112 T.C. No. 22 

UNITED STATES TAX COURT

GEORGE W. GUILL, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 16796-97. Filed June 18, 1999.

P, an independent contractor, commenced a lawsuit

against D, alleging that D was liable to P for breach

of contract and conversion arising out of P's work for

D. As to the conversion claim, the jury awarded P

actual and punitive damages, together with interest and

costs. P received the award in 1992, and, from this

amount, P paid his attorneys their fees and the court

costs (collectively, legal costs). P deducted the

legal costs on his 1992 Schedule C, Profit or Loss From

Business, reporting that the costs arose out of his

sole-proprietor business, and he reported the actual

damages on that schedule as income from the business. 

P did not include the punitive damages in his 1992

gross income. R determined that the legal costs were

deductible as a nonbusiness itemized deduction on

Schedule A, Itemized Deductions, and that the punitive

damages were reportable as nonbusiness income. R

concedes that the legal costs are a business expense to

the extent they are attributable to P's recovery of the
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actual damages. R asserts that the remaining legal

costs are a nonbusiness itemized deduction because they

are attributable to P's recovery of the punitive

damages. P and R agree that the punitive damages are

includable in P's business income if the legal costs

are a business expense.

Held: All of the legal costs are attributable to

P's trade or business; hence, the legal costs are all

deductible on Schedule C as a business expense.

Bobby Wayne Enlow, for petitioner.

Jeanne Gramling, for respondent.

OPINION

LARO, Judge: This case is before the Court fully

stipulated. See Rule 122. George W. Guill petitioned the Court

to redetermine deficiencies of $100,916 and $434 in his 1992 and

1993 Federal income tax, respectively. Following the parties'

concessions, the primary issue left to decide is whether all of

the attorney's fees and court costs (collectively, legal costs)

paid by petitioner in the successful prosecution of his claim of

conversion are expenses of his sole-proprietor business;

petitioner was awarded actual damages, punitive damages, costs,

and interest. We hold they are. Section references are to the

Internal Revenue Code in effect for 1992. Rule references are to

the Tax Court Rules of Practice and Procedure. Dollar amounts

are rounded to the nearest dollar.
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Background

All facts have been stipulated and are so found. The

stipulation of facts and exhibits submitted therewith are

incorporated herein by this reference. Petitioner resided in

Columbia, South Carolina, when he petitioned the Court.

Petitioner began working as an agent for Academy Life

Insurance Co. (Academy) in the late 1970's. He worked for it as

an independent contractor under a contract between the two. 

Academy fired him in July 1986. When it did, it was

contractually obligated to pay him renewal commissions on

policies that he or an agent under his supervision had sold. 

After his firing, Academy remitted to him reduced monthly

commissions. It also stopped sending to him the paperwork

documenting his commissions.

In September 1987, petitioner sued Academy for breach of

contract and conversion, praying in his complaint for an award of

actual and punitive damages. Petitioner alleged that Academy was

liable to him for: (1) An unlawful termination of contracts with

resulting failure to pay money due thereunder (breach of contract

and conversion), (2) unfair trade practices (also seeking treble

damages and attorney's fees), (3) a termination of resident

counselor status, (4) a failure to pay commissions, and (5) the

fraudulent filing of Federal tax forms reporting income not paid

to him. Following a jury trial, the U. S. District Court hearing

the case directed a verdict against Academy for breach of

contract and sent the issues of conversion and resulting damages
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to the jury. The judge instructed the jury as follows with

respect to punitive damages:

The plaintiffs [petitioner and the male taxpayer

in Whitley v. Commissioner, T.C. Memo. 1999-124] are

also seeking punitive damages in their conversion cause

of action.

The law permits the jury, under certain

circumstances, to award punitive damages in order to

punish a wrong-doer for some extraordinary misconduct,

and to serve as a warning not to engage in such conduct

in the future.

Thus, if you find that the plaintiffs have shown

by a preponderance of the evidence, that the defendant

converted the plaintiffs' money with malice, ill will,

a conscious indifference to the rights of others, or a

reckless disregard for the rights of others, you may

award the plaintiffs punitive damages.

If you so find, it becomes your right to award

punitive damages in such an amount as you unanimously

agree to be proper in light of the character of the

wrong committed, the punishment which should be

applied, and the ability of the defendant to pay. 

The jury found against Academy on the conversion claim and

awarded petitioner $51,499 in actual damages for unpaid

commissions and $250,000 in punitive damages, together with

"interest thereon at the rate of 8.85 per cent and his costs of

action". The jury's verdict was affirmed upon appeal.

Academy paid $371,542 to petitioner in 1992, and, from that

amount, he paid his attorneys the legal costs, which consisted of

$148,617 in attorney's fees and $3,279 in court costs. 

Petitioner included the actual damages in income on his Schedule

C, Profit or Loss From Business, and he claimed on that schedule

a deduction for the legal costs. Petitioner did not report any

of the punitive damages on his 1992 Federal income tax return. 
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1 Respondent concedes that the litigation costs attributable

to the actual damages are deductible on Schedule C as a business

expense.

