The following article is reprinted from The M&A Tax Report, Vol. 13, No. 4, November 2004, Panel Publishers, New York, NY.
TAX IMPLICATIONS OF COMPANIES PAYING
EMPLOYEES' LEGAL FEES
By Robert W. Wood and Dominic L. Daher
There has been no shortage of scandal in
the business world over the last few years. Enron, MCI, Tyco, Global Crossing,
Adelphia, Imclone, Martha Stewart, Frank Quattrone, and more. Indeed, whole
industries are in the crosshairs: the securities industry, the mutual fund
industry, the hedge fund industry, and the list goes on. Indemnity issues
can arise for individuals too, though I'm primarily concerned here with
cases where both the company and executives (or directors) end up with
counsel.
Elliot Spitzer and New York State may get
a lot of the press, but a lot of the scrutiny is by the federal rather
than by state government. The Justice Department (which frequently coordinates
its investigations with other federal agencies) has been an integral force
behind many investigations exposing these scandals. In fact, the Justice
Department has assembled a "Corporate Task Force" to specifically target
corporate (and other non-corporate, large organization) fraud.
In January of 2003, Larry D. Thompson,
then Deputy Attorney General, issued a memorandum entitled "Principles
of Federal Prosecution of Business Organizations." Thompson advocated strict
prosecution of organizations which break the law, as well as those individuals
within these organizations who assist these entities in carrying out illegal
activities. Thompson suggests that in deciding whether to go after an organization,
the government should consider factors including: (1) the nature and seriousness
of the offense; (2) the pervasiveness of wrongdoing within the organization;
(3) the organization's history of similar conduct; (4) the organization's
timely and voluntary disclosure of wrongdoing and its willingness to cooperate
in investigations of its employees and agents (including waiving of the
organization's attorney-client and work product privileges); (5) the existence
and adequacy of the organization's compliance program; (6) the organization's
remedial actions; (7) collateral consequences (such as disproportionate
harm to equity holders); (8) the adequacy of prosecution of individuals
within the organization responsible for its wrongful conduct; and (9) the
overall adequacy of remedies.
Perhaps this new culture of compliance,
of contrition and conservatism is merely a pendulum swing from the supposed
greed of the 80s and 90s, the former being particularly earmarked by Gordon
Gekko's oft-repeated capitalist mantra. Indeed, the first decade of the
new millennium seems already to be a backlash, a decade of paying for the
"greed is good" indulgence.
The Manchurian Candidate? From a tax perspective, the pervasiveness
of investigations raises a host of issues. The extent to which an organization
is willing to cooperate in the investigation of its employees and agents
itself raises tax issues. In his memo, Thompson notes that the payment
of attorneys' fees on behalf of an employee or agent may be considered
a relevant factor in determining the extent and value of an organization's
cooperation with the government. In other words, if an organization pays
attorneys' fees on behalf of its officers and directors (or even its rank-and-file
employees), that organization may be subject to more stringent prosecution
by the government. I presume that this connection between fees and the
vim and vigor of an investigation has not gone unnoticed by organizations
being investigated by the government for potential wrongdoing. My guess
is their lawyers have noticed too.
An article on the front page of the Wall
Street Journal discussed the plight of Jeffrey Eischeid, a onetime brainchild
of KPMG's tax shelter marketing efforts. For years, Eischeid marketed tax
shelters that KPMG assured him were legal. Now, KPMG is giving Eischeid
a Hobson's choice: (1) agree to cooperate with federal prosecutors (which
could land him in jail) and we'll pay your legal fees; or (2) invoke your
Fifth Amendment rights and pay your own legal fees.
Of course, KPMG has its own problems. Even
so, KPMG's solidarity is not awe inspiring. Eischeid's legal fees are likely
to be substantial (perhaps even in the millions). No matter who pays Eischeid's
legal fees, the tax consequences to either him or to KPMG may prove to
be significant.
Requirements for Deducting Legal Fees Using Eischeid's dilemma as an example,
what are the tax consequences if Eischeid decides to cooperate and KPMG
pays his legal fees? The Internal Revenue Code does not expressly provide
for a deduction for legal fees. Even so, legal fees arising from a trade
or business or Section 212 activity are generally deductible under the
general business expense provision of Section 162, or under Section 212
(which allows for deductions related to the production of income or investment
activities). To be deductible under Sections 162 or 212, legal fees must
(among other things) be ordinary, necessary and reasonable, and they must
be directly connected (or proximately result from) the taxpayer's trade
or business.
