Court Opinion

ID: 4589391
Source: CourtListenerOpinion
Date Created: 2020-11-20 18:44:05.814558+00
Date Added: 2024-06-11T07:50:15.668653
License: Public Domain

John L. Locke and Irene F. Locke, Petitioners v. Commissioner of Internal Revenue, RespondentLocke v. CommissionerDocket No. 4608-74United States Tax Court65 T.C. 1004; 1976 U.S. Tax Ct. LEXIS 152; February 23, 1976, Filed *152 Decision will be entered for the respondent.  An action was instituted against the taxpayer under SEC rule 10b-5 to recover damages on account of the sale of certain stock to the taxpayer.  Upon inquiry, the taxpayer had advised the seller with respect to the stock. Taxpayer was an "insider" within the scope of rule 10b-5, but was not an officer or director of the corporation, and his stock ownership was nominal.  The taxpayer sought to deduct the resulting legal expenses of his successful defense to the suit as an ordinary and necessary expense under sec. 162.  Held: The taxpayer did not give any advice in his capacity as a corporate executive. The purchase of the stock was not made by the taxpayer in his trade or business.  While the taxpayer was concerned over the possible damage to his business reputation, such concern cannot be separated from the claim for monetary damages.  The legal expenses incurred by the taxpayer were not an ordinary or necessary expense of his business of being a corporate executive. Further held: While such legal expenses constitute a capital expenditure relating to the taxpayers' acquisition of the stock, sec. 1.1341-1(h), Income Tax Regs., *153  specifically excludes legal expenses from the operation of sec. 1341.  Taxpayer is not entitled to the benefits of that section.  Dwight J. Drake, for the petitioners.Charles L. Eppright, for the respondent.  Quealy, Judge.  QUEALY*1004  The respondent determined deficiencies for taxable years 1969 and 1970 in the amounts of $ 11,996.05*154  and $ 72,796.60, respectively.The questions remaining for decision are (1) whether petitioners may deduct, as an ordinary and necessary business *1005  expense under section 162 1 or as an ordinary and necessary expense for the production of income under section 212, legal fees paid in 1969 and 1970 in the successful defense of a lawsuit brought against petitioner John L. Locke alleging fraud in the sale of securities in violation of Securities and Exchange Commission rule 10b-5; 2 and (2) if petitioners may not deduct the legal expenses, whether section 1341 should be applied to reduce the deficiency.FINDINGS OF FACTSome of the facts have been stipulated.  The stipulation of facts and the exhibits attached thereto are incorporated herein by this reference.Petitioners John L. and Irene F. Locke, husband and wife, resided in Seattle, Wash., at the time their petition was*155  filed.  Petitioners filed joint Federal income tax returns with the Internal Revenue Western Service Center, Ogden, Utah, for calendar years 1969 and 1970.  Irene F. Locke is a petitioner solely by reason of having filed a joint return with her husband, John L. Locke (hereinafter referred to as petitioner).At all times material herein, petitioner was in the trade or business of being a corporate executive. As such, petitioner had a reputation for integrity in his community.At the time the transactions hereinafter referred to took place, petitioner was chairman of the board and chief executive officer of Fisher Flouring Mills Co. and of two subsidiary corporations operating television broadcasting stations in Seattle, Wash., and in Portland, Oreg.  Petitioner was also a director of a large insurance company and a director of several other corporations, including a mutual savings bank.  Petitioner participated actively in various civic and religious organizations in the community.Fisher Flouring Mills Co. was one of a large group of businesses owned primarily by the descendants of one O. W. Fisher.  Such enterprises included, in addition to the flouring mill and television stations, *156  a grain warehouse corporation, a real estate corporation, and various investments in holding companies.Members of the Fisher family also owned a substantial interest in Louisiana Long Leaf Lumber Co. (hereinafter referred to as *1006  Long Leaf), a publicly owned corporation.  O. D. Fisher was chairman of the board of Long Leaf.Petitioner was the son-in-law of O.D. Fisher and undertook the handling of many matters involving the Fisher interests on behalf of his father-in-law.  In this respect, since Mr. Fisher was of advanced age, other members of the family might contact petitioner for information, guidance, and advice with respect to the Fisher businesses.On March 15, 1966, the First National Bank of Nevada (hereinafter referred to as the bank), and one Raymond B. Callahan (hereinafter referred to as Callahan) held 115 shares of common stock of Long Leaf as trustees of a trust created by Alice E. Callahan, now deceased.  