Opinion ID: 566858
Heading Depth: 2
Heading Rank: 1

Heading: Deductibility of legal fees generally

Text: 12 In holding that no part of the legal fees is deductible, the Tax Court cited Lykes v. United States, 343 U.S. 118, 72 S.Ct. 585, 96 L.Ed. 791 a case that explains the limitations on the deductibility of legal fees. In Lykes, the Supreme Court held that under Section 23(a)(2) of the 1939 Code, the predecessor to Section 212(2) of the 1954 Internal Revenue Code, 4 the legal fees committed to contesting the amount of federal gift tax were not deductible. In discussing its holding, the Court stated that [l]egal expenses do not become deductible merely because they are paid for services which relieve a taxpayer of liability.    It is not a ground for defense that the claim, if justified, will consume income-producing property of the defendant. Id. at 124-126, 72 S.Ct. at 588-589. Although Congress passed a statute specifically reversing Lykes as it applies to gift tax, the decision applies to the case at hand, insofar as it logically establishes that the remote possibility that income will be consumed in order to satisfy an adverse judgment is not enough to permit deductibility for the conservation of assets. The nexus between the legal fee and the business asset must be closer than that. 13 Here the link between the legal fee and the certificate of deposit is similarly attenuated. Taxpayer hired a lawyer because he was indicted for racketeering activity, a federal crime. Additionally, because RICO's forfeiture provision also prevents the criminal from savoring the fruits of his ill-gotten gain, a finding of liability will expose the defendant to financial liability as well as prison. However, because his certificates of deposit do not relate directly to the alleged activity (App. A13), the link between the legal fee and the claimed deduction is non-existent. 14 In United States v. Gilmore, 372 U.S. 39, 83 S.Ct. 623, 9 L.Ed.2d 570 (1963) a case interpreting Lykes, the Supreme Court offered further clarification of the principle that compels our analysis. In Gilmore, the Court held that a taxpayer in a divorce proceeding may not deduct legal fees incurred to resist the claims by his wife to certain of his income-producing assets. The Court stated that the possibility that an adverse judgment against the taxpayer would require him to hand over some of his assets to his wife does not permit him to deduct the legal fees. Rather, the Court looked to 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. Id. at 49, 83 S.Ct. at 629. Therefore, because the taxpayer in Gilmore paid a lawyer to defend him in divorce proceedings, the possibility that a finding of liability might require him to satisfy his wife's claims by turning over income-producing assets was insufficient grounds to invoke Section 23(a)(2), the precursor to Section 212(2). 15 We need not dwell further on the distinction between the origin and consequences of the claim, because under the version of Section 1963(a) of the Criminal Code in force at the time of trial, forfeiture of these certificates of deposit was not even a consequence of a successful RICO claim against taxpayer. The Government's racketeering claim arose in connection with taxpayer's alleged racketeering activities but had no connection with either the certificates of deposit or the condominiums. Therefore the costs of defending against the racketeering indictment are non-deductible personal expenses under Section 262 of the Code. Glimco v. Commissioner, 397 F.2d 537, 540 (7th Cir.1968), certiorari denied, 393 U.S. 981, 89 S.Ct. 452, 21 L.Ed.2d 442. Unlike the eight other defendants who were named in the indictment and convicted, taxpayer was acquitted of involvement in racketeering activity. Therefore, he was not engaged in a business (albeit an illegal business) that would permit him to deduct the legal fees expended to defend himself. It is true that had he been convicted, taxpayer would have been able to deduct his legal fees under Section 162(a) of the Code, Commissioner v. Tellier, 383 U.S. 687, 86 S.Ct. 1118, 16 L.Ed.2d 185 (1966), as did the convicted defendants, but that would be a different case. The other defendants did not rely on Section 212(2) for their deduction, claiming that their income-producing assets might be subject to forfeiture under RICO. Rather, the deduction there stemmed from a finding that the defendants were engaged in a business, and that their legal fees were specifically connected to the conduct of their business. 16 In addition to the principles established by Lykes, Gilmore and Glimco, the deductibility of a taxpayer's legal fees does not turn on the nature of the type of property to be surrendered on a finding of liability even if a potential judgment against the taxpayer might be satisfied therefrom. Consistent with the Supreme Court's decisions in Lykes and Gilmore, the Treasury Regulations under Section 212 provide: 17 An expense (not otherwise deductible) paid or incurred by an individual in determining or contesting a liability asserted against him does not become deductible by reason of the fact that property held by him for the production of income may be required to be used or sold for the purpose of satisfying such liability. 18 Treas.Reg. § 1.212-1(m) (26 C.F.R.). As noted above, taxpayer does not claim a deduction independent from the legal fees supposedly committed to defend the certificates from forfeiture. Therefore, the fact that the certificates produce income for the taxpayer does not mean that if they were forfeitable (which they were not) 5 , then taxpayer could deduct them. A court must look, as Gilmore commands, to the origin and nature of the claim. 19 Taxpayer relies further on Ruoff v. Commissioner, 277 F.2d 222 (3d Cir.1960), and Petschek v. United States, 335 F.2d 734 (2d Cir.1964), for the proposition that legal fees may be deducted when they are paid to conserve income producing property. This argument begs the question, for both decisions result from a finding that the legal fees were committed by the respective taxpayers to conserve property that was in fact linked with a trade or business. In Ruoff, the court permitted the deduction under Section 23(a)(2) (the precursor to Section 212(2)), because the Attorney General of the United States had seized all of the taxpayer's income-producing property pursuant to the Trading with the Enemy Act of 1915, 50 U.S.C. Appendix, Section 1 et seq. Ruoff, 277 F.2d at 229. Having actually lost possession of the property, the taxpayer was entitled to deduct the cost of retaining a lawyer in the attempt to retrieve it. The Ruoff taxpayer paid out legal fees specifically to defend particular property seized by the Government. Id. 20 The Second Circuit applied the same reasoning in Petschek, permitting the taxpayer in that case to deduct legal fees expended in an unsuccessful attempt to recover income-producing property--namely, the stock held by taxpayer in four corporations which had been seized by the nations of Yugoslavia and Rumania as part of each government's respective program for nationalizing private enterprise. 335 F.2d at 735-736. 21 In contrast to Ruoff and Petschek, the taxpayer in the instant case did not forfeit or lose property. He hinges his deduction on a risk of loss that is entirely speculative. The United States did not and could not require the forfeiture of the taxpayer's certificates of deposit, because, as demonstrated above, the funds used to purchase them were not obtained through racketeering (App. A13), and therefore were not forfeitable under the version of Section 1963(a) in force at the time, supra at 447. Taxpayer's legal fees bear no relation to the conservation or maintenance of property held for the production of income within the meaning of Section 212(2), unlike the property at issue in either Ruoff or Petschek. This case therefore resembles Gilmore, 372 U.S. at 51-52, 83 S.Ct. at 630-631, rather than either Ruoff or Petschek, for the Government's claim here did not stem from taxpayer's racketeering activities, so that his legal expenses were not deductible under Section 212(2).