitlement to any claimed deduction. Rule 142(a);
6
Respondent determined in the notice of deficiency that petitioners were
allowed to deduct $64,180 of these expenses as a miscellaneous itemized
deduction.
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INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co.
v. Helvering, 292 U.S. 435, 440 (1934).
The primary issue is whether petitioners are entitled to a pass-through
deduction for certain legal and professional fees that JGx5 claimed on its
corporate income tax return.7 Petitioners claim that $64,180 of these fees is
deductible under section 162(a) as ordinary and necessary business expenses of
JGx5.8 Respondent contends that these fees are not deductible under section
162(a) but concedes, as determined in the notice of deficiency, that they are
properly deductible by petitioners under section 212, as nonbusiness income-
producing expenses. The distinction matters inasmuch as a deduction under
7
An eligible small business corporation that elects S corporation status is
generally exempt from corporate income tax. See sec. 1363(a). Instead, the S
corporation’s shareholders must report pro rata shares of the S corporation’s
taxable income, losses, deductions, and credits. Sec. 1366(a)(1)(A); sec. 1.1366-
1(a), Income Tax Regs. An S corporation item generally retains its character for
the shareholder. Sec. 1366(b). An S corporation’s taxable income is generally
computed in the same manner as an individual’s. Sec. 1363(b).
8
Petitioners have raised no argument and adduced no evidence to support
any deduction for $8,600 of the total $72,780 of legal and professional fees that
respondent disallowed in the notice of deficiency. We deem petitioners to have
waived or conceded any issue as to $8,600 of the disallowed deduction.
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section 212 may be less beneficial to petitioners than a deduction under section
162(a).9
Section 162(a) allows a deduction for “all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade or
business”. Petitioners have not shown that either the first payment of $39,609, on
February 1, 2012, or the second payment of $12,321, on June 13, 2012,
represented expenses “paid or incurred” by JGx5 so as to support a deduction
under section 162(a).10 Petitioners wired both of these payments to Anglorand
from their personal account, in partial satisfaction of their personal commitment to
contribute at least 500,000 rand of the consortium’s legal expenses.
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
9
As miscellaneous itemized deductions, sec. 212 deductions, unlike sec.
162(a) deductions, are generally deductible only to the extent they exceed 2% of
an individual’s adjusted gross income, see sec. 67, and may also be limited by
application of the alternative minimum tax, see sec. 56(b).
10
The taxable year for which business expenses may be deducted depends
upon whether the taxpayer uses the cash basis or accrual basis method of
accounting. See sec. 7701(a)(25) (“The terms ‘paid or incurred’ and ‘paid or
accrued’ shall be construed according to the method of accounting upon the basis
of which taxable income is computed[.]”). The record does not reflect whether
JGx5 was a cash basis or accrual basis taxpayer.
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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.
We are similarly unimpressed by petitioners’ assertion that their February 1
and June 13, 2012, payments to Anglorand represented “loans” to JGx5 pursuant
to the “Special Minutes”. 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.
Unlike the other two payments, the $12,250 payment on December 20,
2012, was in fact made by JGx5. Respondent has not argued that this payment
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was not “paid or incurred” by JGx5 within the meaning of section 162(a). As
explained below, however, this payment is also nondeductible by JGx5 because
petitioners have failed to show that it was an ordinary and necessary business
expense of JGx5.11
For the reasons just discussed, the legal and professional fees at issue were
the expenses of petitioners rather than of JGx5. A taxpayer generally may not
deduct the payment of another person’s expense. See Deputy v. du Pont, 308 U.S.
488, 494-495 (1940); Betson v. Commissioner, 802 F.2d 365, 368 (9th Cir. 1986),
aff’g in part, rev’g in part, T.C. Memo. 1984-264; Hood v. Commissioner, 115
T.C. 172, 179-181 (2000); J. Gordon Turnbull, Inc. v. Commissioner, 41 T.C. 358,
378 (1963) (“Legal fees paid on behalf of, and for services rendered to, another are
generally not deductible as ordinary and necessary business expenses of the
payer.”), aff’d, 373 F.2d 87 (5th Cir. 1967). An exception to this general rule may
apply if a taxpayer pays someone else’s expenses to protect or promote his own
separate trade or business. See, e.g., Gould v. Commissioner, 64 T.C. 132, 134-
135 (1975); Lohrke v. Commissioner, 48 T.C. 679 (1967). This exception
11
Respondent has not raised, and accordingly we do not consider, any issue
as to whether this amount should be considered a constructive dividend from JGx5
to petitioners. Cf. Hood v. Commissioner, 115 T.C. 172, 179-182 (2000) (holding
that legal fees a corporation paid for the primary benefit of its sole shareholder
constituted nondeductible constructive dividends).
