Tax Lawyer's Blog

West Covina Motors, Inc. v. Commissioner (T.C. Memo. 2008-237):  There were five issues involved in this case, three which dealt directly with the deductibility of legal fees, one which dealt with the write down of inventory and one which dealt with the abatement of penalties.

 This post deals only with the legal fee issues.

Judge Diane Kroupa ruled against the Petitioner’s and found that none of the legal fees were currently deductible:

We first decide whether petitioner may deduct legal expenses it incurred in the bankruptcy of its landlord, Hassen Imports Partnership (HIP) for 1999 and 2000 (the years at issue). We find that petitioner may not deduct these expenses.

The second issue is whether petitioner may deduct legal expenses related to the purchase of Clippinger Chevrolet (Clippinger) for the years at issue. We find that it may not.

The third issue is whether petitioner may deduct $54,558 in miscellaneous legal expenses for 1999. We find that petitioner is not entitled to the deduction.

The Law

Deduct or Capitalize?

Attorney’s fees that are paid as ordinary and necessary business expenses are currently deductible under IRC §162. However, §263 requires that legal fees that are capital in nature be capitalized.

Origin of the Claim

In order to determine whether a particular legal fee expenditure is ordinary and necessary or capitalizable the courts apply what is know as the “origin of the claim” doctrine:

The substance of the underlying claim or the nature of the transaction out of which the expenditure in controversy arose governs whether the item is a deductible expense or a capital expenditure, regardless of the payor’s motives or the
consequences resulting from the failure to defeat the claim.

The Ruling

With respect to the legal fees incurred by the petitioner in connection with it’s its landlord’s bankruptcy, the Court found** that the fees were expended to prevent petitioner from being evicted from the premises and, therefore, were incurred in defense of title and not deductible. 

With respect to the legal fees incurred by the petititioner in connection with acquiring another business (i.e. Clippinger Chevrolet), the Court found that the fees were not deductible under §162 but, instead, capitalizable under §263 and rejected the petitioner’s argument that the legal fees related to the acquisition of inventory:

It is well settled that legal expenses incurred in the acquisition or disposition of a capital asset are capital expenditures. Woodward v. Commissioner, 397 U.S. at 574. Moreover, we find petitioner’s argument that most of the Clippinger purchase price represented automobile inventory conflicts with the evidence in the record.

The Court also disallowed a deduction for the miscellaneous legal fees because at trial the Petitioner failed to proffer evidence of their deductibility.

Author’s Advice: Have your lawyer talk with your tax advisor before he or she makes a claim on your behalf. Under the origin of the claim doctrine, the way the claim is worded can and often does effect affect the tax treatment of the legal fees incurred.

** This finding appears to be superfluous because the Judge also found that these legal fees were paid on behalf of another and, therefore, not deductible in any case.

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