Callahan was the sole income beneficiary of the trust.  Callahan is distantly related to petitioner by marriage.By letter dated March 15, 1966, Callahan requested certain information from the petitioner in regard to the value of the Long Leaf common stock. *157  By letter dated April 7, 1966, petitioner replied to Callahan setting forth certain facts with respect to Long Leaf.  Petitioner advised Callahan against selling the Long Leaf stock and stated that petitioner would be willing to pay $ 1,000 per share for the stock even though there was no market and during the preceding year there had been sales at $ 200 per share. Petitioner made this statement to persuade Callahan that he should not sell the stock.By letter dated April 20, 1966, addressed to the petitioner, Callahan accepted the petitioner's purported offer to purchase the stock held by the trust for $ 1,000 per share. As a result, the petitioner and his wife thereupon purchased the 115 shares of Long Leaf stock from the trust for an agreed price of $ 115,000.Pursuant to an agreement dated November 15, 1966, between Boise Cascade Corp., Long Leaf, and the stockholders of Long Leaf, petitioner and his wife sold the 115 shares of Long Leaf, along with the 3 shares previously owned, to Boise Cascade Corp. for a total consideration of $ 804,912.65.  Said agreement was the result of contacts by various shareholders or directors of Long Leaf commencing in late 1965.  At that time, *158  petitioner owned 3 shares of common stock of Long Leaf and was neither a director nor officer of that company.  From time to time, however, petitioner attended directors meetings on invitation.  In May 1966, petitioner was made a director of Long Leaf and *1007  participated in the negotiations which culminated in the agreement dated November 15, 1966.On October 10, 1967, the bank and Callahan commenced an action against petitioner in the United States District Court for the District of Nevada to recover damages on account of petitioner's alleged failure to advise Callahan prior to the purchase of 115 shares of Long Leaf common stock that negotiations were then pending with Boise Cascade Corp. for the purchase of said stock. The jurisdiction for said action, as stated in the first amended complaint, was as follows:This is an action for damages for fraud in the sale of stock by plaintiffs to defendant JOHN L. LOCKE.  Jurisdiction in this Court is established by Title 28 U.S.C. Section 1331; by the Securities Exchange Act of 1934 (15 U.S.C. Sections 78aa and 78j) and by Title 17, Section 240.10b-5, Code*159  of Federal Regulations -- Commodities and Securities Exchanges.The complaint alleged that petitioner had been involved in negotiations with Boise Cascade Corp. concerning the latter's purchase of Long Leaf shares since November 1965, and that by virtue of his participation in such negotiations, his correspondence with officers of Long Leaf and his attendance at a Long Leaf directors meeting, petitioner knew that the value of the stock of Long Leaf was in excess of $ 6,100 per share in February 1966, and that by March 25, 1966, petitioner knew that Boise Cascade Corp. would pay in excess of $ 6,500 per share for 80 percent or more of the stock of Long Leaf.  The amended complaint further alleged that in his April 7, 1966, response to Callahan's inquiry, petitioner concealed the facts that negotiations were pending with Boise Cascade Corp., and that there was a reasonable expectation of selling the stock pursuant to such negotiations for a price in excess of $ 6,500 per share. The amended complaint sought damages of $ 674,646.35 with interest, plus punitive damages in the same amount, allegedly due by reason of "the false and fraudulent statements made by [petitioner]."Petitioner's*160  answer to the amended complaint consisted of a general denial and specific allegations that petitioner did not know at the time of the representations in his letter to Callahan or at the time of the sale that the value of Long Leaf was in excess of $ 1,000 per share, that O. D. Fisher, who owned a block of stock in Long Leaf large enough to prevent the sale to Boise Cascade Corp., opposed the sale of Long Leaf stock, and that petitioner in *1008  his communication with Callahan adverted to the fact that should Long Leaf shareholders all get together to sell their stock, they could get a "pretty fancy price" for their stock which bore no relationship to the earning prospects for Long Leaf.  Petitioner contended that he was not an "insider" within the meaning of rule 10b-5, that no negotiations were carried on at the corporate level, that no material facts were omitted or falsely stated, and that Callahan did not rely on petitioner's statement in his decision whether to sell.Following pretrial proceedings as a result of which the District Court found that no issue of law remained to be argued, trial was ordered before a jury.  