T.C. Memo. 1999-2

UNITED STATES TAX COURT

DENNIS W. STARK, Petitioner v. 

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 8848-96. Filed January 4, 1999.

Joseph Falcone and Brian H. Rolfe, for petitioner.

Robert D. Heitmeyer, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GALE, Judge: Respondent determined the following deficiency

in, and penalty on, petitioner's Federal income tax:

Accuracy-Related Penalty

Year Deficiency Sec. 6662(a) 

1992 $132,341 $26,468

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the year in issue, and
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1 Some of the facts have been stipulated and are so found. 

We incorporate by this reference the stipulation of facts, the

supplemental stipulation of facts, and attached exhibits.

all Rule references are to the Tax Court Rules of Practice and

Procedure.

After concessions, the issues for decision are: (1) Whether

Lakeview Automotive, Inc., an S corporation wholly owned by

petitioner, is entitled to a deduction for a bad debt loss under

section 166 or, in the alternative, a theft loss under section

165; (2) whether Lakeview Automotive, Inc., is entitled to a

deduction for a claimed rental expense; (3) whether Lakeview

Automotive, Inc., is entitled to a deduction for legal fees

incurred in defending a suit brought by a former shareholder;

(4) whether Lakeview Automotive, Inc., is entitled to deductions

for amounts expended for a fence gate, roof work, and computer

equipment; and (5) whether petitioner is liable for an accuracyrelated penalty under section 6662(b)(2).

FINDINGS OF FACT1

At the time the petition in this case was filed, Dennis W.

Stark (petitioner) resided in Harrison Township, Michigan. 

Petitioner was the president and sole shareholder of Lakeview

Automotive, Inc. (Lakeview), an automotive parts wholesaler. 

Lakeview was originally formed as a partnership by petitioner's

father, William Stark (William), and William's brother-in-law. 

Lakeview's operations were conducted from real property at 6841
- 3 -

2 Lakeview elected S corporation status on Dec. 23, 1988. 

Middlebelt Road, Garden City, Michigan (Automotive Property). 

In 1984, William bought his brother-in-law's one-half

interest in Lakeview's predecessor partnership, thereby acquiring

a 100-percent ownership interest. That same year, William

incorporated Lakeview, and he and petitioner became 50-percent

shareholders.2 William retained direct ownership of the

Automotive Property, however. 

William also owned the lot adjacent to the Automotive

Property, at 6435 Middlebelt Road (Fence Property), on which he

operated the Stark Fence Company. The rear and side doors of the

Automotive Property building were not accessible except through

the Fence Property. On September 29, 1989, for the consideration

of $1, William transferred the Fence Property to Lakeview Realty

Company, a general partnership formed on the same date and in

which William and petitioner each owned a 50-percent capital

interest. There is no evidence that petitioner made any capital

contribution to the Lakeview Realty Company partnership in

exchange for his 50-percent capital interest. The Fence Property

was appraised at $150,000 on October 30, 1989. Also on September

29, 1989, William conveyed his interest in the Automotive

Property by a quitclaim deed to Lakeview for the consideration of

$1. 

Petitioner and William began to have disagreements that made
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3 Although the Redemption Agreement provided that William

would execute a quitclaim deed with respect to his interest in

the Fence Property, William had in fact previously quitclaimed

such interest to the Lakeview Realty Company partnership. 

Accordingly, on the Apr. 1, 1991 closing date of the Redemption

Agreement, William effected the transfer to petitioner by

assigning his partnership interest in Lakeview Realty Company to

petitioner, and petitioner on the same day executed a certificate

of discontinuance of the Lakeview Realty Company partnership.

it impossible to operate Lakeview together. Their

incompatibility resulted in an agreement executed on March 20,

1991, under which Lakeview agreed to redeem William's shares and

petitioner agreed to purchase William's interest in the Fence

Property (Redemption Agreement). On April 1, 1991, pursuant to

the Redemption Agreement, Lakeview paid $490,000 to William in

redemption of his shares, thereby terminating his interest in the

corporation, and petitioner paid $75,000 to William in exchange

for William's interest in the Fence Property.3 The Redemption

Agreement further provided for the repayment of a $39,079.75 debt

Lakeview owed to William and contained a general release

provision whereby the parties--namely, petitioner, William, and

Lakeview--agreed to mutually forgive and release each other from

any claims existing as of the April 1, 1991 closing date (except

the aforementioned debt of Lakeview to William, payment of which

was to be made at closing). 

Subsequent to the execution of the Redemption Agreement,

William became convinced he had been cheated. In William's view,

petitioner and Lakeview's attorney had taken advantage of his

diminished capacity, caused by a near fatal aortic aneurysm, the

earlier death of his wife, and his emotional distress resulting

from the disagreements with his son, to pressure him into the
- 5 -

buyout against his best interests and at an unconscionable price. 

On November 1, 1991, William filed an action in State court

naming Lakeview, petitioner, and Lakeview's attorney as

defendants, and seeking rescission of the Redemption Agreement,

return of the Fence Property, an accounting and appointment of a

receiver to operate Lakeview, and damages from Lakeview,

petitioner, and the corporate attorney, including punitive

damages from the latter two. The complaint alleged undue

influence on the part of petitioner and the corporate attorney,

failure of consideration, breach of fiduciary duty by the

corporate attorney and by petitioner in his role as an officer of

Lakeview, and intentional infliction of emotional distress by

petitioner. William's complaint was submitted for mediation, and

on August 10, 1992, a mediation panel unanimously proposed an

award of $100,000 in favor of William for which petitioner and

Lakeview would have joint and several liability, and an award of

$30,000 for which the corporate attorney would be liable. 

William rejected the mediation proposal, and the case proceeded

to trial. A jury found in favor of the defendants on all counts

except rescission, which was decided in favor of the defendants

by the court on November 2, 1992. Lakeview paid $93,491 in legal

fees during 1992 in connection with the foregoing litigation and

claimed a deduction therefor on its return for that year. 