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typically applies only where the taxpayer pays the obligations of another person or
entity in financial difficulty and where the obligor’s inability to meet his
obligations threatens the taxpayer’s own business with direct and proximate
adverse consequences. Hood v. Commissioner, 115 T.C. at 180-181; see also
Square D Co. v. Commissioner, 121 T.C. 168, 200 (2003).
“[T]he showing a corporation must make to deduct the expenses of its
shareholder is a strong one.” Hood v. Commissioner, 115 T.C. at 181. The test is
sometimes expressed as having two prongs: (1) the taxpayer’s primary motive for
paying the expenses must be to protect or promote the taxpayer’s business and (2)
the expenditures must constitute ordinary and necessary business expenses for the
furtherance or promotion of the taxpayer’s business. Lohrke v. Commissioner, 48
T.C. at 688; see also Capital Video Corp. v. Commissioner, 311 F.3d 458, 464 (1st
Cir. 2002), aff’g T.C. Memo. 2002-40; Menard, Inc. v. Commissioner, T.C.
Memo. 2004-207, rev’d on other grounds, 560 F.3d 620 (7th Cir. 2009).
Petitioners do not meet either prong of this test. As to the first prong,
petitioners have not shown that the expenses in question were incurred primarily
for the benefit of JGx5 and that any benefit to petitioners was only incidental. See
Capital Video Corp. v. Commissioner, 311 F.3d at 464. The benefits to petitioners
are obvious: The costs were incurred to recover their investments in R&E. And
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as they acknowledge on brief, treating the payments as business deductions of
JGx5 rather than as section 212 expenses of petitioners would result in more
favorable tax treatment for petitioners. The business justification for JGx5 to pay
these expenses is not at all obvious. There is no suggestion, for instance, that any
payment of the expenses by JGx5 would have been motivated by any genuine
consideration to avoid adverse business consequences as might result if petitioners
were unable to meet their financial obligations. The record does not suggest that
petitioners were experiencing any financial difficulty in 2012. To the contrary, in
2012 Mr. Garcia reported over $400,000 of wage income.
As to the second prong, petitioners have not shown that the legal expenses
in question represent ordinary and necessary business expenses in the furtherance
of the business of JGx5. The proper focus of our inquiry as applied to legal
expenses is on the origin of the subject of the litigation and not on the
consequences to the taxpayer. Capital Video Corp. v. Commissioner, 311 F.3d at
464 (citing United States v. Gilmore, 372 U.S. 39, 48 (1963)). The origin of the
claim was Investec’s alleged fraudulent activity that devalued the R&E shares that
petitioners held as minority shareholders. Petitioners--not JGx5--joined the
shareholder litigation group against Investec. As noted, the litigation and
petitioners’ obligation to fund the litigation arose before JGx5 was ever created.
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At all relevant times, the R&E shares were registered in petitioners’ names. As
Mr. Garcia testified, the purpose of the litigation was to secure judgment in favor
of the R&E shareholders and recover their investments.
Petitioners contend that in the “Special Minutes” they assigned all their
R&E litigation rights to JGx5 and that the prospect of an ultimate payout to JGx5
from the R&E litigation constitutes a legitimate business activity of JGx5 as to
which the legal expenses should be deemed an ordinary and necessary business
expense. As noted, we assign little significance to these “Special Minutes”,
unsupported as they are by any objective evidence. In any event, contrary to the
teaching of Gilmore, petitioners’ argument focuses improperly on the potential
consequences of the R&E shareholders’ lawsuit--a potential payout in which JGx5
would allegedly share--rather than upon the origin and character of the underlying
claim. Moreover, the absence of any reliable documentation, such as a contract,
defining the role of JGx5 in the litigation or guaranteeing it a share of any future
recovery further supports the conclusion that petitioners engaged in the R&E
litigation in their personal capacities as investors in R&E and not on behalf of
JGx5.
In the light of these considerations we assign little credence to petitioners’
assertions that JGx5 engaged in “litigation funding” as a business and that
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petitioners lent money to JGx5 to fund the litigation. In the first instance, for an
activity to constitute a trade or business, “the taxpayer must be involved in the
activity with continuity and regularity and * * * the taxpayer’s primary purpose for
engaging in the activity must be for income or profit.” Commissioner v.