In its instructions to the jury, the District Court*161  defined an "insider" within the scope of rule 10b-5, as follows:Plaintiffs contend that defendant was an "insider" within the scope of Rule 10b-5.  An "insider" is a person who, because of this position or intimate association with the corporation, has greater knowledge of the financial affairs of the corporation.  An "insider" is not limited to persons who are directors and management officers.  Because of his superior knowledge, an "insider" has a duty to disclose facts known to him not available to plaintiffs and which he should have reasonably known would be important to them in determining the value of the stock which they held and whether or not they should sell such stock.With respect to the factual issues presented at the trial, the District Court instructed the jury as follows:It is incumbent upon plaintiffs to prove by a preponderance of the evidence the following:1. That defendant used or employed manipulative or deceptive conduct in buying plaintiff's stock. More specifically, (a) that he made an untrue statement of a material fact; or (b) that he omitted to state a material fact which was necessary in order to make the statements he did make in the light of the circumstances*162  under which they were made not misleading; or (c) that he failed to disclose a fact known to him which was not available to plaintiffs and which he should reasonably have known would be important to plaintiffs in determining whether to sell their stock to him.2. That the misrepresentations or omissions, if any, were made with the purpose or intent of inducing plaintiffs to sell their stock.3. That the misrepresentations or omissions, if any, concerned or related to a material fact or facts.  A fact or omission of fact is material if it concerns something which a reasonable man would consider important in deciding what he should do in a particular transaction.4. That plaintiffs relied on the alleged misrepresentations or omissions. There is reliance by plaintiffs if the claimed wrongful conduct was or would be a substantial factor in plaintiffs' determination of whether they should sell their stock to defendant.*1009  The jury rendered a verdict in favor of petitioner.  Plaintiffs' motions for judgment notwithstanding the verdict and for a new trial were denied.  No appeal was taken.In his defense to the suit filed by the bank and Callahan, petitioner incurred legal expenses*163  of $ 15,529 in the taxable year 1969 and $ 101,821 in the taxable year 1970.  In the individual income tax returns filed by the petitioner and his wife for said taxable years, petitioner deducted these expenses as ordinary and necessary expenses incurred by the petitioner in his trade or business within the meaning of section 162.  In his notice of deficiency, respondent has disallowed the deductions as claimed on the ground that these expenses were incurred in connection with the purchase and sale of a capital asset.OPINIONThe petitioner seeks to deduct as ordinary and necessary expenses incurred in a trade or business, within the meaning of section 162, legal expenses incurred in defense of an action brought against him under section 78j of title 15 of the United States Code, as implemented by rule 10b-5 of the Securities and Exchange Commission.Section 78j, title 15, of the United States Code, relating to manipulative and deceptive devices, provides, in part, as follows:It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails * * *(b) To use or employ, in connection with the purchase or sale*164  of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.The Securities and Exchange Commission has, pursuant to this statute, issued regulations relating to employment of manipulative or deceptive devices.  These regulations have the effect of law.  Rule 10b-5 thereof provides, in part, as follows:It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails * * *(a) To employ any device, scheme, or artifice to defraud,(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or*1010  (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,in connection with the purchase or sale of any security.The facts are not *165  generally in dispute.  Petitioner was a prominent businessman and civic leader.  His trade or business was that of "corporate executive." As such, he served as chairman of the board and chief executive officer of a group of businesses owned or controlled by the Fisher family.  Petitioner was the son-in-law of O. D. Fisher, who had developed these businesses.  Petitioner had obtained a position of leadership in the Fisher family enterprises.  