Sometime in late 1992 petitioner engaged a certified public

accountant to prepare amended returns for Lakeview for the years

1984 through 1990 in order to report income that petitioner
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believed had previously been unreported by Lakeview. It was

petitioner's belief that Lakeview had failed to report income

from cash sales in those years, due to William's practice of

removing all or most cash from the register and splitting it with

petitioner. The accountant computed a ratio of cash to other

sales for the then-most recent 18-month period, and on the basis

of that ratio computed an estimate of the cash sales that may

have occurred, but were not reported, for the years 1984 through

1990. On the basis of these estimates, the accountant prepared

amended returns for Lakeview that reported additional income in

each of the foregoing years. There are no work papers, corporate

records, or other documentation in the record that support the

accountant's estimates. 

In December 1992, Amended U.S. Corporation Income Tax

Returns (Forms 1120X) for Lakeview's 1984, 1985, 1986, 1987, and

1988 taxable years, and amended U.S. Income Tax Returns for an S

Corporation (Forms 1120S) for Lakeview's 1989 and 1990 taxable

years, were prepared and signed by the accountant as return

preparer. The returns were subsequently filed on an unknown

date. The returns reported previously unreported income of

Lakeview totaling $189,098. Petitioner filed Amended U.S.

Individual Income Tax Returns (Forms 1040X) for his 1989 and 1990

taxable years reporting his allocable share of the previously

unreported income reported on Lakeview's amended returns for

those years. 

Sometime in December 1992, petitioner caused to be prepared 
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4 The record is silent regarding the difference between the

$131,895 figure used both as the debt for which William Stark's

acknowledgment was sought in the Release Agreement and as the

(continued...)

an "Agreement to Release and Hold Harmless" (Release Agreement)

that was to be executed by petitioner, William, and Lakeview. 

The Release Agreement was subsequently presented to William in

late 1992 or in 1993. The Release Agreement certified that the

parties had reviewed the Lakeview amended returns discussed above

and contained a representation by the parties that they would

file their individual State and Federal income tax returns

(including any amended returns) in a manner consistent with

Lakeview's amended returns. The Release Agreement further

contained an acknowledgment by William of an indebtedness of

$131,895 to Lakeview, Lakeview's forgiveness of the debt in 1992,

and William's acknowledgment of receipt of an IRS Form 1099

reporting nonemployee compensation in that amount from Lakeview

for 1992. Finally, the Release Agreement certified that the

parties had reviewed another IRS Form 1099 reporting income of

$75,000 paid to William by Lakeview in 1992, which was described

as "for consulting services rendered and in consideration for

this Agreement". The Release Agreement was not executed.

Notwithstanding the failure to execute the Release

Agreement, Lakeview issued a Form 1099 for 1992 reporting income

of $131,895 paid to William Stark, on which the payment was

characterized as "Nonemployee compensation". On its 1992 return,

Lakeview deducted $134,1164 as "forgiveness of debt". At no
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(...continued)

amount of "Nonemployee compensation" reported as paid to William

Stark by Lakeview, and the $134,116 figure deducted as the

"forgiven" debt on Lakeview's 1992 return.

point did Lakeview institute legal proceedings or otherwise seek

to collect on an indebtedness from William. Petitioner consulted

with an attorney and accountant in connection with the decision

not to seek collection.

Also notwithstanding the failure to execute the Release

Agreement, Lakeview issued a $75,000 check that was dated

December 30, 1992, and made payable to William. William

deposited the check on April 1, 1993. The following handwritten

legend appears on the back of the check above William's

endorsement: 

RECEIVED AS PAYMENT OWED FOR 1⁄2 INTEREST OF LAND & BUILDING

AT 6835 MIDDLEBELT RD GARDEN CITY[.]

A Form 1099 reporting income of $75,000 paid to William was

issued by Lakeview for 1992, on which the payment was

characterized as "Nonemployee compensation". On its 1992 return,

Lakeview claimed a $75,000 deduction for "rent".

In 1990, when petitioner and William were 50-percent

shareholders of Lakeview, Lakeview had purchased automobiles for

use by William and petitioner. Lakeview paid $31,878.25 to

purchase an automobile for William's use. In connection with

that purchase, the car dealer issued a check for $9,000 to

Lakeview as payment for a traded-in vehicle, and William

deposited the check into his personal account. 
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During the tax year 1992, a fence gate at the entrance to

Lakeview's premises was hit by a gravel truck and was damaged

beyond repair. Lakeview arranged for the installation of a new

gate, which was mounted on wheels and opened parallel to the

fence, as opposed to swinging on a hinge as the old gate had

operated. In addition, poles were added to the fence to support

the new sliding gate. On its 1992 return, Lakeview deducted the

$2,000 that it paid for the fence gate work as a repair expense.

Also during 1992 Lakeview paid a roofing contractor for work

done on the roof of the Automotive Property to correct leaks. 

Previous attempts at repairing the roof were unsuccessful, due to

the fact that the roof had originally been designed to collect

water for cooling purposes. Consequently, the roofing material

was removed down to the wooden structure of the building, to

which a new roof drain was added, and a new roof was reapplied. 

The replacement roof is expected to last 20 years. On its 1992

return, Lakeview deducted the $3,400 that it paid for the roof

work as a repair expense.

OPINION

1. "Forgiveness of Debt" Deduction

Respondent disallowed a $134,116 "forgiveness of debt"

deduction claimed by Lakeview on its 1992 return. Petitioner

contends that from 1984 through 1990, William skimmed cash from

Lakeview and split it with petitioner. When petitioner

subsequently became the sole shareholder of Lakeview, he filed

amended corporate returns for Lakeview reporting additional
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5 We note that the sum of (i) one-half of the additional

income of $189,098 reported on Lakeview's amended returns for

1984 through 1990 (i.e., $94,549), plus (ii) the $31,878 purchase

price for the automobile provided William, plus (iii) the $9,000

converted check, equals $135,427, not $134,116. Petitioner

offers no explanation for this discrepancy.

income for those years totaling $189,098, based upon his

accountant's estimate of Lakeview's cash sales during the period. 

