Case: 18-60299 Document: 00514894508 Page: 1 Date Filed: 03/29/2019
IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT
No. 18-60299 United States Court of Appeals
Fifth Circuit
FILED
March 29, 2019
Consolidated with 18-60304
Lyle W. Cayce
JAMES A. CAVANAUGH, JR., Clerk
Petitioner - Appellant
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent - Appellee
Appeals from a Decision of the
United States Tax Court
T.C. No. 30825-09
T.C. No. 29194-11
Before CLEMENT, GRAVES, and OLDHAM, Circuit Judges.
PER CURIAM:*
This case requires us to answer the question whether a settlement
payment to avoid liability arising from the death of a sole shareholder’s
girlfriend is a deductible business expense for his S corporation. The IRS and
Tax Court have said it is not. We affirm.
* Pursuant to 5TH CIR. R. 47.5, the court has determined that this opinion should not
be published and is not precedent except under the limited circumstances set forth in 5TH
CIR. R. 47.5.4.
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FACTS AND PROCEEDINGS
James Cavanaugh, Jr. is the CEO and sole shareholder of Jani-King
International, Inc., a commercial cleaning franchisor operating as an S
corporation. In November 2002, Cavanaugh went on a Thanksgiving vacation
to the Caribbean island of St. Maarten, where he owned a residence. With him
were his girlfriend, Colony Anne (Claire) Robinson, and Jani-King employees
Ronald Walker (his bodyguard) and Erika Fortner (his employee and former
girlfriend). On November 28, 2002, Claire died at the residence, likely of a
cocaine overdose.
Claire’s mother Linda Robinson sued Cavanaugh and Jani-King,
alleging that Claire’s death was caused by the Jani-King employees acting in
the course and scope of their employment. Robinson alleged that Cavanaugh,
Walker, and Fortner facilitated Claire’s access to and ingestion of cocaine,
causing her death.
After some discovery, Jani-King’s board of directors met to discuss the
suit. Cavanaugh explained to the board that he believed the claims were
frivolous but was willing to personally contribute his own defense costs,
estimated to be $250,000. Jani-King’s corporate counsel explained to the board
that Robinson would likely not prevail in her suit, but a negative outcome was
possible. They acknowledged the “substantial possibility of a negative impact
on the company’s relationship with its franchisees and the company’s business”
that could result from negative publicity arising from the suit. Jani-King’s
counsel ultimately recommended that the company settle, and the board
authorized a settlement payment of up to $5 million.
The parties settled the lawsuit for $2.3 million to be paid over the course
of two years. Cavanaugh paid $250,000 toward the settlement, Jani-King the
remainder. Jani-King reimbursed Cavanaugh for his portion of the settlement.
Jani-King then deducted its settlement payment, the reimbursement payment,
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and its related legal expenses as ordinary and necessary business expenses.
Because Jani-King is an S corporation, its deductions flow through to and are
reflected on Cavanaugh’s personal tax returns.
The IRS disallowed the claimed deductions. And despite having paid $2.3
million ostensibly to avoid protracted litigation and the attendant negative
publicity, Cavanaugh decided to fight for the deductions, contesting the IRS’s
determination that the expenses did not qualify as ordinary and necessary
business expenses.
The Tax Court eloquently articulated the parties’ basic dispute:
From Cavanaugh’s perspective, it is an unfortunate
fact of business life that corporations and prominent
individuals get sued, sometimes on dubious facts and
theories of liability. Settling such suits may be distasteful,
but even a small chance of an enormous payout may justify
a deal that protects assets from the uncertainty of
litigation and protects a business reputation from scandal.
The Commissioner has a different view--he argues
that however jumbled and wrinkly the legal topography
created by the collision of Code, regulations, and caselaw
may sometimes seem, it cannot possibly hide a crevice dark
enough to successfully shelter an argument that the price
paid for the death of the boss’s girlfriend is a deductible
corporate business expense.
The Tax Court held that Jani-King could not deduct the settlement
payment, reimbursement payment, or related legal expenses. The court first
held that United States v. Gilmore, 372 U.S. 39 (1963), controls. In Gilmore,
the Supreme Court held that when determining the deductibility of litigation
expenses as business expenses, “the origin and character of the claim with
respect to which an expense was incurred, rather than its potential
consequences upon the fortunes of the taxpayer, is the controlling basic test.”
372 U.S. at 49. If the claim “arises in connection with the taxpayer’s profit-
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seeking activities,” related expenses may properly be characterized as a
business expense rather than a personal expense. Id. at 48.
The Tax Court found that Cavanaugh did not show that Robinson’s suit
arose in connection with Jani-King’s profit-seeking activities. Therefore, Jani-
King’s settlement payment and related legal expenses were not deductible as
ordinary and necessary business expenses. The court also found that Jani-King
was not obligated to reimburse Cavanaugh, Cavanaugh was not unable to
cover his part of the settlement, and the reimbursement was not an ordinary
and necessary business expense, so the reimbursement payment was not
deductible. Again, Cavanaugh appealed.
