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.
-4-
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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Capital Video Corp. v. Commissioner
Court: Court of Appeals for the First Circuit
Date filed: 2002-11-27
Citations: 311 F.3d 458
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