Respondent issued petitioner a notice of deficiency that

reflects respondent's determination that the $250,000 in punitive

damages is includable in petitioner's 1992 gross income as "Other

Income" and that he must deduct the legal costs on Schedule A,

Itemized Deductions, as a miscellaneous deduction. Respondent's

determination as to the punitive damages and the legal costs

resulted in certain other "mechanical" adjustments, one of which

was the applicability of the alternative minimum tax.

Discussion

In a case of first impression, we must decide whether the

litigation costs attributable to an independent contractor's

recovery of punitive damages are deductible on Schedule C as a

business expense or on Schedule A as a nonbusiness itemized

deduction.1 Petitioner also contests respondent's determination

that petitioner did not receive the punitive damages on account

of a personal injury. We recently held that the punitive damages

received by Mr. Whitley, petitioner's coplaintiff in the Academy

lawsuit, were includable in Mr. Whitley's gross income. See

Whitley v. Commissioner, T.C. Memo. 1999-124. We relied mainly

on O'Gilvie v. United States, 519 U.S. 79 (1996), Commissioner v.

Schleier, 515 U.S. 323 (1995), and United States v. Burke,

504 U.S. 229 (1992), concluding that punitive damages received

under South Carolina law are not excludable from gross income
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under section 104(a)(2). We apply the reasoning in Whitley and

hold the same here. 

As to the primary issue, section 162(a) governs the

deductibility of litigation costs as a business expense. 

Section 162(a) allows an individual to deduct all of the ordinary

and necessary expenses of carrying on his or her trade or

business. Section 212 governs the deductibility of litigation

costs as an itemized deduction, when the costs are incurred as a

nonbusiness profit-seeking expense. Section 212 allows an

individual to deduct all of the ordinary and necessary expenses

paid or incurred in: (1) Producing income, (2) managing,

conserving, or maintaining property held for the production of

income, or (3) determining, collecting, or refunding a tax. 

Sections 162(a) and 212 are considered in pari materia, except

for the fact that the income-producing activity of the former

section is a trade or business whereas the income-producing

activity of the latter section is a pursuit of investing or other

profitmaking that lacks the regularity and continuity of a

business. See Woodward v. Commissioner, 397 U.S. 572, 575 n.3

(1970); United States v. Gilmore, 372 U.S. 39, 44-45 (1963);

Bingham's Trust v. Commissioner, 325 U.S. 365, 374-375 (1945). 

A deduction of litigation costs under section 162(a) may be 

more desirable to an individual than is a deduction under section

212. The primary advantage to a deduction under section 162(a),

vis-a-vis a deduction under section 212, rests on each

deduction's effect on gross income and adjusted gross income. 
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A deduction under section 162(a) is subtracted in full from gross

income to arrive at adjusted gross income. A deduction under

section 212 is subtracted from adjusted gross income to arrive at

taxable income and is subject to certain floor limitations in

section 67(a). The benefit from a deduction of litigation costs

under section 212 may also be limited by application of the

alternative minimum tax. See sec. 56(b); see also Benci-Woodward

v. Commissioner, T.C. Memo. 1998-395.

Whether an ordinary and necessary litigation expense is

deductible under section 162(a) or section 212 depends on the

origin and character of the claim for which the expense was

incurred and whether the claim bears a sufficient nexus to the

taxpayer's business. See Woodward v. Commissioner, supra; United

States v. Gilmore, supra at 44-45; see also Peckham v.

Commissioner, 327 F.2d 855, 856 (4th Cir. 1964), affg. 40 T.C.

315 (1963). Ordinary and necessary litigation costs are

generally deductible under section 162(a) when the matter giving

rise to the costs arises from, or is proximately related to, a

business activity. See Woodward v. Commissioner, supra;

Kornhauser v. United States, 276 U.S. 145, 153 (1928). 

Litigation costs must be "attributable to a trade or business

carried on by the taxpayer" in order to be deductible as a

business expense. Sec. 62(a)(1).

The ascertainment of a claim's origin and character is a

factual determination that must be made on the basis of the facts
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and circumstances of the litigation. See United States v.

Gilmore, supra at 47-49. The most important factor to consider

is the circumstances out of which the litigation arose. See

Boagni v. Commissioner, 59 T.C. 708 (1973). In passing on this

factor, the fact finder must take into account, among other

things, the allegations set forth in the complaint, the issues

which arise from the pleadings, the litigation's background,

nature, and purpose, and the facts surrounding the controversy. 

See id. at 713.