STANDARDS OF REVIEW
The Tax Court’s legal conclusions are reviewed de novo and its factual
findings for clear error. Harris v. Comm’r of Internal Revenue, 16 F.3d 75, 81
(5th Cir. 1994). “A factual finding is clearly erroneous only if, based on the
entirety of the evidence, the reviewing court is left with the definite and firm
conviction that a mistake has been made.” United States v. Cordova-Soto, 804
F.3d 714, 718 (5th Cir. 2015).
DISCUSSION
I. Disallowance of Jani-King’s deduction for its settlement
payment and related legal expenses
A. Applicability of Gilmore
Cavanaugh first argues that Gilmore is inapposite because it does not
address a situation where a corporation is directly named in the underlying
suit. Relying primarily on Kopp’s Co., Inc. v. United States, 636 F.2d 59 (4th
Cir. 1980), Cavanaugh argues that the court must give significant weight to a
corporation’s direct exposure to a monetary judgment, rather than examining
the origin of the claim. In response, the Commissioner contends that Gilmore
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controls even when corporations are named as defendants in the underlying
litigation.
Section 162 of the Internal Revenue Code “permits an individual or
corporate taxpayer to deduct all ordinary and necessary expenses paid or
incurred in carrying on a trade or business.” Estate of Meade v. Comm’r of
Internal Revenue, 489 F.2d 161, 164 (5th Cir. 1974). When determining
whether litigation expenses were “incurred in carrying on a trade or
business,” 1 this court generally looks to the origin of the claim from which the
expenses arose. Id. at 165–66 (relying on Gilmore); see also Marcello v. Comm’r
of Internal Revenue, 380 F.2d 499, 504–05 (5th Cir. 1967). “Legal expenses do
not become deductible merely because they are paid for services which relieve
a taxpayer of liability.” Lykes v. United States, 343 U.S. 118, 125 (1952).
Importantly, “[w]hen a taxpayer claims a Section 162(a) deduction, he has the
burden to prove that the expense in question has a business origin.” Marcello,
380 F.2d at 504.
We decline Cavanaugh’s invitation to follow the scarce out-of-circuit
cases since Gilmore that have distinguished its origin-of-the-claim test when
the taxpayer corporation is named in the underlying suit. See Kopp’s, 636 F.2d
at 60–61; Dolese v. United States, 605 F.2d 1146 (10th Cir. 1979). Those cases
directly conflict with Gilmore, which is binding on this court. Each
concentrates on the consequences of the litigation rather than the underlying
claim’s origin. See Kopp’s, 636 F.2d at 61 (focusing on the company’s “direct
exposure to the risk of a monetary judgment”); Dolese, 605 F.2d at 1151–52
(focusing on the restraining order that arose out of a divorce action). This
circuit has repeatedly confirmed that it follows Gilmore, which has not
otherwise been confined to its facts. See Meade, 489 F.2d at 164; Marcello, 380
1 The parties do not dispute that the expenses at issue are ordinary and necessary.
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F.2d at 504–05; see also Northwestern Indiana Telephone Co. v. Comm’r of
Internal Revenue (NITCO), 127 F.3d 643 (7th Cir. 1997) (applying Gilmore
even though the taxpayer corporation was directly named in the underlying
litigation). 2
We are bound by Gilmore and must apply its origin-of-the-claim test.
Simply being named in the Robinson suit is insufficient to prove that Jani-
King’s expenses are deductible business expenses.
B. Origin of the Claim
Under Gilmore, “[w]e must identify the claim that gave rise to the legal
fees whose deductibility is here in question, and then determine whether the
claim was proximately related to the trade or business of” Jani-King. Peters,
Gamm, West & Vincent, Inc. v. Comm’r of Internal Revenue, 71 T.C.M. (CCH)
2789, 1996 WL 182545, at *5 (T.C. 1996). This inquiry “does not contemplate
a mechanical search for the first in the chain of events which led to the
litigation but, rather, requires an examination of all the facts.” Id. (quoting
Boagni v. Comm’r of Internal Revenue, 59 T.C. 708, 713 (T.C. 1973)).
