Opinion
Docket No. 28368.
1951-10-11
WILLIAM L. BUTLER, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Andrew B. Young, Esq., and David P. Brown, Esq., for the petitioner. Stanley W. Herzfeld, Esq., for the respondent.
Petitioner, who was engaged in the business of acting as a consultant, officer, or director of public utility corporations, was an officer and director of a corporation undergoing reorganization under section 77B of the Bankruptcy Act. He paid $9,976.50 in settlement of a claim which arose from an alleged breach of a fiduciary duty arising out of certain profits made by his wife with respect to her purchases and sales of bonds of the corporation. Held, such payment was made in connection with petitioner's trade or business; and, since its allowance as a deduction would not frustrate a clearly defined public policy, it is deductible in the year in which paid. Held, further, legal expenses incurred by petitioner in such settlement are also deductible. Andrew B. Young, Esq., and David P. Brown, Esq., for the petitioner. Stanley W. Herzfeld, Esq., for the respondent.
The respondent determined a deficiency in income tax for the taxable year 1946 in the amount of $6,071.38.
The issues are: (1) whether $9,976.50 paid by the petitioner in settlement of a claim is deductible, and (2) whether legal expenses in the amount of $718.77 incurred in such settlement are deductible.
Some of the facts were stipulated.
FINDINGS OF FACT.
The stipulated facts are so found and are incorporated herein.
Petitioner, an individual, filed his income tax return for 1946 with the collector of internal revenue at Philadelphia, Pennsylvania. Since prior to 1934 he has been married to Helen E. Butler (hereinafter referred to as Helen).
Since 1919 and throughout all times material to this proceeding petitioner has been engaged, either on his own account or as an employee of others, in the business of acting as an officer, director, and adviser of numerous public utility corporations. From 1930 to 1937 petitioner was vice-chairman of the board of Philadelphia & Western Railway Company at Norristown, Pennsylvania (hereinafter referred to as the Company); and from 1937 to 1945, he was executive vice-president of the Company. His services to the Company were performed concurrently with his services to other corporations and required about one-third of his time. He resigned from such position on April 15, 1945. Compensation for services to the Company were not received directly from it but from the Conway Corporation of which petitioner was vice-president. This latter corporation had a contract with the Company to manage its affairs.
Prior to July 1, 1934, the Company had issued certain 5 per cent first mortgage bonds due in 1960. Default in interest payments on these bonds occurred on July 1, 1934, and the Company on July 3, 1934, filed a petition under section 77B of the Bankruptcy Act of the United States in the United States District Court for the Eastern District of Pennsylvania. This petition was approved on July 3, 1934, with the Company continuing in possession of its properties and assets subject to the jurisdiction of the court. The Conway Corporation continued under its contract to manage the Company. Petitioner served as a director or as an officer in charge of the operation of the Company as well as of its rehabilitation.
During the years 1935 to 1940 (while the Company was still undergoing reorganization under section 77B) Helen purchased some of the Company's first mortgage 5 per cent bonds due in 1960 in the face amount of $44,000, at a total cost of $2,807. No purchase orders for said bonds were placed with brokers nor were there any negotiations by her or by petitioner with the former bondholders for these purchases. Rather, the brokers would contact petitioner when they had any available, since Helen was quite deaf and could not carry on any telephone conversations at that time. At the time of such purchases the Company's financial affairs were so bad that there was no demand for said bonds in the market. None of them were purchased as the result of information of the Company's affairs or prospects acquired by petitioner as an officer of the corporation. During the years, petitioner and Helen had made it a practice to invest in the stocks or bonds of corporations in which petitioner was serving at the time. Petitioner and Helen had individually invested in securities of Cincinnati & Lake Erie Railroad Company while this corporation was in receivership and petitioner was its operating manager in the employ of receivers appointed by the Court. They were made after petitioner had obtained advice of counsel that he could legally purchase such securities while acting as an officer for the receivers.
During 1943 and 1944 the Company's' bonds greatly increased in value, due in part to increased wartime traffic, in part to the imminence of approval and completion of a plan of reorganization, but primarily due to the fact that in these years a contest for the control of the corporation developed between the former bondholders and stockholders and the present owners of the Company. Petitioner, not within to become involved in this contest for control, resigned as an officer of the Company and Helen sold her bonds also to avoid becoming involved in the contest.
