Ordinarily, deductible business expenses include payments to settle disputes, whether the payments are made to satisfy judgments or as out-of-court settlements. But the IRS is clear that it will allow the deduction only if the argument arose from a business-related activity, as opposed to a personal matter.
And when it comes to your reputation, the line between business and personal is thin indeed. What controls the outcome are the particular circumstances.
For example, a federal appeals court refused to allow a write-off for the cost of settling a will contest, notwithstanding that the taxpayer settled to protect his reputation as a lawyer. Apparently because of a close friendship, attorney William McDonald was named the major beneficiary in the will of a client, an elderly widow. The New York lawyer had not prepared the original will, but did draft a later codicil that modified the will by including him among the beneficiaries. That circumstance prompted some of the widow's relatives to contest the will on the basis that he had exerted undue influence. He agreed to an out-of-court settlement of $121,000, and the written agreement states that "it appears the litigation of the issues would engender much publicity and would endanger the reputation of McDonald as an attorney."
The court barred a business expense for the $121,000. The proper standard for deductibility here, said the court, is the "origin-of-the-claim" test. The origin of the lawyer's rights under the will was his personal relationship with the client, not his law practice. Consequently, it made no difference that his primary purpose in agreeing to the settlement was to protect his reputation as a lawyer.
The origin-of-the-claim test also tripped up pro-football star Michael Hayden when he tried to deduct a payment to hush a sex scandal. While the former safety for the Los Angeles Raiders and co-captain for the Denver Broncos was negotiating a contract renewal with Denver, ex-girlfriend Michelle Moore filed a sexual-assault charge against him for what happened when he visited her home in an unsuccessful attempt to make amends after they had an argument. The Broncos found out and threatened to trade or release him if the matter became public.
To stop this, Michael paid Michelle $25,000 for dropping the complaint and keeping quiet. The Broncos then signed him to a five-year contract. He deducted the $25,000 as a "professional development expense." His reasoning: He wouldn't have made it if his job hadn't been jeopardized.
The IRS tossed it out as a nondeductible personal expense and the Tax Court agreed. The 1991 decision held that the origin of the charge leading to the payment arose out of Michael's personal relationship with Michelle, not out of his job. That the consequences of the allegations against the athlete were business-related didn't make the payoff deductible.
J. C. McCaa, an Arkansas auto dealer who disapproved of divorce, settled a claim for personal injuries resulting from his having struck a girlfriend of his married son. A skeptical Tax Court concluded that the payment was made to shield him and his family from potential scandal, not to avoid cancellation of his dealer's franchise.
William Harper taught high-school science and owned rental property. He paid damages and legal expenses to settle an invasion-of-privacy suit brought against him by a tenant. She asserted that William installed a listening device in her apartment and connected it to his office so he could hear what was said and done in the apartment. The suit, noted the Tax Court, might make it more
difficult for William to do business in his West Virginia community, but the payments weren't deductible because they were made for his own personal protection.
Julian Block writes and practices law in Larchmont, N.Y. He is frequently quoted in the New York Times, the Wall Street Journal, and the Washington Post, and has been cited as: "a leading tax professional" (New York Times); "an accomplished writer on taxes" (Wall Street Journal); and "an authority on tax planning" (Financial Planning Magazine).
His tax guides include "Tax Deductible Travel and Moving Expenses," "Tax Tips for Marriage and Divorce," "Easy Tax Guide for Writers, Photographers, and Other Freelancers," and "Home Seller's Guide to Tax Savings." For information about his books, go to julianblocktaxexpert.com.