The Tax Court found that the “claim” was undisputed: the Robinson suit
against Cavanaugh and Jani-King. The court further found that the origin of
the claim was that Claire was allegedly provided cocaine by Jani-King
employees. The court found that providing cocaine does not arise from, further,
or use property directly employed in Jani-King’s franchising business. This is
a finding of fact that is reviewed for clear error. See Marcello, 380 F.2d at 505
2 Even were we to follow Kopp’s, Cavanaugh would not prevail. In the Kopp’s line of
cases, the corporations showed that the litigation directly threatened or inhibited their ability
to engage in profit-seeking activities. See Kopp’s, 636 F.2d at 60; Dolese, 605 F.2d at 1149,
1151–52; Naporano Iron & Metal Co. v. United States, 6 Cl. Ct. 422, 431 (Cl. Ct. 1984); see
also Comm’r of Internal Revenue v. Heininger, 320 U.S. 467, 469 (1943) (owner of mail-order
false-teeth business was deprived of access to the mails by a fraud order). Cavanaugh made
no such showing.
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n.16; Heininger, 320 U.S. at 475 (“Whether an expenditure is directly related
to a business and whether it is ordinary and necessary are doubtless pure
questions of fact in most instances.”).
Cavanaugh contends that because Jani-King engages only in profit-
seeking activities, its employees’ actions—alleged to have been within the
course and scope of their employment—must have arisen from profit-seeking
activities. The Commissioner argues that simply because a corporation’s
possible liability rests on an activity alleged to have been within the course and
scope of employment does not make that activity related to a corporation’s
profit-seeking activity for the purposes of tax deductibility.
Cavanaugh ignores the “basic principle of examining each activity to
ascertain whether its objective was to make a profit.” Synanon Church v.
Comm’r of Internal Revenue, 57 T.C.M. (CCH) 602, 1989 WL 59409, 1989 Tax
Ct. Memo LEXIS 270, at *90 (T.C. 1989). Even when the underlying suit
includes allegations of employees acting within the course and scope of their
employment, the court must determine whether their activities arose from or
were connected to the corporation’s profit-seeking activity.
Take, for example, the Seventh Circuit’s opinion in NITCO. NITCO was
a closely held, independent telephone company. NITCO, 127 F.3d at 645. The
primary shareholder’s son formed a cable television company, NICATV. Id. In
the shareholder’s attempt to help his son, NITCO paid his salary, NITCO
employees “constructed and operated NICATV,” NITCO paid NICATV’s utility
bills, and NITCO wrote off a $100,000 debt from NICATV. Id. at 646. One of
NICATV’s competitors filed a complaint with the FCC alleging NICATV was
illegally affiliated with NITCO, which was prohibited from offering cable
services. Id. at 645. The FCC eventually brought an enforcement action against
the companies, and NITCO and the son brought a separate suit alleging
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constitutional violations. Id. NITCO deducted the attorneys’ fees for these
actions as business expenses. Id. at 645–46.
The Seventh Circuit affirmed the Tax Court’s finding that the origin of
the claims giving rise to NITCO’s legal expenses did not involve its profit-
making activities. Id. at 646. The court found that NITCO’s activities
supporting NICATV—including those by employees presumably acting within
the course and scope of their employment—were not undertaken with a profit
motive. Id. Therefore, the court found that the claims “originated with the
nonbusiness activity of underwriting” NICATV and affirmed that NITCO’s
legal expenses were not ordinary and necessary business expenses. Id.
Similarly, in Synanon Church, the Tax Court examined all the relevant
activities undertaken by a formerly nonprofit church to determine whether
each constituted a trade or business and was undertaken with a profit motive.
1989 WL 59409, 1989 Tax Ct. Memo LEXIS 270, at *89–102. The Tax Court
affirmed the disallowance of deductions for litigation expenses arising from
activities it found not to be profit-seeking, even expenses arising from suits
alleging that church employees “committed tortious acts” in the course and
scope of their employment. Id. at *139–40. The court held that Synanon failed
to show that the tort claims “arose from, or were proximately related to, any
specific business activity.” Id. at *139.
Cavanaugh does not argue that providing cocaine to Claire was done
with a profit-seeking motive. Nor does he argue that the alleged actions arose
from or were proximately related to any specific Jani-King business activity.
The Tax Court’s finding that the Jani-King employees’ alleged actions were not
profit-seeking is not clearly erroneous.
Cavanaugh also contends that “all expenses incurred in defending
against a [non-collusive] suit founded on a theory of respondeat superior would
be deductible as a business expense . . . even where . . . the origin of the suit
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has no connection to the corporation’s profit-seeking activities.” He argues that
the “nexus with the business is the allegation that the employee is acting
within the course and scope of his employment.”
This is a novel argument, but Cavanaugh marshals no legal support for
it. And he runs up against Gilmore and the cases just discussed, where courts
have affirmed the disallowance of deductions when employees are alleged to
have been acting in the course and scope of employment if their actions did not
involve the company’s profit-making activities. See NITCO, 127 F.3d at 646;
Synanon Church, 1989 WL 59409, 1989 Tax Ct. Memo LEXIS 270, at *139–40;
cf. Cummins Diesel Sales of Or., Inc. v. United States, 207 F. Supp. 746, 748–
79 (D. Or. 1962) (finding that the salary of a nurse hired by a company to care
for its principal officer and stockholder was “predominantly personal” and “not
chargeable to a corporation as an ‘ordinary and necessary’ business expense”)
(cited favorably by Jack’s Maint. Contractors, Inc. v. Comm’r of Internal
Revenue, 703 F.2d 154, 156–57 (5th Cir. 1983)).