Helen sold these bonds during 1943 and 1944 for a total selling price of $19,200 from which sale she received a gain in the amount of $16,413. She reported all of this profit as long term capital gains in her individual income tax returns for the years 1943 and 1944, and paid the taxes thereon. She had also reported interest received on said bonds during 1941, 1942, and 1943 in her individual income tax returns for those years.
On or about October 19, 1945, the Bondholders Committee for Philadelphia & Western Railway Company filed with the United States District Court for the Eastern District of Pennsylvania, a petition for a rule to show cause why an order should not be entered against petitioner and other officers and directors of the Company to account for any profits made by them or their close relatives, either directly or indirectly, from the sale of the bonds of the Company. Such an order to show cause was entered by the court against petitioner and the other defendants on October 19, 1945. After a hearing on the rule, on February 11, 1946, the court entered its opinion in which the petition was dismissed as to two of the defendants. Petitioner was not present at the hearing on the rule, by reason of a continuance by the court as to him, and was not referred to in the said opinion of February 11, 1946.
On or about May 23, 1946, the Bondholders Committee filed a Petition to Settle Claims Against Directors in the said proceeding. The petitioner recited among other things, as the reasons of the Bondholders Committee for the filing thereof, that the parties named in the opinion of the court issued on February 11, 1946, announced their intention to request the court to reopen the record for additional evidence and also indicated their intention of appealing the decision, and that the Bondholders Committee believed that ‘the law involved in the case was not clearly settled‘ and also recognized ‘certain equities in the defendants' favor.‘ The court, after a hearing on the petition on August 16, 1946, entered its order approving the proposed settlement, and entered judgment against the defendants. Judgment was ordered to be entered against petitioner in the amount of $9,976.50.
Although the petitioner was not named in the opinion of the court of February 11, 1946, he consented to the entry of judgment against him since he was desirous of avoiding any unfavorable publicity which would affect his business reputation. Petitioner paid the Company $9,976.50 on August 22, 1946, and received a release dated September 21, 1946. Petitioner paid legal fees of $718.77 arising from the suit; $200 on May 21, 1946, and $518.77 to other counsel on October 21, 1946.
In his Federal income tax return for 1946 petitioner claimed a deduction of $10,695.27, this figure made up of the amount paid to the Company plus legal fees incurred therein.
OPINION.
RICE, Judge:
The first issue is whether the respondent erred in disallowing the deduction of $9,976.50 paid by petitioner in 1946 to the Company as a compromise settlement pursuant to an order of the United States District Court for the Eastern District of Pennsylvania. Respondent disallowed said deduction on the ground that it was deductible neither as a business expense under section 23(a)(1) of the Internal Revenue Code, nor as a loss under section 23(e)(1) or (2).
Both parties agree that petitioner's business was that of acting as a consultant, officer, or director of public utility corporations. The respondent maintains, however, that the expense or loss which petitioner suffered was not incurred in petitioner's trade or business of participating in the management of public utility corporations, but rather that it grew out of his acting as a trustee responsible to the court because of the reorganization under section 77B of the Bankruptcy Act in which the Company was engaged. We cannot agree with respondent in this argument. Petitioner's business was that, as we said above, of acting as a consultant, officer, or director of public utility corporations. He had been engaged in this business since 1919 either on his own account or an an employee of others. He became associated with the Company in 1930 as an employee of the Conway Corporation, a public utility management and consulting firm, in which petitioner was vice-president from 1926 to 1945. This corporation had the management contract with the Company. When the Company filed its petition under section 77B of the Bankruptcy Act in 1934, the management contract was continued subject, of course, to the jurisdiction of the court. We fail to see how such activity on the part of petitioner under such bankruptcy proceedings was any less his business than management of a solvent corporation.