Petitioner contends that although he repaid to Lakeview his share

of the diverted cash, William did not, and thus remained

obligated to the corporation for the diverted amounts. The

$134,116 "forgiveness of debt" deduction claimed by Lakeview in

1992 represents the sum of what petitioner contends is William's

share of the skimmed cash, plus the price of an automobile

purchased for William with corporate funds, along with the $9,000

check issued to Lakeview for a traded-in car that William

converted to personal use.5 

a. Theft Loss

Notwithstanding Lakeview's return position that it was

entitled to a $134,116 deduction for the "forgiveness of debt",

petitioner on brief first argues that Lakeview is entitled to

deduct this amount as a theft loss under section 165. Petitioner

contends that William's actions amounted to embezzlement under

Michigan law, and Lakeview is therefore entitled to a deduction

because section 1.165-8(d), Income Tax Regs., identifies a

"theft" as including embezzlement. However, even if we accept

petitioner's contentions regarding the cash diversions, it is

well established that a diversion of corporate funds by
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shareholders with complete, or near complete, control of the

corporation does not entitle the corporation to a theft loss

deduction, regardless of how embezzlement is defined under local

law. Federbush v. Commissioner, 34 T.C. 740, 752 (1960), affd.

325 F.2d 1 (2d Cir. 1963); United Mercantile Agencies, Inc. v.

Commissioner, 23 T.C. 1105, 1114 (1955), remanded on other

grounds sub nom. Drybrough v. Commissioner, 238 F.2d 735 (6th

Cir. 1956); Ace Tool & Engg., Inc. v. Commissioner, 22 T.C. 833,

842 (1954). In such a situation, the shareholders have the

implied consent of the corporation and take the funds under a

claim of right. Federbush v. Commissioner, supra at 750; United

Mercantile Agencies, Inc. v. Commissioner, supra. 

Petitioner and William together owned 100 percent of the

stock of Lakeview at the time when petitioner contends that cash

was skimmed, and petitioner concedes that he received half of the

diverted funds. The same is true regarding the automobiles

provided to them. The diversion of Lakeview's assets was not a

theft for purposes of allowing the corporation a deduction. 

Federbush v. Commissioner, supra; United Mercantile Agencies,

Inc. v. Commissioner, supra. This conclusion is buttressed by

the terms of the Redemption Agreement, which was executed in

1991, after the purported thefts. In that agreement,

notwithstanding petitioner's full knowledge of the cash skimming,

neither Lakeview nor petitioner sought to press any claim or

offset against William for the purported embezzlement. On the

contrary, the document acknowledged a debt of $39,079.75 owed by
- 12 -

Lakeview to William. 

b. Bad Debt Deduction

Petitioner alternatively contends that William's diversions

of corporate funds gave rise to a debt by operation of law that

was owed to Lakeview, and that this debt became worthless in

1992, thereby entitling it to a bad debt deduction under section

166(a)(1). 

Section 166(a)(1) allows a deduction for "any debt which

becomes worthless within the taxable year." Under section 1.166-

1(c), Income Tax Regs., the debt must be "bona fide", defined as

"a debt which arises from a debtor-creditor relationship based

upon a valid and enforceable obligation to pay a fixed or

determinable sum of money."

The existence of a debt for purposes of section 166

ordinarily requires a showing that contemporaneously with a

transfer of money the transferor and recipient both intend to

establish an enforceable obligation of repayment. Delta Plastics

Corp. v. Commissioner, 54 T.C. 1287, 1291 (1970); Fisher v.

Commissioner, 54 T.C. 905, 909-910 (1970). Here, however,

petitioner argues that a debt arose not from the parties' intent,

but by operation of law, relying on Iowa S. Utils. Co. v. United

States, 348 F.2d 492 (Ct. Cl. 1965). In that case, the Court of

Claims held that an intent to create a debtor-creditor

relationship is unnecessary to create a bona fide debt where the

debt arises by operation of law.

Petitioner's argument fails for several reasons. First,
- 13 -

petitioner has failed to demonstrate the amount of the debt. A

debt for purposes of section 166 must be an enforceable

obligation to pay a "fixed or determinable sum of money”. Sec.

1.166-1(c), Income Tax Regs. In Iowa S. Utils. Co., the debt had

been adjudicated, and the State court judgment served to make the

debt "a fixed or determinable sum" in the Court of Claims' view. 

Iowa S. Utils. Co. v. United States, supra at 495. Here, the

only evidence of the amounts William diverted, which he disputes,

is the testimony of petitioner and his accountant that the ratio

of cash to total sales for the then-current 18-month period was

computed, and then an estimate of the cash sales for the years

1984 through 1990 was made by applying the current-period ratio

to actual sales in those past years. There is no evidence in the

record of the reasonableness of this estimate, the

appropriateness of applying the current ratio to past years, or

of any corporate records to support the accuracy of this

estimate. On this record, petitioner has failed to show that the

debt he alleges was of a "fixed or determinable" amount.

Second, petitioner has not shown that the debt became

worthless in 1992. Section 166 allows a deduction for debts

which become worthless "within the taxable year." To meet this

requirement, the taxpayer must prove that the debt had value at

the commencement of the year for which deduction is sought and

that it became worthless during that year. Estate of Mann v.

United States, 731 F.2d 267, 275 (5th Cir. 1984); James A. Messer

Co. v. Commissioner, 57 T.C. 848, 861 (1972); Shipley v.
- 14 -

6 The record is clear that William had sufficient assets

from which to pay the alleged debt in 1992. In the previous

year, William had received $42,579.75 from Lakeview in addition

(continued...)

