Gralia v. Comm'r

MEMORANDUM OPINION

HALPERN, Judge: By notice of deficiency (the notice), respondent determined deficiencies of $ 163,475 and $ 62,572 in petitioners' Federal income tax for taxable (calendar) years 1996 and 2001, respectively.

Unless otherwise stated, section references are to the Internal Revenue Code in effect for the years in issue and Rule references are to the Tax Court Rules of Practice and Procedure.

The parties submitted this case fully stipulated under Rule 122. The stipulated facts are so found, and the stipulation of facts, with accompanying exhibits, is incorporated herein by this reference.

Respondent has conceded one issue; we must decide only whether (1) petitioners' deduction of a $ 600,000 settlement (the settlement) is a miscellaneous itemized deduction and (2) petitioners may deduct $ 15,217 in related legal fees (the legal fees). ¹ Petitioners bear the burden of proof. See Rule 142(a). ^2*222

Petitioners are husband and wife who made joint returns of income for the years in issue. At the time they filed the petition, they resided in Florida.

Ernest A. Gralia, Jr. (petitioner), was a general contractor involved in the construction of residential and commercial buildings and was the owner and principal officer *223 of an S corporation, E.A. Gralia Construction Co. (Gralia Construction). Charles F. Maurer, Jr. (Mr. Maurer), was the son of the owner of a site development business, which petitioner sometimes hired as a subcontractor on construction projects. In 1972, when Mr. Maurer graduated from high school, petitioner hired him as a laborer. In 1973, petitioner asked Mr. Maurer if he would like to work in the company office instead of the field, and Mr. Maurer accepted. Over the next few years, as Mr. Maurer began his college education in business and finance, petitioner increasingly depended on him to manage the office.

In 1975, petitioner became interested in undertaking government-subsidized housing projects. In late 1975, two men asked petitioner to quote a price for the construction of a proposed subsidized project, Pheasant Hill Village. The two men were the sole general partners of Pheasant Hill Village Associates (Pheasant Hill). In February 1978, petitioner acquired a 55-percent general partnership interest in Pheasant Hill (thereby replacing one of the general partners) and became managing general partner of that partnership. One month later, petitioner's *224 lawyer formed Eastmont Development Corp. (Eastmont). Petitioner was its president, Mr. Maurer its treasurer, and petitioner's lawyer its clerk. The same men were its three directors. Petitioner transferred a 45-percent general partnership interest in Pheasant Hill to Eastmont, and Eastmont replaced petitioner as managing general partner. Eastmont issued stock to petitioner and to no one else. Mr. Maurer understood himself to be entitled to one-third of Eastmont's stock.

Petitioner became involved in three other partnerships (together with Pheasant Hill, the partnerships). In the first two partnerships, petitioner and Eastmont (or its wholly owned subsidiary) were general partners. In the third partnership, 120 Chestnut Street Limited Partnership (Chestnut House), petitioner was both general partner and a limited partner.

In September 1981, Mr. Maurer left his positions at Gralia Construction and Eastmont. At that time, he asked petitioner for his share of Eastmont's stock. Petitioner demurred.

In April 1982, Mr. Maurer commenced a civil action against petitioner and others in the Superior Court of Hampden County, Massachusetts (the State court case and the superior *225 court, respectively). Among other things, Mr. Maurer sought to recover his share of Eastmont's stock and any associated dividends or other benefits. The superior court bifurcated the action, addressing liability first and damages second. In February 1988, the superior court issued a "Memorandum" (the first State court ruling), holding that Mr. Maurer was a one-third owner of Eastmont. In December 1988, the superior court issued its "Findings, Rulings and Order for Judgment" (the second State court ruling; together with the first State court ruling, the State court rulings). The superior court prefaced its discussion with its understanding of the nature of Mr. Maurer's claims:

This is not a stockholders' derivative action in which the plaintiff seeks damages on behalf of the corporation for monies improperly expended by it. In this case[,] the plaintiff is seeking to recover his proportionate share of monies or other benefits which * * * [petitioner] may have taken from the corporation in the nature of dividends. He is seeking to enforce the fiduciary duty which * * * [petitioner], as majority shareholder, owed to him as minority shareholder (as defined in Donahue v. Rodd Electrotype Co. of New England, 367 Mass. 578, 328 N.E.2d 505 [(1975)]), *226 rather than recompense for any loss alleged to have been caused to the corporation by * * * [petitioner's] actions. See Bessette v. Bessette, 385 Mass. 806, 434 N.E.2d 206 (1982). The effort, therefore, was to identify those payments or direct benefits which * * * [petitioner] had received from Eastmont Development Corporation since its formation.

The superior court found, among other facts, that petitioner had been improperly claiming Eastmont's share of the partnership losses.