SEC. 23. DEDUCTIONS FROM GROSS INCOME.In computing net income there shall be allowed as deductions:(a) EXPENSES.—(1) TRADE OR BUSINESS EXPENSES.—(A) In General.— All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; traveling expenses (including the entire amount expended for meals and lodging) while away from home in the pursuit of a trade or business; and rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which the taxpayer has not taken or is not taking title or in which he has no equity.(e) LOSSES BY INDIVIDUALS.— In the case of an individual, losses sustained during the taxable years and not compensated for by insurance or otherwise—(1) if incurred in trade or business; or(2) if incurred in any transaction entered into for profit, though not connected with the trade or business; or
The respondent also argues that there was no proximate relationship between the payment of the compromise settlement by petitioner and his services as a director and officer of the Company. Kornhauser v. United States, 276 U.S. 145 (1928). This Court has held that the payment in settlement of a suit for breach of trust or mismanagement of funds by a fiduciary, where the threatened litigation is bona fide, is deductible in those instances where the threatened litigation arises either out of the business of the taxpayer or some transaction he has entered into for profit. John Abbott, 38 B.T.A. 1920 (1938); Great Island Holding Corporation, 5 T.C. 150 (1945). In the latter case, we said:
We do not doubt that the payment in question is one for which the petitioner is entitled to a deduction under section 23 of the Revenue Act of 1938. Whether the deduction be characterized as an ordinary and necessary business expense or as a loss incurred in his trade or business is of little moment here, for the payment is obviously one or the other and the result is the same. See Bishop Trust Co., Ltd., 47 B.T.A. 737; John Abbott, 38 B.T.A. 1290. The controversy amounted to a demand by the preferred shareholders for damages against the principal officer of the corporation for alleged mismanagement of corporate affairs. The payment was directly connected with and proximately resulted from petitioner's business activity. Kornhauser v. United States, 276 U.S. 145; Commissioner v. Heininger, 320 U.S. 467. * * * (p. 163).
Stephen H. Tallman, 37 B.T.A. 1060 (1938), cited by respondent as authority for not allowing the deduction is readily distinguishable from the case at bar. In that case the deduction was not allowed since it involved the liability of a fiduciary in an isolated fiduciary activity not incidental to, nor itself the trade or business of the taxpayer, nor was it a transaction entered into for profit by the taxpayer.
There is no reason in this case to deny the deduction because its allowance would frustrate a clearly defined public policy. Commissioner v. Heininger, 320 U.S. 467 (1943). While the litigation arose and involved the question of the breach of the fiduciary's duty, the fact that petitioner agreed to the compromise payment in no wise necessitates the conclusion that such was actually the case. The opinion of the District Court of February 11, 1946, did not concern the petitioner since the court had granted continuances as to him. In that opinion was dismissed as to two of the defendants. In addition the settlement petition filed on May 23, 1946, indicated that the Bondholders Committee, which was petitioner in the claim, was not certain that the opinion of the court would be affirmed upon appeal. Petitioner testified that the reason he entered into the agreement and paid the settlement was because of his fear of damage to his reputation as a public utility consultant or manager from unfavorable publicity which might result from continued litigation.
It must be borne in mind that we are not here dealing with an instance where the petitioner purchased the bonds in question. Petitioner did not purchase any bonds, nor did he enjoy any profits from them. The bonds were purchased from 1935 to 1940 by Helen following an established policy on her part to purchase securities in which petitioner was acting as a consultant, director or officer. No orders were placed with brokers for these bonds, nor were any of their owners consulted by either petitioner or Helen. When bonds were available on the market (and there was little market for them at that time), the broker was the one who inquired as to whether she was interested in purchasing them. They were purchased at the prevailing market rate. Profits resulting from Helen's dealing in these bonds were reported by her in her individual tax returns and she paid the taxes on them. The proceeding by the Bondholders Committee was therefore not against petitioner for any profits which he might have obtained but rather for profits obtained by relatives. The suit was bona fide and as indicated by the petition for settlement neither side was convinced of its ultimate success. Under such circumstances, the deduction of the compromise payment by petitioner to prevent further damage to his business reputation certainly can not be said to be against public policy.
For reasons set out above we hold that the respondent erred in not allowing the deduction of $9,976.50 paid by petitioner in a compromise settlement of litigation.
The next issue is whether petitioner may deduct legal expenses in the amount of $718.77 incurred in connection with said litigation. In Kornhauser v. United States, 276 U.S. 145 (1928), the Court said:
The basis of these holdings seems to be that where a suit or action against a taxpayer is directly connected with, or, as otherwise stated (Appeal of Backer, 1 B.T.A. 214, 216), proximately resulted from, his business, the expense incurred is a business expense within the meaning of (the Internal Revenue Code) * * * . These rulings seem to us to be sound and the principle upon which they rest covers the present case. * * * (p. 153).
It is not uncommon for corporate officers or directors to be involved in litigation concerning their activities in such capacities, and employment of counsel is a necessarily accepted means of defending such actions. Such expenses are, therefore, both ordinary and necessary.
Since such litigation concerning an alleged breach of duty by the petitioner arose out of the petitioner's trade or business, respondent erred in disallowing the deduction of said attorneys' fees.
Decision will be entered for the petitioner.