Commissioner, 17 T.C. 740 (1951). We do not believe petitioner

has shown that the purported debt had value at the beginning of

1992. The undisputed terms of the Redemption Agreement provide

for the forgiveness and release of all claims that Lakeview,

William, or petitioner may have had against each other as of the

execution date, which was March 20, 1991 (except for a debt owed

by Lakeview to William, acknowledged in the Agreement). The

actions of William that petitioner contends gave rise to the

purported debt, i.e., the skimming of cash (of which petitioner

was aware) and the conversion of the car and trade-in payment to

personal use, all occurred prior to the execution of the

Redemption Agreement. Thus, any debt arising from William's

skimming and conversion was forgiven by Lakeview on March 20,

1991. The debt had no value at the beginning of 1992.

Even if William's purported debt to Lakeview somehow

survived the release in the Redemption Agreement, petitioner has

failed to show that it became worthless in 1992. Petitioner

contends that he had sufficient evidence of the worthlessness of

the debt in 1992 based on the advice of his attorney that the

cost of collecting the debt would have exceeded its value. In

making this argument, petitioner concedes that William had

sufficient assets from which to collect the debt that petitioner

claims was owed to the corporation.6 
- 15 -

6(...continued)

to the $490,000 received for his Lakeview stock and the $75,000

received for his half interest in the Fence Property. During

1992, William received another check for $75,000 from Lakeview. 

In addition, William owned several parcels of real estate. 

Where the surrounding circumstances indicate a debt is

worthless and uncollectible, and the legal action to enforce

payment in all probability would not result in satisfaction on

execution of a judgment, a showing of these facts will be

sufficient evidence of the worthlessness of the debt. Sec.

1.166-2(b), Income Tax Regs. We have allowed a bad debt

deduction where the taxpayer received advice of legal counsel,

based on objective facts, that the cost of recovery would exceed

the amount of the debt. See Johnstone v. Commissioner, 17 B.T.A.

366, 368 (1929); United States Tool Co. v. Commissioner, 3 B.T.A.

492 (1926); Green v. Commissioner, T.C. Memo. 1976-127. 

Nevertheless, a debt is not worthless merely because it may be

difficult to collect. Reading & Bates Corp. v. United States, 40

Fed. Cl. 737, 757 (1998). To be entitled to a deduction under

section 166(a)(1), a taxpayer must exhaust all reasonable means

of collection or prove that such steps would be futile. H.D. Lee

Mercantile Co. v. Commissioner, 79 F.2d 391, 393 (10th Cir.

1935); Perry v. Commissioner, 22 T.C. 968, 974 (1954); A.

Finkenberg's Sons, Inc. v. Commissioner, 17 T.C. 973, 984 (1951). 

Choosing not to enforce a debt does not render it worthless. 

Southwestern Life Ins. Co. v. United States, 560 F.2d 627, 644

(5th Cir. 1977).
- 16 -

We do not believe that the record, including the testimony

of petitioner's attorney, supports petitioner's contention that

the cost of collecting on the alleged debt would have exceeded

its value. Petitioner's attorney in the litigation over the

Redemption Agreement, William Horton, testified that based on his

experience in litigating against William, he believed that

William would be a tenacious and difficult adversary in any

further litigation. In light of this experience, Mr. Horton

believed that pursuing the debt "wasn't worth it" and so advised

petitioner and his accountant.

This testimony does not establish that the costs of

collection would exceed the value of a debt claimed to equal

$134,116. Indeed, petitioner presented no evidence that he or

Lakeview ever even made a demand for payment to William. In

light of the fact that William had sufficient assets with which

to pay the alleged debt, we do not believe that petitioner has

proven that attempts to collect on the debt would have been

futile. We thus conclude that petitioner has failed to prove

that, assuming a bona fide debt existed, it was worthless. 

2. Rent Deduction

Lakeview deducted $75,000 as rent on its 1992 return, which

was disallowed by respondent. Petitioner claims that Lakeview

paid $75,000 to William in late 1992 as "back rent" on the Fence

Property. Petitioner testified that sometime after the

conclusion of the trial in the action brought by William, William

demanded that he be paid rent by Lakeview for Lakeview's use of
- 17 -

the Fence Property during the period that he owned it outright

(which was from sometime in 1984 until September 29, 1989). 

According to petitioner, the $75,000 figure was based on his

computation of annual rent equal to 10 percent of the Property's

appraised value of $150,000 for 5 years ($15,000 (10 percent of

$150,000) X 5 years = $75,000).

Petitioner offered no evidence to corroborate his testimony,

and a substantial amount of other evidence undermines it.

First, contrary to petitioner's testimony at trial, Lakeview

earlier characterized the $75,000 differently on the Form 1099 it

prepared with respect to the payment. On the Form, the box for 

"Nonemployee compensation" was checked rather than the box for

"Rent". Previously, in the Release Agreement prepared at

petitioner's direction, the $75,000 payment was characterized as

"for consulting services rendered and in consideration for this

Agreement". Lakeview's accountant testified that it was his

understanding that the $75,000 payment was intended as

consideration for William's execution of the Release Agreement. 

William denied providing any consulting services to Lakeview

during 1992, and in light of the fact that he was involved in

acrimonious litigation with the company and petitioner during

that time, we find his denial credible.

Second, petitioner's testimony is further contradicted by

William's testimony that he never demanded rent, but instead

sought to be paid the remaining one-half of the purchase price he

considered owed to him for the Fence Property. (William had
- 18 -

previously received a payment of $75,000 for his one-half

interest in the Fence Property as part of the Redemption

Agreement in 1991, and although he had previously gifted the

other one-half interest in the Fence Property to petitioner in

1989, he claimed at trial that he did not understand or intend

the gift.) On the $75,000 check issued to him by Lakeview on

December 30, 1992, William wrote above his endorsement that the

amount was received as payment owed for one-half interest in the

Fence Property.

Third, the surrounding circumstances do not support

petitioner's contention at trial. During the same period for

which petitioner claims William sought back rent for the Fence

Property, William also owned outright the Automotive Property

which was also being used by Lakeview. We find it implausible

that William would have demanded back rent from Lakeview for one

parcel but not the other.

Finally, petitioner has offered no evidence that $15,000, or

10 percent of appraised value, per year represented the fair

rental value of the Fence Property, or that 5 years is the

appropriate rental period. In the circumstances, we find it more

likely that the $75,000 payment was premised on one-half of the

appraised value of the Fence Property; petitioner's formula has

the appearance of an after-the-fact rationale.