As such, he was closely associated with the operations of the various businesses in which the Fisher family had an interest, and his advice and consultation were sought in connection therewith.The members of the Fisher family owned a substantial interest in Louisiana Long Leaf Lumber Co. O. D. Fisher was chairman of the board.  Prior to May 1966, petitioner did not have any official connection with Long Leaf.  He merely owned, with his wife, 3 shares of the common stock. However, due to his relationship with O. D. Fisher, a gentleman of advanced years, petitioner was invited from time to time to sit in on meetings of its board of directors.  In the course of such meetings, consideration was given to the possible future of Long Leaf.One Raymond*166  B. Callahan was the income beneficiary of a trust owning 115 shares of common stock of Long Leaf.  On March 15, 1966, Callahan wrote a letter to the petitioner requesting certain information with respect to Long Leaf.  The petitioner promptly replied, outlining the situation with respect to the future of Long Leaf and, in an effort to influence Callahan against selling the stock, stated that petitioner would be willing to pay $ 1,000 per share for such stock. In a letter dated April 20, 1966, Callahan treated the petitioner's reply as an offer to purchase the stock held in the trust for $ 1,000 per share and indicated his acceptance of that offer.  As a result, petitioner and his wife purchased the 115 shares of common stock in the trust for an agreed price of $ 115,000.As a result of negotiations, which had been pursued intermittently for some months previously, an agreement was reached under date of November 15, 1966, pursuant to which Boise Cascade Corp. would purchase the stock of Long Leaf at a price of approximately $ 6,500 per share. That agreement was duly consummated, *1011  and early in 1967 the petitioner sold the 115 shares of Long Leaf, as well as the 3 shares *167  previously owned, to Boise Cascade Corp. for $ 804,912.65.Upon learning of the sale, the bank and Callahan brought suit against the petitioner, alleging that the petitioner had committed fraud in failing to advise them of the pending negotiations with Boise Cascade Corp.  The cause of action was predicated on rule 10b-5 of the Securities and Exchange Commission.  In the suit, the plaintiff sought to recover the difference between the amount paid for the stock by the petitioner and the amount for which the stock was sold to Boise Cascade Corp., together with punitive damages. The petitioner was thus threatened with a claim in the amount of $ 674,646.35 with interest, plus punitive damages.The suit was vigorously contested by the petitioner and at no time did he consider settlement.  In a trial on the merits, the factual issues were submitted to the jury and the jury found for the petitioner.  It is the legal expense of petitioner's successful defense of this claim which is in issue.The petitioner claims the right to deduct the legal expenses incurred in the suit against him on the grounds that (a) such expenses were incurred in his trade or business as a corporate executive, and*168  (b) such expenses were ordinary and necessary in order to preserve his reputation as a corporate executive, which was endangered by the claim of fraud asserted in this litigation.In his argument, petitioner construes Woodward v. Commissioner, 397 U.S. 572 (1970), and related cases as being limited to situations where the "origin of the claim litigated is in the process of acquisition itself." See also Vincent Boagni, Jr., 59 T.C. 708">59 T.C. 708 (1973); Richard Baier, 63 T.C. 513 (1975). Petitioner argues that the litigation with Callahan arose after the stock had been purchased, and was predicated not upon the purchase itself, but upon petitioner's position as a "corporate executive insider," and the action was in tort, based on rule 10b-5.  Petitioner cites Mitchell v. United States, 435">408 F.2d 435 (Ct. Cl. 1969).This argument would seem to beg the question.  Even assuming that petitioner's alleged failure to inform can be divorced from his purchase of the stock, for such failure to give rise to a cause of action based on rule 10b-5 it was not necessary that petitioner*169  be either an officer, director, or stockholder of Long Leaf.  See White v. Abrams, 495 F.2d 724 (9th Cir. 1974). To be an "insider" such relationship is not requisite.  Petitioner's admitted status as an *1012  "insider" within the meaning of rule 10b-5 resulted from a personal relationship with O. D. Fisher and the members of the Fisher family.  His trade or business as a corporate executive was not predicated upon any relationship to Long Leaf, and petitioner derived no income therefrom, except to the extent that he received dividends on the 3 shares of common stock he and his wife then owned.  