[Petitioner] apparently has used his position of control to usurp a much larger proportion of the equity ownership than that to which he is entitled. On the record before me it is not possible to right the wrong that has been done to Eastmont except by ordering * * *[petitioner] to amend his tax returns for the years in question to reflect the true division of ownership.The superior court also ordered petitioner to pay Mr. Maurer approximately $ 12,000 for causing Eastmont to pay the premiums on petitioner's life insurance policy. Petitioner appealed, and, in October 1994, the Massachusetts Appeals Court (the appeals court) affirmed most of the State court rulings. ^3*227

In November 1996, Mr. Maurer commenced a civil action against petitioner and others in the U.S. District Court for the District of Massachusetts (the District Court case and the District Court, respectively). Mr. Maurer amended his complaint three times, ⁴ and, for purposes of this case, we consider only the Third Amended Complaint and Jury Demand (the third amended complaint). In January 2001, Mr. Maurer agreed to the dismissal of his action against the defendants in the District Court case in return for $ 600,000.

A single law firm represented the defendants in the District Court case. That law firm billed "The Gralia Group" for its services, and, in 2001, Gralia Construction paid the law firm $ 15,217 (i.e., the legal fees).

Petitioners filed a Form 1040, U.S. Individual Income Tax Return, for 2001. They attached thereto a Schedule C, Profit or Loss From Business, which showed petitioner *228 as the proprietor of a business described as "CONSULTING-DIRECTOR". On that Schedule C, petitioners claimed deductions for the settlement and the legal fees, which caused them to have a net loss on Schedule C of $ 615,217. In October 2002, petitioners filed Form 1045, Application for Tentative Refund, claiming a carryback net operating loss for 1996 as a result of the Schedule C loss claimed on their 2001 Form 1040. In November 2003, petitioners filed Forms 1040X, Amended U.S. Individual Income Tax Return, for 1996 and 2001.

In an attachment to the notice, respondent set forth his adjustments giving rise to the deficiencies in issue. He explained that he was disallowing the deduction for the settlement on the ground that the settlement was not "an ordinary and necessary business expense as per Section 162 of the Internal Revenue Code." He explained that he was disallowing the deduction for the legal fees on the ground, among others, that petitioner had not paid them. The disallowance of the carryback to 1996 followed from the disallowance of deductions for the settlement and the legal fees.

On brief, respondent concedes: "[P]etitioners are *229 entitled to deduct the * * * [settlement] on Schedule A of their 2001 return as a miscellaneous expense subject to the limitations under I.R.C. section 67." Specifically, respondent concedes that petitioners may deduct the settlement as either an employee business expense under section 162(a) or an expense related to petitioner's investment in Eastmont under section 212(2). Respondent's concession, however, does not help petitioners much; because of the alternative minimum tax, any miscellaneous itemized deduction will have only a limited effect (if any) on petitioners' tax liabilities. ^5*230 See sec. 56(a)(4), (b)(1)(A)(i), (d).

Section 162(a) allows a deduction for "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business". Section 212(2) allows a deduction for certain expenses related to investments; i.e., expenses "for the management, conservation, or maintenance of property held for the production of income". Most section 162(a) expenses related to the performance of services as an employee and section 212(2) expenses related to stock ownership are deductible only as itemized deductions. Here, if the settlement is such an employment-or shareholder-related expense, then it is a "miscellaneous itemized deduction". See sec. 67(b).

Respondent argues that petitioner paid the settlement neither in connection *231 with his trade or business as a self-employed consultant nor in connection with his trade or business as a real estate developer. Rather, respondent argues, petitioner paid the settlement in connection with either his employment by Eastmont or his status as an Eastmont shareholder. According to respondent, in both cases the result is the same: Petitioners may deduct the settlement only as a miscellaneous itemized deduction under section 67.

Respondent also denies that petitioner himself paid the legal fees, asserting that petitioner's lawyers issued bills to "the Gralia Group", i.e., all the defendants in the District Court case, and that Gralia Construction paid those bills.

Petitioners assert that Mr. Maurer's claims in the District Court case were "against * * * [petitioner] directly for * * * business opportunities * * * [petitioner] personally" usurped from Eastmont. Petitioners argue that petitioner settled a claim against himself as a real estate developer and not any claim against himself as a mere officer or shareholder of a real estate developer. First, petitioners argue that, because in the State court case Mr. Maurer did not make any derivative claim *232 as a shareholder of Eastmont, "res judicata" (claim preclusion) barred him in the District Court case from making any similar claim. Second, petitioners argue that Mr. Maurer's claim for his share of the "benefits of stock ownership in Eastmont" fails to state a "damage claim" because Eastmont never made any dividends, profits, or distributions. Because Mr. Maurer made only those two claims, petitioners argue that, to understand the reason petitioner settled, we must look through the stated claims to "determine the essence of Mauer's [sic] claim". Petitioners find "the true substance of Mauer's [sic] claim" in paragraph 39 of the third amended complaint: "[Petitioner] has ignored the corporate form, [and] engaged in self-dealing by usurping corporate opportunities rightfully belonging to Eastmont". According to petitioners, "There is no money in the claims of Mauer [sic] against * * * [petitioner] other than those which can be traced to the Partnership Equity." Thus, the claim petitioner settled for $ 600,000 was a claim against himself personally for "the benefits", i.e. "partnership equity", petitioner "obtained at Mauer's [sic] expense".