In Oden v. Commissioner, the Tax Court
took these requirements a step further by invoking the "furtherance" test.
The "furtherance" test first adopted in Oden requires that the expense
in question be in furtherance of the trade or business or Section 212 activity
(in addition to being ordinary, necessary, etc.) to be deductible. In Oden,
the Tax Court denied the taxpayer's deduction for legal fees-which were
the proximate result of the taxpayer's malicious behavior-because the taxpayer's
behavior (making malicious comments about a former employee to a potential
employer) was not in furtherance of his trade or business. Many courts
have subsequently declined to follow Oden, but it may be worth thinking
about the furtherance test whenever it could potentially apply. (Are you
thinking about sexual harassment suits? Read on.)
The "ordinary and necessary" requirement
has generated substantial confusion over the years, though it seems awfully
pedestrian. Generally speaking, an expense (for legal fees or otherwise)
is "ordinary" if a business person would commonly incur it in the particular
circumstances involved. Taxpayers frequently confuse the "ordinary" requirement
with the notion that the particular expense must arise over and over again,
and hence would be ordinary in the common usage of that word. Thus, taxpayers
generally think of the "ordinary" requirement as synonymous with recurrent.
However, the courts have been much more
expansive in their interpretation of the ordinary and necessary requirement.
In fact, the Supreme Court has noted that an ordinary expense of a particular
nature may be extremely irregular in occurrence, stating:
A lawsuit effecting the safety of
a business may happen once in a lifetime. The counsel fees may be so heavy
that repetition is unlikely. Nevertheless, 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.
Moreover, the Tax Court has noted that
the employment of an attorney satisfies the "ordinary" requirement if it
is consistent with the behavior of a reasonably prudent man in the same
circumstances.
Just as the "ordinary" requirement has
been liberally interpreted, the "necessary" requirement has also been given
wide berth. It is not necessary to inquire whether the taxpayer really
had to incur a particular expense, such as paying legal fees of an employee
or agent of the organization, if incurring such an expense is "appropriate
or helpful." Given the authorities, the word "appropriate" or "helpful"
might be more apropos than "necessary".
The "ordinary and necessary" nature of
the payment of legal fees in this context is rarely questioned (by the
IRS or by the judiciary), assuming that the requisite nexus can be established
between the lawsuit and the business of the defendant. Nevertheless, there
is still the question of the overall "reasonableness" of an expense.
For legal fees to be deductible by an organization,
they must generally be directly connected to its trade or business. Nonetheless,
the deduction of legal fees is not dependant on the success of the case.
Instead, the deductibility of legal fees is determined under the origin
of the claim doctrine.
Origin of the Claim The origin of the claim doctrine is merely
the sensible proposition that, "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 of whether
the expense was 'business' or 'personal' and hence whether it is deductible
or not."
Perhaps the most well-known "origin" case
is United States v. Gilmore. There, the expenses of divorce litigation
were held nondeductible personal expenditures, even though an adverse decision
in the matter was likely to destroy the taxpayer's business. The origin
of the claim was the divorce litigation, not the potential consequences
of the divorce to the business. Thus, the litigation expenses were nondeductible
personal expenditures.
To determine the deductibility of legal
fees, one must begin with the identity of the payor. Only the payor is
entitled to potentially applicable deductions. Consider, for example, if
a corporation deducts legal fees arising out of the action of its agents,
equity holders, or employees. To be deductible, the organization must pay
or incur the amount for its own benefit, rather than for the benefit of
others. Even so, legal fees and expenses relating to the actions of officers
and directors in conducting a corporation's business have generally been
held deductible by the paying corporation, on the theory that the matter
is proximately related to the business of the corporation, and the results
achieved in litigation are beneficial to the corporation.
Nonetheless, corporations have been denied
deductions for legal expenses incurred in defending suits against employees
which are unrelated to the company's trade or business. Indeed, where the
employee is a major equity holder in the organization, it may be best to
avoid this type of situation altogether. One way of doing so is to have
the individual make a contribution to capital to the organization for the
amount of his legal fees. This is generally tax-free under Section 118,
Section 351, or Section 721. In any case, the organization can then use
the amount contributed to pay the legal fees, and this amount can be deducted
by the organization as an ordinary and necessary business expense.