Section 162(a)(3) allows a deduction for all ordinary and

necessary expenses of carrying on a trade or business, including

rentals. However, deductions are a matter of legislative grace,
- 19 -

and a taxpayer claiming a deduction bears the burden of clearly

showing that the terms of the applicable statute have been

satisfied. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84

(1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435 (1934). 

On this record, we do not believe petitioner has demonstrated

that Lakeview paid $75,000 for rent in 1992, and we accordingly

sustain respondent's determination to disallow this amount.

3. Legal Expenses

a. Background--Origin of the Claim Test

Respondent argues that Lakeview is not entitled to deduct

$93,491 in claimed legal expenses incurred in connection with the

lawsuit brought by William because the lawsuit constituted a

personal dispute between William and petitioner. Thus,

respondent contends, under the "origin of the claim" test of

United States v. Gilmore, 372 U.S. 39 (1963), the legal expenses

were personal to petitioner and may not be deducted by Lakeview. 

Alternatively, respondent argues that to the extent any of the

expenses are found not to be personal to petitioner but

attributable to Lakeview, they must be capitalized because "they

are not proximately related to the trade or business conducted by

Lakeview * * * but rather related to the control of the

corporation." 

Petitioner likewise employs the "origin of the claim" test,

and argues against capitalization of the legal expenses on the

grounds that they were expended to defend against an attack on

the business, that was "in essence a hostile takeover attempt", 
- 20 -

and accordingly are deductible as ordinary and necessary business

expenses under the reasoning of A.E. Staley Manufacturing Co. v.

Commissioner, 119 F.3d 482, 491 (7th Cir. 1997), revg. 105 T.C.

166 (1995), and Federated Dept. Stores, Inc. v. Commissioner, 171

Bankr. 603 (S.D. Ohio 1994). Petitioner further contends that to

the extent any personal benefit was conferred on him, the legal

expenses are nonetheless deductible by Lakeview because the

corporation was a principal defendant in the lawsuit and its

assets were directly threatened, citing Kopp's Co. v.

Commissioner, 636 F.2d 59 (4th Cir. 1980).

We disagree with both of the analyses offered by the

parties, but hold for respondent for different reasons.

The Supreme Court has held that the determination of whether

a litigation expense is a deductible business expense or a

nondeductible personal one depends upon "the origin and character

of the claim" being litigated. United States v. Gilmore, supra

at 49. In that case, the taxpayer sought to deduct the legal

expenses he incurred in a divorce proceeding, on the grounds that

he was seeking to conserve income-producing property; namely, his

controlling stock interests in certain automobile dealerships,

against his wife's claim to all or part of them under community

property laws. Applying the "origin of the claim" test, the

Court concluded that the claim arose entirely from the marital

relationship, not from any income-producing activity, and

consequently the expenses were nondeductible personal ones. Id.
- 21 -

7 The legal expenses incurred by Lakeview's corporate

attorney in defending against William's lawsuit were not paid by

Lakeview and are not at issue in this case.

at 51-52.

The "origin of the claim" test is likewise used to determine

whether litigation expenses are to be classified as ordinary or

capital. Woodward v. Commissioner, 397 U.S. 572 (1970); United

States v. Hilton Hotels Corp., 397 U.S. 580 (1970).

Application of the "origin of the claim" test requires an

examination of all the facts and circumstances and focuses on the

"kind of transaction" from which the litigation stems. Boagni v.

Commissioner, 59 T.C. 708, 713 (1973). 

b. Personal versus Business Expense

The lawsuit in which the legal expenses were incurred was

brought by William against petitioner, Lakeview, and Lakeview's

attorney7 because William believed he had been cheated in the

Redemption Agreement and wanted to get back his Lakeview stock

and the management role that such ownership entailed, as well as

his interest in the Fence Property. William believed that

petitioner and the corporate attorney had taken advantage of his

diminished capacity, caused by a serious heart ailment and

emotional distress, to pressure him into the buyout against his

best interests and at an unconscionable price. William further

alleged that he had been improperly pressured into entering the

Redemption Agreement due to petitioner's tantrums designed to

frustrate business decision-making or to embarrass him in front
- 22 -

of Lakeview's employees, petitioner's periods of silence, and

petitioner's willful absence from the business premises. As

relief, William sought rescission of the Redemption Agreement and

return of his Lakeview stock and interest in the Fence Property,

appointment of a receiver and an accounting, consequential

damages stemming from his loss of income from Lakeview and his

income tax liabilities incident to the disposition of his stock

and real property, and damages for intentional infliction of

emotional distress.

Based on our review of the pleadings in the lawsuit and

other evidence in the record, we believe that William's principal

claims in the litigation were for the return of his Lakeview

stock and the Fence Property. The other damages sought by him

were largely derivative, designed either to preserve the status

quo ante (such as the accounting and appointment of a receiver),

or to compensate him for consequential losses resulting from the

stock redemption and sale of the Fence Property, or to punish the

defendants for wrongful acts that led to or were connected with

his decision to enter the Redemption Agreement (e.g., punitive

damages or damages for intentional infliction of emotional

distress).

Respondent argues that under United States v. Gilmore,

supra, the legal fees are nondeductible personal expenditures

because "The origin of the lawsuit, and of its defense by the

petitioner, was the breakdown of a father-son relationship" and

that "these fees were incurred primarily for the individual
- 23 -

benefit of the petitioner on account of a highly personal,

emotionally charged familial dispute."

We believe respondent misapplies Gilmore. Petitioner and

William had been business partners. Their dispute, and William's

claims, arose from the terms and circumstances of William's

buyout and, to a certain extent, petitioner's treatment of him in

the workplace. We believe that all of the claims concerned

actions by petitioner in his capacity as a shareholder, officer,

or employee of Lakeview, or in the workplace. In our view, these

claims had their origin in "income-producing activities" as that

term was used in Gilmore to distinguish the origins of deductible

business expenses from those of nondeductible personal ones. 

That the litigants were father and son, and their dispute heavily

infused with familial emotions, does not make the attendant legal

expenses "personal" within the meaning of Gilmore. Had Mr.