Petitioners assert that, although Gralia Construction *233 paid the legal fees in 2001, Gralia Construction issued petitioner a Schedule K-1, Shareholder's Share of Income, Credits, Deductions, etc., causing petitioners to report as income the legal fees Gralia Construction paid on petitioner's behalf.

We agree with respondent that petitioner has failed to show that he paid the settlement in connection with his trade or business as a real estate developer.

In effect, petitioners argue that, although Mr. Maurer failed to state a valid claim in the District Court case, petitioner settled because Mr. Maurer could have made a valid claim. ^6*234 Petitioners suggest that, because of the "laxity of notice pleading," petitioner did not bother to move for summary judgment, but rather, after almost two decades of litigation, preemptively settled. The plausibility of their argument notwithstanding, petitioners have failed to show that Mr. Maurer had any claim against petitioner personally other than to enforce the fiduciary duty that the superior court had concluded that petitioner, as a majority shareholder, owed to Mr. Maurer, as a minority shareholder. ⁷

Petitioners argue the following: (1) Petitioner usurped corporate opportunities of Eastmont; (2) Mr. Maurer, in his own right, had a claim to those corporate opportunities; therefore, (3) petitioner settled the claim with Mr. Maurer. Petitioners imply that, because petitioner improperly took corporate opportunities in which Mr. Mauer *235 had a right to participate (and petitioner personally profited therefrom), Mr. Maurer, for that reason, and for no other reason, had a direct claim against petitioner. Petitioners are mistaken.

To prove that Mr. Maurer had a claim against petitioner personally for the usurpation of joint opportunities, petitioners must show that Mr. Maurer was personally entitled to participate in the "usurped" corporate opportunities. Petitioners must show that Mr. Maurer and petitioner were partners or coadventurers and that petitioner took for himself something belonging to the joint venture. See generally Meinhard v. Salmon, 249 N.Y. 458, 164 N.E. 545 (N.Y. 1928). That is, petitioners must show that Mr. Maurer had a claim that did not derive from his one-third ownership of Eastmont. Except obliquely, petitioners do not even suggest Mr. Maurer had any right to participate in the partnerships. Petitioners come closest to making that averment in the conclusion of their reply brief: Petitioner and Mr. Maurer "specifically contemplated partnership equity ownership in their names". Petitioners, however, offer no evidence that Mr. Maurer had any right to participate in the partnerships (or any other "usurped" corporate *236 opportunities, which petitioners fail to specify) except through Eastmont.

In conclusion, petitioners have failed to show that Mr. Maurer was entitled to recover against petitioner personally on a claim of usurpation of any joint opportunity. They have failed to show that petitioner settled any claim other than a claim Mr. Maurer had as a one-third owner of Eastmont. On the evidence considered so far, they have failed to show that the settlement was deductible as other than an employment-related section 162(a) expense or a shareholder-related section 212(2) expense; they have therefore failed to show that it is deductible as other than a miscellaneous itemized deduction.

Although petitioners assert that they reported as income the legal fees Gralia Construction paid on petitioner's behalf, they have failed to satisfy their burden of proof. Petitioners have provided no Schedule K-1 received from Gralia Construction, and the Schedule E, Supplemental Income and Loss, attached to their 2001 Form 1040, reports only a loss from Gralia Construction. Although Schedule B, Interest and Ordinary Dividends, reports a $ 15,365 ordinary dividend from Gralia Construction, petitioners *237 have failed to establish any connection between the legal fees and that ordinary dividend ($ 148 more than the legal fees). Nevertheless, on brief, respondent appears to concede that petitioners may deduct the legal fees as a miscellaneous itemized deduction. We accept that concession and so hold.

On the evidence considered so far, petitioners may deduct the settlement and the legal fees only as miscellaneous itemized deductions.

Petitioners make an alternative argument with respect to the settlement that avoids its classification as a miscellaneous itemized deduction. They argue that they may deduct the settlement under section 1341(a)(4) as the restoration of an amount received under a so-called claim of right. Section 67(b)(9) excludes from the definition of "miscellaneous itemized deductions" "the deduction under section 1341".

Section 1341(a) addresses the computation of tax where a taxpayer restores a substantial amount held under a claim of right. In pertinent part, section 1341 provides:

SEC. 1341(a). General Rule. -- If --