Distinguishing Fines or Penalties Now we must shift gears. The general rule
is that payments are deductible (either by settlement or judgment) if made
in the ordinary course of a trade or business (or payments made in the
production of income or in furtherance of investment activities). In contrast,
the Internal Revenue Code expressly prohibits a deduction for "any fine
or similar penalty paid to a government for the violation of any law".
Attorneys' fees incurred in defending against the imposition of fines or
penalties have also been held to be nondeductible on the theory that they
are tainted by the nature of the litigation.
Hence, returning to Eischeid and his former
firm KPMG, it is possible that some of Eischeid's and KPMG's attorneys'
fees relating to the current federal investigations may ultimately be disallowed
under Section 162(f). Section 162(f) denies a deduction for both criminal
and civil penalties, as well as for sums paid in settlement of a potential
liability for a fine or penalty. It is the latter element of the provision
that often causes controversy. It may (or may not) be clear that a fine
is likely to be imposed when a potential liability is satisfied.
In some cases, whether a fine or penalty
may be imposed may depend on the intent of the perpetrator. If the fine
or penalty is in fact imposed, the denial of the deduction is absolute.
It does not matter whether the violation of law was intentional or unintentional.
In either case, no deduction will be permitted for the payment of a fine
or penalty even if the violation is inadvertent, or if the taxpayer must
violate the law in order to operate profitably.
These rules seem to be bubbling to the
surface a lot lately. One can hardly pick up a newspaper without learning
about another corporate wrongdoer forced to pay a fine or penalty. In 2003,
MCI was fined a record $500 million by the SEC for accounting fraud. Roughly
$1.5 billion was shelled out by the securities industry in 2003 for its
indiscretions. Interestingly, of this amount, only about $450 million was
characterized as nondeductible fines or penalties. That indicates a key
point about all of this from a payor's perspective-often there is wiggle
room in characterizing the nature of the payment.
Indeed, Exxon was almost as fortunate as
the securities industry players when paying for its Exxon Valdez oil spill
catastrophe. The U.S. government's $1.1 billion settlement with Exxon actually
cost Exxon a mere $524 million on an after-tax basis. The Congressional
Research Service determined that more than half of the civil damages-totaling
$900 million-could be deducted on Exxon's federal income tax returns.
Frequently, the line-drawing exercises
that take place here are imprecise. Ultimately, it is axiomatic that fines
or penalties, as well as their corresponding legal fees, are nondeductible
under Section 162(f). Yet, it is often not so easy to tell if a payment
is truly a fine or penalty or is rather a less ostracized type of payment.
The Unkindest Cut of All There are many similarities between deducting
legal fees under Section 162 and deducting them under Section 212. Yet,
there is one big difference-the AMT. If my reference to trusted Brutus
stabbing Caesar seems overblown, just wait. Legal fees deducted under Section
212 are subject to disallowance for AMT purposes. Legal fees taken as miscellaneous
itemized deductions are also subject to a 2% of AGI floor and cut-back
for high-income taxpayers. Let's look at a simple example.
Assume John is indicted on multiple counts
of racketeering, conspiracy, extortion, fraud, and obstruction of justice.
Assume further that John's various income producing activities constitute
activities engaged in for the production of income. Accordingly, John's
legal fees ($500,000) may only be deducted under Section 212 (instead of
Section 162), and will be disallowed entirely for AMT purposes (and further
limited by Sections 67 and 68). During the year of his indictment, John
had been quite successful in producing substantial income ($500,000) from
his various activities. At trial, John pleads not-guilty, claiming he is
a law-abiding businessman. The jury is not convinced, and convicts John
on multiple counts of racketeering.
On his tax return, John deducts his attorneys'
fees under Section 212. But, because this deduction is disallowed entirely
for AMT purposes (and further limited by Sections 67 and 68), John ends
up owing roughly $136,000 in federal income taxes (even though he had deductions
equal to or greater than his income). Of this amount, over 98% results
from the application of the AMT. Had John instead been able to take advantage
of Section 162, his tax liability for the year would have been about $1,000.
