Opinion ID: 408238
Heading Depth: 2
Heading Rank: 2

Heading: Origin of the Claim

Text: 22 Characterization of a transaction for taxation is a two step process. The initial step is to discover the origin of the claim from which the tax dispute arose. This attribution determination is critical to proper tax characterization because of the inherently factual nature of taxation. Once a transaction is placed in its proper context, the nature of that transaction becomes discernible, and its tax character may be identified. Thus, the second step, the actual tax characterization, is dependent upon the proper resolution of the preliminary attribution question. 23 Attribution through the origin of the claim test was first explained by the Supreme Court in United States v. Gilmore, 372 U.S. 39, 83 S.Ct. 623, 9 L.Ed.2d 570 (1963), and its companion case, United States v. Patrick, 372 U.S. 53, 83 S.Ct. 618, 9 L.Ed.2d 580 (1963). 24 Gilmore involved divorce litigation. The main issue in the divorce proceedings was the disposition of the husband's controlling interests in three corporations. The husband argued that his primary purpose in so vigorously litigating the divorce was to protect his capital investment in the corporations. That purpose, he asserted, allowed him to deduct his litigation expenses as expenditures for the conservation of property held for the production of income. See Section 23(a)(2) of the Internal Revenue Code of 1939. 25 The Court of Claims allocated the litigation expense between personal and income preservation motives, allowing a deduction for 80 percent of the expense. Gilmore v. United States, 290 F.2d 942 (Ct. Cl. 1961). The Supreme Court reversed. 26 Relying on Lykes v. United States, 343 U.S. 118, 72 S.Ct. 585, 96 L.Ed. 791 (1952), the Court rejected the notion that the attribution process is based on the consequences to the taxpayer if he fails in his defense of a legal action. Gilmore, 372 U.S. at 43-44, 46-48, 83 S.Ct. at 627-28. In other words, the Court rejected the notion that attribution is a forward-looking process. It held instead that the characterization, as 'business' or 'personal,' of the litigation costs of resisting a claim depends on whether or not the claim arises in connection with the taxpayer's profit-seeking activities. It does not depend on the consequences that might result ... from a failure to defeat the claim .... Gilmore, 372 U.S. at 48, 83 S.Ct. at 628 (emphasis in original). 27 Thus, as noted earlier, the characterization process has a preliminary step: the cost (or income) at issue must be attributable to a business activity to be a business expense, a personal activity to be a personal expense, or a capital activity to be an adjustment in the value of the capital asset. 28 Patrick, the companion case to Gilmore, also involved a divorce proceeding and the deductibility of litigation costs. Those costs, however, were incurred in negotiating a property settlement agreement, which divided up ownership of the family business. The parties agreed that only one-sixth of the total legal cost went to the divorce itself, the rest to the financial arrangements. The Fourth Circuit concurred, ruling that the bulk of the expense was properly allocated as a deductible ordinary and necessary business expense, pursuant to section 212(2) of the 1954 Code. Patrick v. United States, 288 F.2d 292 (4th Cir. 1961). 29 Again, the Supreme Court reversed, ruling that the case was indistinguishable from Gilmore. The fact that certain expenses actually were paid to transfer stock and rearrange property interests was not controlling. The expenses all flowed from claims arising out of the marital relationship, and thus were attributable to that relationship and were not deductible. Patrick, 372 U.S. at 57, 83 S.Ct. at 621. 30 In both Patrick and Gilmore, because the Court attributed the expenses to a purely personal transaction, the characterization of those expenses presented no problem. If the costs had been attributable to a business transaction, it would have been necessary to determine if the costs represented deductible expenses or adjustments to the cost of a capital asset. 31 A significant expansion of Gilmore and Patrick occurred in Woodward v. Commissioner, 397 U.S. 572, 90 S.Ct. 1302, 25 L.Ed.2d 577 (1970), and its companion case, United States v. Hilton Hotels Corp., 397 U.S. 580, 90 S.Ct. 1307, 25 L.Ed.2d 585 (1970). 32 Woodward involved the attribution of various expenses incurred by shareholders in an appraisal action. The taxpayers were majority holders of an Iowa corporation, where state law allows shareholders to vote on a perpetual extension of corporate charter. But if the approval is not unanimous, the dissenting minority holders must be allowed to sell their shares for real value. In Woodward, the dissenting minority and the majority could not agree on real value. The majority holders brought an appraisal action. Following resolution of the real value issue, the majority holders sought to deduct the cost of the appraisal as an ordinary and necessary business expense. The Eighth Circuit disagreed, and disallowed the deduction. Woodward v. Commissioner, 410 F.2d 313 (8th Cir. 1969). The Supreme Court affirmed. 33 The basis of the taxpayers' argument was that their primary purpose in expending the funds was to allow their business to continue. They noted that the appraisal action did not involve any title issues, only the value of the shares. 34 The Supreme Court rejected the primary purpose test. A test based on the taxpayer's 'purpose' in undertaking or defending ... litigation would encourage resort to formalisms and artificial distinctions. Woodward, 397 U.S. at 577, 90 S.Ct. at 1306. Instead, the Court applied the origin of the claim test as established in Gilmore. Woodward, 397 U.S. at 578, 90 S.Ct. at 1306. The establishment of a price being a crucial part of a purchase of assets, the Court determined that the appraisal action originated in the efforts to buy the stock, thus, the appraisal costs were attributed to the stock purchase. As the purchase of stock was a capital transaction for tax purposes, the cost of the appraisal was characterized as a part of the cost of the stock acquired. It was treated as an adjustment to basis, not a deductible expense. Id. at 578-79, 90 S.Ct. at 1306-07. 35 The companion case, Hilton Hotels, involved the cost of an appraisal arising from dissenters' rights in a merger. The taxpayer tried to distinguish Woodward on the ground that title to the stock passed prior to a value being fixed. The Court saw no distinction, and applied the same reasoning as in Woodward. Hilton Hotels, 397 U.S. at 583-85, 90 S.Ct. at 1308-09. 36 Following Woodward and Hilton, this court has explicitly applied the origin test on several occasions. 3 In Redwood Empire Savings & Loan Association v. Commissioner, 628 F.2d 516 (9th Cir. 1980), for instance, we applied the origin test to determine if defense and settlement costs were deductible. We identified the origin of the suit to be a sale of land, and thus characterized the expenditures in the subsequent fraud suit as nondeductible costs going to the price of land. Id. at 520-21. See also Madden v. Commissioner, 514 F.2d 1149, 1151-52 (9th Cir. 1975), cert. denied, 424 U.S. 912, 96 S.Ct. 1108, 47 L.Ed.2d 316 (1976); DeMink v. United States, 448 F.2d 867, 869 (9th Cir. 1971).