Legal Costs To Recover Punitive Damages Are A Deductible Business Expense

By Peter C. Barton, JD, CPA, and Clayton R. Sager, PhD, University of Wisconsin-Whitewater

In Guill v. Commissioner, the Tax Court recently ruled that legal costs to recover taxable punitive damages were deductible as an IRC section 162(a) business expense rather than as a miscellaneous itemized deduction under IRC section 212, thereby avoiding an alternate minimum tax (AMT) problem. This issue is timely because the Y2K bill passed by Congress in July 1999 allows punitive damages.

In 1989, Congress amended IRC section 104(a) to tax punitive damages where no physical injury is involved. For cases before the 1989 amendment, in O'Gilvie v. U.S., 519 U.S. 79 (1996), the Supreme Court ruled that punitive damages to punish the defendant and deter wrongdoing are taxable. In 1996, Congress amended section 104(a)(2) to tax all punitive damages. Ordinary and necessary expenses of carrying on a trade or business are deductible on Schedule C under section 162(a). IRC section 212 allows deductions for nonbusiness expenses of income-producing activities that lack the regularity and continuity of a business. Section 212(1) expenses for the production or collection of income are Schedule A miscellaneous itemized deductions (MIDs) under IRC section 63(d) and IRC section 67. MIDs are deductible only in excess of 2% of AGI, and they are not deductible at all for the AMT.

Guill, an independent contractor insurance agent, worked for Academy Life Insurance for several years. Guill alleged that, after firing him in 1986, Academy did not pay him all of the renewal commissions he had earned. He sued for breach of contract, conversion, unfair trade practices, failure to pay commissions, and overstatement of income reported to the IRS. A U.S. district court jury awarded Guill $51,499 in actual damages and $250,000 in punitive damages on the conversion claim, plus interest.

Guill reported the actual damages on his 1992 Schedule C; however, he did not report the punitive damages. Also, he deducted legal costs consisting of $148,617 in attorney's fees and $3,279 in court costs on Schedule C. The IRS included the punitive damages in Guill's other income and allowed the legal costs as a MID, thereby creating an AMT liability. The resulting deficiency was $100,916. The IRS conceded that the legal costs attributable to the actual damages (about 17%) were indeed deductible on Schedule C.

The Tax Court ruled that all of Guill's legal costs were IRC section 162(a) business expenses deductible on Schedule C because the legal costs were attributable entirely to claims that arose from Guill's insurance business. The lawsuit would not have arisen if Academy had not breached its contract with Guill. However, the court pointed out that if litigation does not arise entirely out of the taxpayer's trade or business, an allocation of the legal costs is necessary. Some of the legal costs could be nondeductible personal expenses or capitalized costs, as well as section 212 expenses. The allocation depends on the origin and character of the claims for which the legal costs were incurred, which in turn is based on the facts and circumstances of the litigation. The type of damages and the amount of damages awarded under each claim are irrelevant. The Tax Court also noted that, since Guill's litigation arose entirely from his insurance business, the $250,000 in punitive damages was self-employment income subject to the self-employment tax.

Although Guill clarifies the deductibility of legal costs to recover punitive damages when the claims arise entirely from the taxpayer's business, it is uncertain how the Tax Court will make the allocation when the claims have different sources. For example, will more legal costs be allocated to claims having greater legal merit? *

Cite: Guill v. Commissioner, 112 TC No. 22 (June 18, 1999).

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