Petitioner's legal costs, which the parties agree are

"ordinary" and "necessary" expenses, bear the required nexus to

his sole-proprietor insurance business to meet the requirements

for deductibility under section 162(a). As a matter of fact,

petitioner's lawsuit against Academy arose entirely from his

insurance business. Each cause of action petitioner alleged in

the lawsuit was spawned entirely from the fact that, after

Academy fired him, it failed to honor the terms of their working

agreement by not paying him the commissions to which he was

entitled under their agreement. But for the agreement, and the

fact that Academy breached the agreement by unilaterally

terminating its obligation to pay commissions to petitioner, the

instant lawsuit, as it was framed, would never have arisen, and

petitioner would never have incurred (or paid) any of the legal

costs.
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Respondent devotes much time in his opening brief to his

proffered method of apportioning petitioner's legal costs between

his business and nonbusiness activities, spending little time

arguing that apportionment of the legal costs is appropriate. As

we understand respondent's argument on apportionment, petitioner

must apportion his legal costs because, respondent asserts,

petitioner has not proven that he incurred 100 percent of the

costs in his insurance business. We disagree. After reviewing

the record, which includes 19 stipulations and 9 exhibits, we are

persuaded by more than a preponderance of the evidence that all

of petitioner's legal costs were attributable to his insurance

business and, more importantly, that all of the costs were

connected to claims which arose in that business. Petitioner's

complaint, for example, attests to the fact that each of his

claims, and not simply his claim of conversion, arose from the

sole-proprietor insurance business.

We consider it both ordinary and necessary from a business

standpoint for petitioner to have filed the lawsuit against

Academy and for him to have sought any and all damages to which

he was entitled on account of Academy's breach of contract and

related conversion. The mere fact that petitioner sought and was

paid punitive damages to punish Academy for its "extraordinary

misconduct, and to serve as a warning [to it and to other

persons] not to engage in such conduct in the future" does not
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2 We recognize that South Carolina law does not provide that

punitive damages are awarded in every case in which a tortfeasor

is held liable for an act of conversion. See Sherrill White

Constr., Inc. v. South Carolina Natl. Bank, 713 F.2d 1047,

1051-1052 (4th Cir. 1983) ("in order to recover punitive damages

[under South Carolina law] there must be more than mere

conversion. There must be malice, ill will, a conscious

indifference to the rights of others, or a reckless disregard

thereof."; citations and quotation marks omitted). The fact that

the converter's degree of culpability enters into an award of

punitive damages under South Carolina law, however, does not

change the fact that the origin and character of a claim for

punitive damage under that law is an act of conversion, which, in

this case, stems from petitioner's business activity.

change the fact that petitioner's legal costs were all

attributable to his business activity. Pursuant to South

Carolina law, see Oxford Fin. Cos. v. Burgess, 402 S.E.2d 480,

482 (S.C. 1991); Rhode v. Ray Waits Motors, Inc., 74 S.E.2d 823,

825 (S.C. 1953); see also Sherrill White Constr., Inc. v. South

Carolina Natl. Bank, 713 F.2d 1047, 1051-1052 (4th Cir. 1983),

and the judge's instructions, the jury in the Academy lawsuit

awarded petitioner both actual and punitive damages on his

conversion claim.2 The fact that petitioner received two

different types of damages on his single claim of conversion does

not mean, as respondent would have us hold, that the claim is

bifurcated into two claims solely for purposes of applying the

Federal income tax laws. Contrary to respondent's position in

this case, the various types of damages which petitioner received

on his conversion claim do not dictate whether his legal costs

must be apportioned between his business and nonbusiness
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activities. An allocation of litigation costs, if and when

applicable, rests on the origin of the claims relating to those

expenses. See Woodward v. Commissioner, 397 U.S. at 577-578;

United States v. Gilmore, 372 U.S. at 44-45; see also Peckham v.

Commissioner, 327 F.2d at 856.

We recognize that, when appropriate, litigation costs must

be apportioned between business and personal claims, and that

business litigation costs are nondeductible to the extent that

they constitute capital expenditures. See, e.g., Kurkjian v.

Commissioner, 65 T.C. 862 (1976) (deduction disallowed for

portion of attorney's fees attributable to personal matters);

Buddy Schoellkopf Prods., Inc. v. Commissioner, 65 T.C. 640, 646-

647 (1975) (deduction disallowed for portion of attorney fees

attributable to acquisition of intangible assets); Merians v.

Commissioner, 60 T.C. 187 (1973) (deduction disallowed for

portion of attorney's fees attributable to personal matters); see

also Boagni v. Commissioner, supra, (recognizing that litigation

costs can be characterized as both deductible and nondeductible

when the litigation is rooted in situations giving rise to both

types of expenditures). This principle of allocation is

inapposite to our decision herein for two main reasons. First,

petitioner's legal costs were all attributable to claims which

originated in his business activity, the primary claim being that

of conversion. Second, in contrast to cases where each of the

underlying claims could have resulted in an award of damages
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3 The parties agree that our holding on this issue means

that the punitive damage award is includable in petitioner's

self-employment income and that it is subject to self-employment

tax. See secs. 1401 and 1402.

regardless of an award of damages on any other claim,

petitioner's award of punitive damages could not have been made

in isolation. As South Carolina's highest court has stated: 

"Punitive damages may be awarded [under South Carolina law] only

upon a finding of actual damages." Dowling v. Home Buyers

Warranty Corp., 428 S.E.2d 709, 711 (S.C. 1993); see also Gamble

v. Stevenson, 406 S.E.2d 350 (S.C. 1991).

We hold that petitioner may deduct the legal costs under

section 162(a).3 In reaching our holdings herein, we have

considered all arguments by the parties, and, to the extent not

addressed above, find them to be meritless or irrelevant. To

reflect the foregoing,

Decision will be entered

under Rule 155.