Groetzinger, 480 U.S. 23, 35 (1987). During 2012 the R&E litigation was JGx5’s
only claimed “litigation funding” activity. We are not convinced that during 2012
JGx5 was involved in any “litigation funding” activity with the continuity and
regularity necessary for that activity to constitute a trade or business. Similarly,
even if, as petitioners allege, Mr. Garcia, through JGx5, provided advisory
services to the R&E litigation, the record does not show that JGx5 provided
advisory services with the continuity and regularity necessary for that activity to
constitute a trade or business.
Petitioners have failed to show that any of the disputed legal and
professional fees were paid or incurred by JGx5 as ordinary and necessary
expenses in carrying on its trade or business. Accordingly, we sustain
respondent’s determination that these items are not deductible by JGx5 under
section 162.
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II. Accuracy-Related Penalty
Respondent determined that petitioners are liable for a 20% accuracy-
related penalty pursuant to section 6662(a) and (b)(2) for an underpayment
attributable to a substantial understatement of income tax.
Under section 7491(c) respondent bears the burden of production with
respect to this penalty. To meet this burden, respondent must produce evidence
establishing that it is appropriate to impose this penalty. Once respondent has met
his burden of production, the burden of proof is upon the taxpayer to show that he
is not liable for the penalty. See Higbee v. Commissioner, 116 T.C. 438, 449
(2001).12
Section 6662(a) and (b)(2) imposes the accuracy-related penalty on any
portion of a tax underpayment that is attributable to any substantial understatement
of income tax, defined in section 6662(d)(1)(A) as an understatement that exceeds
the greater of 10% of the tax required to be shown on the return or $5,000. The
total tax reported on petitioners’ 2012 tax return was $100,661; the understatement
of income tax determined in the notice of deficiency is $27,017. Therefore, the
12
The parties have stipulated the existence of a signed supervisory approval
form which satisfies any burden of production that respondent has under sec.
6751(b)(1) with respect to the sec. 6662(a) accuracy-related penalty. See Graev v.
Commissioner, 149 T.C. __, __ (slip op. at 13-14) (Dec. 20, 2017), supplementing
and overruling in part 147 T.C. 460 (2016).
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amount of tax required to be shown on petitioners’ 2012 tax return was $127,678.
Petitioners’ understatement of tax of $27,017 exceeds $12,768, which is 10% of
the tax required to be shown on their 2012 tax return. Thus, petitioners’
understatement of income tax is substantial for purposes of the section 6662(a)
and (b)(2) accuracy-related penalty. The Court concludes that respondent has met
his burden of production for the accuracy-related penalty for a substantial
understatement of income tax for 2012.
The accuracy-related penalty does not apply with respect to any portion of
an underpayment if the taxpayer acted with reasonable cause and in good faith
with regard to that portion. Sec. 6664(c)(1). Reasonable cause requires that the
taxpayer exercised ordinary business care and prudence as to the disputed item.
United States v. Boyle, 469 U.S. 241, 246 (1985). The term “good faith” has no
precise definition but means, among other things, (1) an honest belief and (2) the
intent to perform all lawful obligations. Sampson v. Commissioner, T.C. Memo.
2013-212, at *18. The determination of whether a taxpayer acted with reasonable
cause and in good faith is made on a case-by-case basis, taking into account all
facts and circumstances. Higbee v. Commissioner, 116 T.C. at 448; sec. 1.6664-
4(b)(1), Income Tax Regs. Generally, the most important factor is the extent of
the taxpayer’s effort to assess the taxpayer’s proper tax liability. Sec. 1.6664-
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4(b)(1), Income Tax Regs. Other circumstances that may indicate reasonable
cause and good faith include an honest misunderstanding of fact or law that is
reasonable in the light of all of the facts and circumstances, including the
experience, knowledge, and education of the taxpayer. Higbee v. Commissioner,
116 T.C. at 449; Sampson v. Commissioner, at *18; sec. 1.6664-4(b)(1), Income
Tax Regs.
Petitioners made no attempts at trial or on brief to establish reasonable
cause and good faith. Accordingly, we sustain respondent’s determination that
petitioners are liable for the section 6662(a) penalty for an underpayment
attributable to a substantial understatement of their 2012 Federal income tax.
The Court has considered all of petitioners’ arguments, contentions, and
statements. To the extent not discussed herein, the Court concludes that they are
moot, meritless, or irrelevant.
To reflect the foregoing,
Decision will be entered
for respondent.