Cavanaugh’s argument would also have the court ignore all the facts and
allegations of the underlying claim and look only at the alleged theory of
liability. We must look not only at the allegation that Jani-King employees
were acting within the course and scope of their employment, but also at the
allegation that they provided cocaine leading to Claire’s death. The origin of
the claim is the employees’ providing cocaine, not their employment by Jani-
King. The Tax Court’s findings are not clearly erroneous. The settlement
payment and related legal fees arose from a claim originating in non-business
activity and Jani-King’s business-expense deductions were properly
disallowed.
II. Disallowance of deduction for reimbursement payment
Cavanaugh contends that Jani-King’s reimbursement payment to him is
deductible because settling the lawsuit was in Jani-King’s best interests. He
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also argues that the corporation’s bylaws make indemnification obligatory, and
Jani-King’s primary motives for reimbursement were to protect its business
and uphold its corporate obligations. The Commissioner responds that
Cavanaugh does not contest the Tax Court’s interpretation of the bylaws
finding that Jani-King was not obligated to make the reimbursement payment.
The Commissioner also argues that the record is devoid of evidence showing
that Cavanaugh was unable to make the $250,000 payment or that
indemnification was necessary to protect Jani-King’s business.
A. Required Payment
A company’s payment under an indemnification agreement can be an
ordinary and necessary business expense. See Union Inv. Co. v. Comm’r of
Internal Revenue, 21 T.C. 659, 663 (T.C. 1954). Article 9.01 of Jani-King’s
bylaws provides for corporate indemnification of:
any . . . Director, officer or employee . . . against any and all
liability and reasonable expense that may be incurred by
him in connection with or resulting from any claim . . . in
which he may become involved as a party . . . by reason of
being or having been such a Director, officer, or employee . . .
provided such person acted, in good faith, in what he
reasonably believed to be the best interests of the
corporation . . . .
Under Article 9.03, if the person is “wholly successful” in the suit, he is entitled
to indemnification as a matter of right. Otherwise, indemnification is “at the
discretion of the corporation” upon a finding by the board of directors or its
counsel that the person met the standards of conduct set forth in Article 9.01.
Although he generally asserts that Jani-King was legally obligated to
indemnify him, Cavanaugh does not argue that the requirements of the bylaws’
indemnification provision were met. Thus, he has waived the argument that
Jani-King was contractually obligated to reimburse him. See, e.g., Willis v.
Cleco Corp., 749 F.3d 314, 319 (5th Cir. 2014) (“A party that asserts an
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argument on appeal, but fails to adequately brief it, is deemed to have waived
it.” (quoting United States v. Scroggins, 599 F.3d 433, 446 (5th Cir. 2010))).
B. Voluntary Payment
Generally, paying another’s debt is not an ordinary and necessary
business expense. See Welch v. Helvering, 290 U.S. 111, 114 (1933). The Tax
Court has recognized an exception when such a payment is made to “protect or
promote [the taxpayer’s] own business.” Lohrke v. Comm’r of Internal Revenue,
48 T.C. 679, 684–85 (T.C. 1967). When a corporation pays a controlling
shareholder’s expense, this test “is more likely to be satisfied if the shareholder
is unable to pay the expense, thus requiring the corporation to pay the expense
in order to protect its own interests.” HIE Holdings, Inc. v. Comm’r of Internal
Revenue, 97 T.C.M. (CCH) 1672, 2009 WL 1586044, at *96 (T.C. 2009); see also
Hood v. Comm’r of Internal Revenue, 115 T.C. 172, 179 (T.C. 2000). Even if the
taxpayer meets the “protect and promote” test, it must also show that the
expense is an ordinary and necessary business expense. Lohrke, 48 T.C. at 688.
This second inquiry is still governed by Gilmore. See, e.g., Capital Video Corp.
v. Comm’r of Internal Revenue, 311 F.3d 458, 464–65 (1st Cir. 2002).
Cavanaugh argues only that the settlement was necessary to protect
Jani-King’s business, not that the reimbursement payment was necessary to
do so. Nor does he contend that he was unable to make the payment, and the
record shows the opposite. Further, as discussed above, the Tax Court’s finding
that the Robinson suit did not arise in connection with Jani-King’s profit-
seeking activities is not clearly erroneous. Therefore, Cavanaugh has not
shown that the Tax Court’s findings regarding Jani-King’s reimbursement
payment are clearly erroneous. The reimbursement payment is not deductible
as a business expense.
CONCLUSION
For the foregoing reasons, we affirm.
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