As distinguished from the Mitchell case, supra, there was no alleged breach of duty by the petitioner as a corporate executive of Long Leaf.Secondarily, petitioner claims the right to deduct the legal expenses as an ordinary and necessary expense incurred to protect his business reputation. See, e.g., Paul Draper, 26 T.C. 201">26 T.C. 201 (1956); J. Raymond Dyer, 36 T.C. 456">36 T.C. 456 (1961). The petitioner was unable to testify.  However, in an effort to establish that petitioner's primary motive in contesting*170  the lawsuit was to protect his reputation, his counsel testified to the effect that petitioner was more concerned over the impact of the lawsuit on his business reputation than was his concern over the potential monetary loss.  Nevertheless, counsel admitted that both were factors.  At another point in his testimony, in describing petitioner's business achievements, his counsel characterized him as a "Scotchman," speaking both ethnically and in habit.  The fact that petitioner had an estate valued "in the millions" was no proof that he would not be concerned over giving up a profit of some $ 675,000.  On the contrary, some of the nation's most wealthy men have been noted for their frugality.While the action was brought by Callahan under rule 10b-5, and as such may be an action in tort, there can be no dispute with respect to the real purpose of the lawsuit. Callahan contended that he had been induced to sell the stock to the petitioner for a fraction of its value as a result of petitioner's failure to disclose facts within his knowledge.  Callahan sought a monetary judgment.  Petitioner elected to contest that claim.  While the outcome of the litigation might affect petitioner's*171  reputation, it also affected his "pocketbook." As distinguished from the Boagni case, supra, there is no basis for allocating a portion of the legal expense to the defense of petitioner's reputation and a portion of the legal expense to the gain realized by the petitioner as a result of the purchase of the stock. In this case the two are inseparable.When petitioner wrote to Callahan, he did not have any business relationship either to Long Leaf or to Callahan.  He was *1013  acting in a personal capacity.  He also purchased the stock in that capacity.  The legal expenses incurred in defending that purchase must be treated as capital expenditures. See, e.g., Madden v. Commissioner, 514 F.2d 1149">514 F.2d 1149 (9th Cir. 1975); Estate of Meade v. Commissioner, 489 F.2d 161">489 F.2d 161 (5th Cir. 1974), cert. denied 419 U.S. 882">419 U.S. 882 (1974); Munn v. United States, 455 F.2d 1028">455 F.2d 1028 (Ct. Cl. 1972); Ransburg v. United States, 440 F.2d 1140">440 F.2d 1140 (10th Cir. 1971); Anchor Coupling Co. v. United States, 427 F.2d 429">427 F.2d 429 (7th Cir. 1970), cert. *172  denied 401 U.S. 908">401 U.S. 908 (1971).In the alternative, the petitioner contends that if the legal expenses are deemed to be capital expenditures, the tax for the year of sale must be recomputed under section 1341 in order to reflect the resulting loss.  That section provides, in part:SEC. 1341. COMPUTATION OF TAX WHERE TAXPAYER RESTORES SUBSTANTIAL AMOUNT HELD UNDER CLAIM OF RIGHT.(a) General Rule.  -- If -- (1) an item was included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item;(2) a deduction is allowable for the taxable year because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item; and(3) the amount of such deduction exceeds $ 3,000,then the tax imposed by this chapter for the taxable year shall be the lesser of the following: (4) the tax for the taxable year computed with such deduction; or(5) an amount equal to -- (A) the tax for the taxable year computed without such deduction, minus(B) the decrease in tax under this chapter (or the corresponding*173  provisions of prior revenue laws) for the prior taxable year (or years) which would result solely from the exclusion of such item (or portion thereof) from gross income for such prior taxable year (or years).The petitioner recognizes that section 1.1341-1(h), Income Tax Regs., specifically excludes legal fees and other expenses incurred by a taxpayer with respect to an item previously included in income from the adjustment provided for in section 1341.  Nevertheless, petitioner argues that equity would require such adjustment, since the legal expense which is not allowed as a current deduction would be chargeable to the basis or cost of the stock, thereby reducing the gain previously reported by the petitioner.  This argument must be addressed to the Congress.Decision will be entered for the respondent.  Footnotes1. All section references are to the Internal Revenue Code of 1954, as amended, unless otherwise indicated.↩2. 17 C.F.R. sec. 240.10b-5↩.