The following article is adapted and reprinted from the M&A Tax Report, Vol. 11, No. 4, November 2002, Panel Publishers, New York, NY.


By Robert W. Wood

We live in an era of scrutiny, one of sharp focus on companies, their boards, their executives, their practices. There is financial statement scrutiny, executive perk scrutiny and, well, scrutiny over just about everything. One investigation or another seems to hit just about everybody. Throw in a measure of uncertainty and potential liability, and you get a queasy feeling.

In this environment, both businesses and individuals are being faced with legal fees arising out of allegations of criminal and quasi-criminal activities. There has long been interesting authority about a taxpayer's ability to deduct legal fees paid or incurred in defending against criminal charges. There are a host of issues.

We'll try to answer at least some of these questions in the next few pages. Of course, attorneys' fees are not always deductible. Sometimes they must be capitalized. This is the whole meaning of the INDOPCO mantra, something has made planning for acquisitions (and many other types of transactions) particularly difficult. Aside from this capitalization question, there are other contexts in which attorneys' fees cause even more serious problems: no tax benefit at all. One of the other areas is where the attorneys' fees are paid or incurred in the context of a strictly personal matter.

No Deductions, Please

The leading case on the subject is still U.S. v. Gilmore, 372 U.S. 39 (1963), in which the U.S. Supreme Court found that a divorce action had its roots in the personal conduct of the litigating husband. Well-founded and long-quoted cases such as Gilmore may lead taxpayers to believe that a business expense deduction is allowed for attorneys' fees only when the capitalization rules are not violated (that is, when the legal expenses are not incurred in connection with a capital asset), and where there is no issue about the expenses being paid or incurred in connection with personal business.

Indeed, there is often no question about the deductibility of legal fees paid by organized crime figures. An example of this amazing principle is contained in John DiFronzo v. Commissioner, T.C. Memo 1998-41 (1998), holding that a convicted member of an organized crime family can deduct the legal fees that he incurred in defending against conspiracy and fraud charges. In 1993, DiFronzo was convicted of mail fraud and other offenses for his involvement in the Chicago crime syndicate's efforts to control gaming operations on an Indian reservation. DiFronzo was found to be a "crew chief" in the Chicago syndicate, through which he participated in various illegal profit seeking ventures.

The legal costs of such activities can be high. DiFronzo claimed business expense deductions of $125,000 for legal expenses incurred in the criminal case brought against him. He even supported the deduction with copies of his personal $50,000 cashier's check to his attorney, his wife's $25,000 check to the attorney, his attorney's deposit slip for $50,000 bearing the notation "5/11/93 DiFronzo $50,000" (perhaps meaning that there had been a cash payment?). The IRS disallowed all of the deductions.

The Tax Court, however, was not so quick to deny a legitimate businessman his business expense deductions. After all, the Tax Court held that DiFronzo was entitled to deduct these legal fees "as a legitimate business expense" to the extent that he substantiated his expenditures. The court found that he had accomplished this substantiation to the extent of $50,000. DiFronzo's conviction on the criminal charges established his involvement in an illegal trade or business, and the Tax Court found that he had engaged in the scam with a genuine intention of making a profit.

Unfortunately for DiFronzo, he was only able to substantiate $50,000 by his check. The judge found that his filing status as married, filing separately, created a burden to demonstrate that he alone made all the payments. Hence, the wife's $25,000 contribution was insufficient proof, as was the deposit slip for $50,000 (the source of the extra $50,000 was not clear).

Ultimately, the DiFronzo case is not surprising, since legal expense deductions are one of the things that businesses count on to reduce or mitigate the admittedly high cost of legal services. It just seems a little amusing that the fact that someone is convicted of a crime means that they may profitably search for deductions. Still, the conviction of the crime may help to establish that the convicted person was truly in business, was serious about their criminal pursuit and was not just engaged in a hobby!

In some cases, the person accused of a crime fails to establish a business nexus between the alleged crime and their livelihood. Thus, a management consultant was not allowed to deduct legal expenses he incurred in defending a charge against him for fraudulently selling securities, since he was not in the business of selling securities. See Daniel Price v. Commissioner, 32 T.C.M. 283 (1973).