Gilmore's wife also been his business partner, and sought a

portion of the automobile dealership stock on that basis, the

Court may well have reached a different result. Cf. Kornhauser

v. United States, 276 U.S. 145 (1928) (legal expenses of taxpayer

in defending against claim of former business partner that fees

paid to taxpayer were for services rendered during partnership,

held deductible). 

Moreover, we believe that the return of his Lakeview stock

was the most significant relief sought by William, given its

value in relation to the other relief sought. That stock had

been redeemed by Lakeview, not purchased by petitioner. 
- 24 -

8 Because we conclude, with respect to the claim that the

legal expenses were personal, that such expenses either were not

personal or were personal because expended in defense of an asset

held not by Lakeview but in petitioner's name, we find it

unnecessary to address petitioner's argument based on Kopp’s Co.

v. Commissioner, 636 F.2d 59 (4th Cir. 1980), that the legal

expenses were not personal because Lakeview's assets were

directly threatened by the litigation.

Accordingly, we have difficulty seeing how the expenses of

defending against William’s effort to reclaim the Lakeview stock

were personal to petitioner rather than an expense of Lakeview.

Such is not the case with the Fence Property, however. 

Although neither party has addressed the issue, we do not believe

that Lakeview is entitled to deduct any portion of the legal fees

allocable to the defense of William's effort to reclaim his

interest in the Fence Property. Pursuant to the Redemption

Agreement, petitioner personally purchased William's interest in

the Fence Property; it was thus not a corporate asset and

Lakeview's expenditures in defense of petitioner's title to it

were, strictly speaking, a constructive dividend.8 Petitioner

has not provided, and we are unable to discern, any basis for

allocating a portion of the legal fees to the Fence Property

defense. In any event, the failure to allocate is of little

consequence because, as discussed more fully infra, the origin of

the claim related to these legal expenses was the process of

acquisition of a capital asset, in this instance an interest in

the Fence Property.

c. Capital versus Ordinary

To the extent that the fees are not personal to petitioner
- 25 -

but an expense of Lakeview, we must decide whether such expense

is required to be capitalized. Madden v. Commissioner, 514 F.2d

1149 (9th Cir. 1975); BHA Enters., Inc. v. Commissioner, 74 T.C.

593, 599 (1980). If an expense is capital in nature, a taxpayer

may not deduct it as an ordinary and necessary business expense

under section 162. Sec. 263(a); INDOPCO, Inc. v. Commissioner,

503 U.S. 79, 84 (1992); Woodward v. Commissioner, 397 U.S. 572,

575 (1970); United States v. Hilton Hotels Corp., 397 U.S. 580

(1970). A taxpayer must capitalize costs associated with the

creation of a separate and distinct asset or where the taxpayer

receives more than incidental future benefits as a result of the

expenditure. INDOPCO, Inc. v. Commissioner, supra at 86-87. In

INDOPCO, Inc. v. Commissioner, supra at 84, the Supreme Court

noted that “deductions are exceptions to the norm of

capitalization".

"[S]tock is most naturally viewed as a capital asset,"

Arkansas Best Corp. v. Commissioner, 485 U.S. 212, 222-223

(1988), and legal expenses incurred in the acquisition of a

capital asset must be capitalized. Woodward v. Commissioner,

supra at 576; Third Natl. Bank v. United States, 427 F.2d 343

(6th Cir. 1970). Expenses are incurred in the acquisition of an

asset if "the origin of the claim litigated is in the process of

acquisition itself." Woodward v. Commissioner, supra at 577.

This Court has held that where the circumstances surrounding

the sale of stock (not sold as inventory) are the subject of

litigation that arose subsequent to the transaction, the legal

fees incurred are capital expenditures. Wagner v. Commissioner,
- 26 -

9 As noted previously, some portion of the legal fees may be

attributable to defending petitioner against William’s effort to

reclaim his interest in the Fence Property. Any portion so

attributable would be required to be capitalized because it arose

from a transaction involving the acquisition of interests in real

(continued...)

78 T.C. 910, 918 (1982); Locke v. Commissioner, 65 T.C. 1004,

1011-1013 (1976), affd. 568 F.2d 663 (9th Cir. 1978). In Locke

v. Commissioner, supra at 1011-1013, this Court found that legal

costs incurred in defending a fraud suit brought by the seller of

stock, subsequent to the consummation of the sale, were capital

expenditures. See also Wagner v. Commissioner, supra (same

result where purchaser brought the suit). In Locke we held that

the origin of the claim was the fraud and concealment that

allegedly took place during the sale of the stock, and therefore

the legal fees incurred were capital in nature since they related

to the acquisition of the stock, a capital asset. 

In the instant case, the essence of the lawsuit brought by

William against Lakeview and petitioner was an effort to rescind

the contract under which Lakeview redeemed William's stock. 

Consummation of that contract, the Redemption Agreement, was a

transaction involving the acquisition and disposition of a

capital asset, stock. Sec. 1221; Frederick Weisman Co. v.

Commissioner, 97 T.C. 563, 572 (1991); Proskauer v. Commissioner,

T.C. Memo. 1983-395. Because Lakeview incurred the legal fees in

defending claims that arose from a transaction involving the

acquisition of a capital asset, under the "origin-of-the-claim"

test the cost of such fees must be capitalized.9
- 27 -

9(...continued)

estate, also a capital asset.

We also have no basis in the record on which to determine

the amount of legal fees allocable to William’s other peripheral

claims, such as intentional infliction of emotional distress. 

Faced with the absence of any evidentiary basis on which to

attribute fees to any particular claim, we are unable to allocate

the legal fees between deductible and capital expenses and hold

that they are, in the aggregate, capital. See Cohan v.

Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930), affg. in part

and remanding in part 11 B.T.A. 743 (1928); Vanicek v.

Commissioner, 85 T.C. 731, 743 (1985); Churchill Farms, Inc. v.

Commissioner, T.C. Memo. 1969-192, affd. sub nom. Bayou Verret

Land Co. v. Commissioner, 450 F.2d 850 (5th Cir. 1971).