Dodging Income: Paying Legal Fees of
Another In O'Malley v. Commissioner, the Tax Court
found a pension fund trustee to be in receipt of gross income where his
employer paid his legal fees in a criminal prosecution for conspiracy to
commit bribery. Even so, the Tax Court permitted O'Malley to deduct these
legal fees as ordinary and necessary employee business expenses. At trial,
O'Malley argued that the legal fees were ordinary and necessary business
expenses of his employer, and, accordingly, they should not be included
in his gross income.
Since O'Malley's employer paid his legal
fees, guess what? Citing Old Colony Trust, the Tax Court determined that
the payment of O'Malley's personal legal fees by the pension fund was income
to him. This kind of quandary actually happens more than you might think.
In fact, on that note, let's return to
our friend Eischeid and KPMG. Depending on the exact nature of any future
actions taken against Eischeid and KPMG, he may end up having to recognize
as gross income any amount KPMG pays for his legal fees. Admittedly, this
is not likely, because it seems probable that any indictment against Eischeid
would name KPMG as a co-defendant.
Perhaps it's a long shot, but let's take
a quick look at what might happen if Eischeid is indicted alone and KPMG
nevertheless pays his legal expenses. Eischeid would probably have to include
the payment of these legal fees as income. Although the gross income hit
is a knock down, the real knock out punch is the AMT. Employee business
expenses are miscellaneous itemized deductions and subject to complete
disallowance for AMT purposes (as well as the cutbacks mandated by Section
67 and 68). As previously demonstrated by the Section 212 example above,
the disallowance of this deduction for AMT purposes can be crippling.
Can the Attorneys' Fee Cases Save the
Day? Everybody knows the decisions, and even
the underlying rationales, of the Circuit Courts of Appeal on the tax treatment
of contingent attorneys' fees. The cases vary wildly, and there is currently
a nasty split in the circuits on this issue. The majority has held that
contingent attorneys' fees are gross income to both the attorney and the
plaintiff.
The minority has held that contingent attorneys'
fees are not gross income to the plaintiff; instead, they are merely taxable
to the attorney. Prior to granting certiorari in Banks and Banaitis, the
Supreme Court declined to resolve the attorneys' fee issue on five prior
occasions. With this as a background, let's see how the attorneys' fee
cases might be useful in furthering Eischeid's cause.
Assuming that for some reason these legal
fees are not deductible by KPMG (perhaps because only Eischeid is indicted
and KPMG is not), might Eischeid be able to use the Cotnam rationale to
disclaim (and exclude from his income) any legal fees paid by KPMG? Well,
perhaps. Eischeid might argue that he never had dominion and control over
the funds paid to his attorneys, and accordingly should not be required
to include these funds in gross income. This argument may not hold water
(depending on which circuit's law applies under the Golsen rule), but sometimes
you have to go with what you've got.
The Service would presumably cite Old Colony
Trust to refute this assertion. However, there is at least a plausible
argument that Old Colony Trust is distinguishable from the situation I
contemplate for Eischeid. After all, KPMG would not be attempting to compensate
Eischeid, as was the case in Old Colony Trust.
A Farewell to Arms It will be interesting to see what happens
in the federal investigations which are now probing Eischeid and KPMG.
Of course, it is possible that neither party will ever be indicted by federal
authorities. KPMG has frequently made the news over its tax shelter activities.
As one would expect, the vast majority of these news stories are anything
but flattering.
Going before Congress with what some reporters
called a "catch me if you can" attitude late last year may ultimately prove
very costly. Even the ancient Greeks (pre-Brad Pitt) warned of the evils
of hubris. In a post-Enron world, hubris can prove to be an organization's
Achilles heel, even with lots of special effects and Brad's own personal
trainer. But on an individual level, the tax effects of a large legal bill,
given an unattractive income and deduction equation, can be quite as devastating
as a Trojan war.
Tax Implications of
Companies Paying Employees' Legal Fees, by Robert W. Wood and Dominic L. Daher ,Vol. 13, No. 4, M&A Tax
Report (November 2004), p. 4.
The reasonableness of a payment in this
context (pursuant to either a settlement or judgment) will generally not
be questioned. Since litigation is by its very nature adversarial, the
reasonableness of a payment to dispose of litigation is rarely questioned.
However, in large part because the pension
fund (his employer) was not named as a defendant in the prosecution, the
Tax Court determined that the expenses were not ordinary and necessary
business expenses of the organization. Instead, the Tax Court found that
the legal fees were personal to O'Malley.