If the taxpayer is convicted, does that mean that the legal fees associated with the unsuccessful defense are not deductible? Traditionally, the answer was yes. However, in Commissioner v. Tellier, 383 U.S. 687 (1966), the Supreme Court allowed a deduction for the unsuccessful defense of a criminal prosecution of a securities dealer convicted of violating the 1933 Securities Act and mail fraud statute in conducting his business. The Tellier decision was noteworthy not only in the fact that it overturned several lower court cases, but also in the fact that it made irrelevant the success or failure of the defense of the criminal charge. See also Rev. Rul. 66-330, 1966-2 C.B. 44.

Illegal Payments

An interesting fillip on this situation is the interrelationship between the legal fees, the conviction of a crime, and the prohibition on deducting bribes and illegal payments. The prohibition on deducting bribes and illegal payments is a separate topic, but does a conviction mean that by definition that prohibition comes into play, too?

Fortunately, the answer seems to be no. In Paul A. Bilzerian, et ux. v. United States, No. 91-1076T (Fed. Cl. June 12, 1998), the Court of Federal Claims denied a government motion for summary judgment, finding that the fact that the taxpayer was convicted of violating securities laws and conspiring to defraud the IRS did not establish whether his payment to a stockbroker was illegal for purposes of Section 162. Under Section 162, a payment cannot be deducted as a business expense if it is an illegal payment (such as a bribe).

Bilzerian involved a taxpayer in the business of buying and selling securities. Mr. Bilzerian transferred 58,000 shares of Robertson common stock to a partnership in which he held a 99.9% interest. The partnership then sold the stock to Jeffries & Co., a broker. The stock value declined after the sale, and Jeffries eventually sold the stock at a loss. Jeffries sought compensation for its loss and Bilzerian's partnership paid Jeffries $125,000. On his tax return, Bilzerian deducted his pro rata share of the $125,000 payment as an ordinary and necessary business expense.

Several years later, Bilzerian was convicted of violating securities laws, making false statements and criminal conspiracy. One of the counts of the indictment charged that he willfully and knowingly conspired to defraud the SEC and the IRS by concealing his ownership in the Robertson stock and secretly compensating Jeffries for a trading loss. In the same year, the IRS issued a deficiency notice to Bilzerian and his wife disallowing the distributive share of the Jeffries payment deduction from the partnership. The reasoning of the IRS notice of deficiency was that this payment was made in furtherance of an illegal stock "parking" agreement between Bilzerian and Jeffries.

Bilzerian paid the assessed taxes, interest and penalties, and sued for a refund. The government moved for summary judgment, arguing that Bilzerian was collaterally estopped from denying that the payment was illegal and therefore nondeductible. The question in Tax Court was whether the criminal conviction determined that the Jeffries payment itself was illegal within the meaning of Section 162(c)(2).

Predictably, the IRS argued that this payment was nondeductible under Section 162 regardless of whether the payment itself was legal, as long as the payment was made in furtherance of an illegal activity. The Tax Court, rejected this expansive notion of what constitutes an illegal payment.

In fact, the Tax Court wrote that Section 162(c)(2) only applies to those payments that are illegal in and of themselves. See Commissioner v. Sullivan, 356 U.S. 27 (1958). See also Commissioner v. Tellier, 383 U.S. 687 (1966). Moreover, the court noted that at one time the IRS and the courts had applied a "public policy" exception to Section 162, so that even if a payment was illegal, if it was contrary to public policy to allow a deduction for it, the deduction would be denied. This amorphous "public policy" doctrine is no longer valid, both in light of the language of Section 162(c)(2) and Regulation Section 1.162-1(a).

The court also found the government's other arguments unpersuasive. The IRS had argued that a payment was an essential part of the conspiracy conviction. The Tax Court, on the other hand, found that the jury could easily have convicted Mr. Bilzerian without his having made the payments, and that the payment was only one of various "means" listed in the indictment that the jury could have found dispositive. The court found that the legality of the payment was not raised and litigated in the criminal trial, and that therefore there was nothing to estop Mr. Bilzerian from claiming the deduction.