Petitioner, again relying on A.E. Staley Manufacturing Co.

v. Commissioner, 119 F.3d 482 (7th Cir. 1997), revg. 105 T.C. 166

(1995), and Federated Dept. Stores, Inc. v. Commissioner, 171

Bankr. 603 (S.D. Ohio 1994), affg. In re Federated Dept. Stores,

Inc., 135 Bankr. 950 (S.D. Ohio 1992), argues that the legal fees

were incurred to avoid a hostile takeover attempt by William and

are thus deductible under section 162(a) as ordinary and

necessary business expenses under the reasoning of those cases. 

In A.E. Staley Manufacturing Co. v. Commissioner, supra, the

Court of Appeals for the Seventh Circuit reversed our decision,

in which we held that certain investment banking fees had to be

capitalized because incurred in connection with a change in

corporate ownership that produced benefits for the corporate

taxpayer extending beyond the taxable year. In reaching that

result, we reasoned that it did not matter whether the change in

ownership occurred as a result of a "hostile" or "friendly"

takeover. Id. at 198. The Court of Appeals disagreed, reasoning
- 28 -

10 The Court of Appeals concluded that a small portion of

the fees were facilitative of the ownership change and were

therefore required to be capitalized.

11 The Court of Appeals concluded in the alternative that a

significant portion of the costs were deductible under sec.

165(a) as costs associated with abandoned capital transactions,

because they were incurred to develop ultimately unsuccessful

alternatives to the ownership change which occurred.

that because the takeover had been hostile, and the bulk of the

fees10 was expended in an effort to thwart it, they produced no

benefit extending beyond the taxable year. According to the

Court of Appeals, the fees were thus more properly viewed as

costs associated with defending a business or existing corporate

policies against attack, which were deductible under section

162(a), rather than as costs associated with facilitating a

capital transaction, required to be capitalized.11

Petitioner contends that we should follow the Court of

Appeals for the Seventh Circuit’s decision and find the legal

expenses at issue herein deductible because they were incurred in

"a defense to an attack on the business" or "to thwart what

amounted to a hostile takeover attempt". However, the instant

case provides no occasion for us to consider whether to adopt the

reasoning of the Court of Appeals decision, because it is readily

distinguishable.

Petitioner's attempt to characterize William's effort to

rescind the Redemption Agreement as a hostile takeover attempt or 

an attack on existing business practices is simply unavailing. 

The critical difference is that the dispute in this case was over

the terms of a completed capital transaction. The origin of
- 29 -

William's lawsuit was a capital transaction, namely, the

redemption of his stock and the sale of certain real property to

petitioner, which William sought to rescind. This case thus

falls squarely within the rule that legal expenses incurred in

the acquisition of a capital asset must be capitalized if “the

origin of the claim litigated is in the process of acquisition

itself.” Woodward v. Commissioner, 397 U.S. 572, 577 (1970); see

also Wagner v. Commissioner, supra; Locke v. Commissioner, supra.

In defending against William's lawsuit, Lakeview sought to

preserve the terms of a completed capital transaction. Lakeview

was successful in that regard. The legal fees incurred by

Lakeview were thus expended to facilitate a capital transaction,

not to thwart it, and they produced benefits extending beyond the

taxable year, e.g., the removal of a shareholder deemed

troublesome by the surviving shareholder, the elimination of

conflicting views regarding management, etc. Requiring that

these legal fees be capitalized thus conforms to the guidelines

established by the Supreme Court in INDOPCO, Inc. v.

Commissioner, 503 U.S. 79, 84 (1992). Because this case does not

involve fees expended to thwart a capital transaction or change

in ownership, the result we reach is not inconsistent with the

holding of the Seventh Circuit Court of Appeals in 

A.E. Staley Manufacturing Co. v. Commissioner, supra. We

accordingly sustain respondent's determination that the legal

fees at issue are not deductible. 
- 30 -

4. Expenditures on Gate and Roof

Respondent disallowed deductions claimed by Lakeview as

repair expenses that included $3,400 for the replacement of a

roof and $2,000 for the replacement of a fence gate. We agree

with respondent that these expenses were capital in nature and

not currently deductible.

Costs of repairs which keep property used in a trade or

business in an ordinarily efficient operating condition may be

deducted as an ordinary and necessary business expense under

section 162. Sec. 1.162-4, Income Tax Regs. Repairs in the

nature of replacements, and costs that appreciably prolong the

useful life of property, or that materially add to its value, are

not deductible but rather must be capitalized. Id. The

determination of whether an expenditure is deductible or must be

capitalized is a question of fact, and distinctions drawn "are

those of degree and not of kind". INDOPCO, Inc. v. Commissioner,

supra at 86. Although a repair adds value to unsound property,

"The proper test is whether the expenditure materially enhances

the value, use, life expectancy, strength, or capacity as

compared with the status of the asset prior to the condition

necessitating the expenditure." Plainfield-Union Water Co. v.

Commissioner, 39 T.C. 333, 338 (1962). 

Petitioner did not repair the gate; he replaced it. 

Ordinarily, a replacement constitutes a capital expenditure, but

petitioner argues that because the gate is a part of the fence,

replacement merely restored the fence to its prior condition and

did not prolong its life. Respondent takes the position that the
- 31 -

costs of the gate must be capitalized because they constitute a

"major repair or replacement." 

Regardless of whether the gate is viewed as separate from or

integral to the fence, we believe the substantial nature of the

replacement renders it a capital expenditure. Furthermore, the

new gate did improve the property as it freed up the area that

formerly was necessary for the path of the old swing gate. Poles

were added to the existing fence to support the new gate. Cf.

Honigman v. Commissioner, 55 T.C. 1067, 1081 (1971), affd. in

part, revd. in part and remanded on other grounds 466 F.2d 69

(6th Cir. 1972) (replacing concrete floor section was a capital

expense where structural supports were added). Considering all

the facts and circumstances, we hold that the expense of

replacing the gate is capital in nature.