Criminal Investment Expenses?

Even if the criminal is not sufficiently accomplished (as a criminal) to be considered engaged in a criminal trade or business (high aspirations, yes?), it is possible he may be able to deduct the legal expenses as investment expenses. In Accardo v. Commissioner, 94 T.C. 96 (1990); aff'd, 942 F.2d 444 (7th Cir. 1991); cert. denied, 503 U.S. 907 (1992), the court found that legal costs incurred by a taxpayer in his successful defense of RICO charges were nondeductible. The court agreed that these expenses did not arise in connection with the management, conservation or maintenance of the property held for the production of income. Although Accardo's acquittal on RICO charges did mean that the government could not seize his assets, this fact alone was insufficient to support the notion that the substantial expenses he incurred in defending himself were incurred for the preservation of his property.

Lies and Videotape

The deductibility of legal fees may be questioned in a seemingly endless set of fact patterns. An important recent gloss was recently offered by the Tax Court in Capital Video Corp., et al. v. Commissioner, No. 02-1564 (15 Jul 2002), Tax Analysts Doc. No. 2002-17308, 2002 TNT 154-38. The Tax Court there found that a company could not deduct the legal fees it paid for the defense of its shareholder. Plus, the shareholder was required to include the legal fee payments in his income as constructive dividends. This is the true double whammy.

Capital Video Corp. (CVC) was engaged in selling pornographic videotapes. During the 1980s and 1990s, CVC and Kenneth Guarino, CVC's shareholder, made "tribute" payments to Natale Richichi, a member of the Gambino crime family. Guarino conspired with Richichi to obstruct the IRS's collection of tax. He was indicted on federal criminal charges for the conspiracy and pled guilty to conspiracy to obstruct the lawful functions of the IRS and to evade federal income tax. CVC was not a defendant in the criminal case.

During 1995-1996 CVC paid Guarino's legal fees. Some of the payments were made after CVC made an S election. CVC claimed the legal fees as business expenses. CVC, after becoming an S corporation, also deducted the legal fees. Guarino did not report the legal fees as income.

The IRS issued a deficiency notice to CVC, disallowing all deductions for the legal fees. Plus, the IRS issued a deficiency notice to Guarino that treated the legal fees paid by CVC while a C corporation as constructive taxable dividends. The deficiency notice increased Guarino's income by the legal expenses paid by CVC as an S corporation.

The Tax Court first noted that the expenses of another generally are not deductible unless they are paid to protect a business, or if the criminal activity sufficiently relates to the conduct of the business. The court considered whether the CVC's purpose or motive in paying Guarino's legal expenses was to protect or promote the company's business. The court concluded that the legal fees were not paid to protect the business.

Thus, the payments weren't deductible by CVC. The court then found that the payment of the legal fees conferred an economic benefit on Guarino without an expectation of repayment. Thus, the legal fees paid by CVC for Guarino while CVC was a C corporation were constructive dividends to Guarino. The court also held that Guarino failed to show that the payments had a sufficient business nexus to qualify as business expenses for Guarino, and it dismissed his arguments that he was entitled to miscellaneous itemized business expense deductions for the legal fees.

On Appeal

The case is now on appeal before the Fifth Circuit. CVC argues that it properly deducted Guarino's legal fees as a business expense. CVC maintains that the Tax Court drew an erroneous and artificial distinction between the payment of "tribute" and the conspiracy to cover up the payment of that tribute. CVC insists that the two actions — payment of tribute and the cover up of those payments — are so intertwined that CVC should be allowed to deduct the legal fees paid to defend Guarino for the charges related to that cover up. In the alternative, CVC insists that Guarino should be allowed to deduct the legal fees as ordinary and necessary business expenses to him as a miscellaneous itemized deduction.

The Fifth Circuit's conclusion? The jury is still out, as they say.