We next consider the $3,400 deduction claimed by Lakeview

with respect to work done on its roof. The roof was removed

"right down to the wood" and then replaced, along with the

addition of a new roof drain. 

Petitioner relies on Oberman Manufacturing Co. v.

Commissioner, 47 T.C. 471, 482 (1967), where the removal of the

material covering the roof, the insertion of an expansion joint,

and the recovering of the roof with new material was held to be

currently deductible since it merely kept the leased property in

an operating condition over its probable useful life. In Oberman

Manufacturing Co., steel plates that were the basic foundation of

the roof were not replaced. By contrast, Lakeview's entire roof
- 32 -

12 On brief respondent argues that petitioner is also

subject to a penalty for negligence or disregard of the rules or

regulations under sec. 6662(b)(1), but there was no determination

to this effect in the Notice of Deficiency or assertion in the

answer. Respondent has not moved to amend the pleadings. In any

(continued...)

was replaced, and a new roof drain was added to the structure of

the building. Lakeview's old roof was beyond repair because of a

flaw in its design for drainage. The replacement roof is

expected to last 20 years. As opposed to the roof at issue in

Oberman Manufacturing Co., the replacement of petitioner's roof

prolonged its useful life. The cost of the new roof is a capital

expense. Ritter v. Commissioner, 163 F.2d 1019 (6th Cir. 1947);

Georgia Car & Locomotive Co., 2 B.T.A. 986, 990 (1925); Ettig v.

Commissioner, T.C. Memo. 1988-182; see also Badger Pipe Line Co.

v. Commissioner, T.C. Memo. 1997-457; Drozda v. Commissioner,

T.C. Memo. 1984-19.

5. Computer

Respondent asserted in his trial memorandum and on brief

that petitioner is not entitled to a deduction taken with respect

to computer equipment in the amount of $723. (Although

respondent uses the figure of $773 in his brief, based on the

entire record the correct figure appears to be $723.) Since

petitioner has not addressed this issue, he is deemed to have

conceded it. See Rules 149(b), 142(a).

6. Accuracy-Related Penalty

In the Notice of Deficiency, respondent determined that

petitioner is liable for an addition to tax for a substantial

understatement of income tax under section 6662(b)(2).12
- 33 -

12(...continued)

event, petitioner’s claim of reasonable cause under sec.

6664(c)(1), discussed infra, would eliminate the negligence

penalty under sec. 6662(b)(1) to the same extent as the penalty

for substantial understatement under sec. 6662(b)(2).

Respondent's determinations are presumed correct, and petitioner

bears the burden of proving that the penalties do not apply. 

Rule 142(a); Bixby v. Commissioner, 58 T.C. 757, 791-792 (1972).

Section 6662(a) imposes a penalty in an amount equal to 20

percent of the portion of an underpayment of tax attributable to

any substantial understatement of income tax. Sec. 6662(b)(2). 

An understatement of tax is substantial if it exceeds the greater

of 10 percent of the tax required to be shown in the return or

$5,000. Sec. 6662(d)(1)(A). No penalty under section 6662(a) is

imposed, however, with respect to any portion of an underpayment

if there was reasonable cause for such portion and the taxpayer

acted in good faith with respect thereto. Sec. 6664(c)(1).

Petitioner contends that there was reasonable cause for the

tax treatment of the items at issue because the deductions

claimed by Lakeview were based on the advice of a certified

public accountant (C.P.A.). 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 the relevant facts

and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. A

taxpayer may demonstrate reasonable cause if he can show that he

relied in good faith on a qualified adviser after full disclosure

of all necessary and relevant information. Jackson v.
- 34 -

13 Petitioner has not argued that any portion of the

understatement should be reduced pursuant to sec. 6662(d)(2)(B)

because there was substantial authority for, or adequate

disclosure of, the tax treatment of any item. 

Commissioner, 86 T.C. 492, 539-540 (1986), affd. 864 F.2d 1521

(10th Cir. 1989).

Petitioner has shown that Lakeview acted with reasonable

cause in claiming the $134,116 “forgiveness of debt” deduction. 

There is ample evidence in the record that Lakeview's C.P.A. was

provided with information concerning petitioner’s position that

William had diverted assets from Lakeview. Furthermore, Lakeview

and its C.P.A. consulted legal counsel concerning whether

recovery from William was feasible. Although Lakeview received

incorrect advice regarding its “forgiveness of debt” deduction,

we are satisfied that it took the deduction in good faith based

on professional advice, after adequate disclosure to advisers. 

Therefore, there was reasonable cause and good faith with respect

to the portion of the underpayment attributable to the

“forgiveness of debt” deduction.

We do not believe that petitioner has shown that he relied

in good faith on qualified advice, or otherwise had reasonable

cause, with respect to the remaining deductions disallowed by

respondent.13 With respect to Lakeview's $75,000 deduction for

“rent”, petitioner has failed to establish that full disclosure

was made to Lakeview's C.P.A. The C.P.A. testified that it was

his understanding that this payment was intended as consideration

for William’s execution of the Release Agreement, although the
- 35 -

C.P.A. signed Lakeview's 1992 Form 1120S that labels the $75,000

as rent. A third characterization of the payment was made on a

Form 1099 issued by Lakeview to William labeling it as

"Nonemployee compensation".

With respect to the claimed deductions for the legal fees,

gate, roof, and computer expenses, petitioner has failed to meet

the burden of showing that Lakeview provided its accountant with

complete and accurate information. The only evidence pertaining

to the issue is Lakeview's C.P.A.'s signature on the

corporation's 1992 return, which we conclude is insufficient

support for the inference that Lakeview supplied its C.P.A. with

complete and accurate information. Petitioner argues on brief

that "at no time did respondent even attempt to claim that

[Lakeview's accountant] * * * had not been given all the facts by

petitioner." However, the burden is on petitioner to

affirmatively show that Lakeview's accountant received the

requisite information. Rule 142(a); see Selig v. Commissioner,

T.C. Memo. 1995-519. 

To reflect the foregoing,

Decision will be entered

under Rule 155.