Itemized Deduction

A step down from business expense deductions, of course, would be to treat the legal fees as miscellaneous itemized deductions. Of course, that could trigger potential AMT liability. In Thomas F. Noones, et ux. v. Commissioner, T.C. Memo 2000-106 (2000), the Tax Court held that an individual could not deduct legal fees as a business expense, but could only take them as a miscellaneous itemized deduction. Noones incurred $197,000 in legal fees defending himself from an indictment related to his corporation's purchase of a note from the FSLIC. He deducted the legal fees on his Schedule C. The IRS characterized the fees as incurred in the production of income (deductible under Section 212), so the legal fees were subject to the 2% floor. They also generated an alternative minimum tax liability.

The Tax Court agreed with the IRS, noting that Noones was never regularly engaged in the trade or business of buying and selling underperforming promissory notes, and that the corporation owned the note, not Noones. (His corporation should have incurred no legal fees, it would seem!)

Legal Fees in Disciplinary and License Proceedings

Even if an action does not involve criminal prosecution, disciplinary or license proceedings against a person in connection with a business or profession may be deductible. The question is whether the conduct stems from the professional business rather than from personal activities. What seems to be important is the nature of the suit against the person, i.e., whether it stems from the professional or business actions, or personal actions.

Thus, a deduction for legal fees that a lawyer pays or incurs in defending a legal malpractice case should be permissible. However, legal fees paid or incurred by a doctor in defending a bribery conviction which ultimately results in the doctor's loss of a medical license would not result in deductible legal fees. The conduct (despite its professional consequences, the suspension of the license) would not be deductible because the bribery was a personal offense. See Margoles v. Commissioner, 27 T.C.M. 319 (1968).

Just Business, Not Personal...

It may sometimes be difficult to determine whether a deduction for legal fees is appropriate based on the business nature of the suit. How do you decide whether the genesis of a suit is really personal? Consider McDonald v. Commissioner, 592 F.2d 635 (2d Cir. 1978), There, a lawyer was denied a deduction for amounts paid to settle a threatened lawsuit to contest a will that made several bequests to the lawyer. The court reasoned that although the suit might threaten the lawyer's profession, the origin of the claim was personal.

Similarly, in Sheldon Solomon v. Commissioner, T.C. Memo 1974-127 (1974), an accountant was denied a deduction for expenses resulting from the settlement of a lawsuit against him for misappropriation of his father's funds. The court determined that the matter was personal. The lawsuit attacked his role as a trustee, and certainly could impact his profession of accountancy. However, the court denied the deduction because the taxpayer did not prove that he was in the business of being a trustee.

The IRS sometimes seeks to dissect a transaction into minute pieces in order to deny deductions where it would seem that purely business activities are being pursued.

For example, in Peters, Gamm, West & Vincent, Inc., et al. v. Commissioner, T.C. Memo 1996-186 (1996), the Tax Court considered charges brought by the SEC against Don Peters, an individual partner in an investment firm. Although the firm was not named, the charges against the individual were pursued and ultimately resulted in significant legal fees. The firm paid the legal fees. The question was whether they were deductible, and if so under what category.

Ultimately, the Tax Court agreed with the IRS that deductions by the corporation should be disallowed, and that the payment should be considered constructively paid by the corporation/investment firm to Don Peters, who in turn could deduct them. Unfortunately, they were held to be deductible by Peters only as investment expenses under Section 212 rather than as trade or business expenses under Section 162. That produced an alternative minimum tax problem for Peters. Legal fees are not deductible for individual alternative minimum tax purposes, often producing unfair results. On the facts, denying the company a deduction in Peters, Gamm simply seemed unjustified.

What Now?

There doesn't seem to be an easy answer to the legal fee deduction quandary. There should be no question about the deductibility of legal fees where the company is under investigation and pays its own legal fees. However, many companies will have to pick up the tab for the legal fees of executives. Here, explicit indemnity obligations can help. But ultimately, questions may arise about the business vs. personal nexus of the expenses.

Deducting Legal Fees For Criminal Defense, Vol. 11, No. 4, The M&A Tax Report (November 2002), p. 1.