Tax Court Addresses Deductibility of Business Owner's Settlement Payment

(Parker Tax Publishing May 2019)

The Tax Court held that a taxpayer, who was in the custom home building and construction business and was the majority shareholder in a C corporation and an S corporation involved in that business, was entitled to deduct a portion of settlement payments made to customers who filed lawsuits relating to faulty construction of homes they purchased. The Tax Court found that, because the lawsuits were partially attributable to each business, the owner could deduct half of the settlement as a passthrough loss from the S corporation and the other half as an unreimbursed employee business expense. Ferguson v. Comm'r, T.C. Memo. 2019-40.

Background

Rick Ferguson has been in the custom home building and construction business for over 30 years. Ferguson operates his business through several different entities that engage in various stages of home design and construction. Ferguson serves as a partner, shareholder, and member in these entities that are organized as partnerships, limited liability companies, and corporations.

This case involved two such entities: Rick Ferguson, Inc. (RFI), and Pinnacle Precast Co. (Pinnacle). RFI, a C corporation of which Ferguson is the majority shareholder, operates as a general contractor on custom home construction jobs. RFI paid Ferguson a salary of $44,400. Pinnacle, an S corporation of which Ferguson was also the majority shareholder, manufactured, supplied, and installed cast stone.

In 2005, RFI contracted with a third party (homeowners) for the sale of three lots in Little Rock, Arkansas, and the construction of a home on those lots. Ferguson signed the contract on behalf of RFI. RFI subcontracted with Pinnacle, which it hired to produce and install cast stone for use in the construction of the dwellings. After construction was completed, relations between Ferguson and the homeowners became acrimonious. The homeowners claimed that the cast stone panels, balustrades, and columns threatened to fall or collapse due to defects in their manufacture and installation.

The homeowners sued RFI, Pinnacle, and Ferguson seeking a multimillion-dollar judgment on various legal grounds. Over the course of the litigation, the homeowners filed amended and second amended complaints. They alleged various problems with the construction of the dwellings, but their primary grievance pertained to the cast stone. The homeowners said that Pinnacle improperly manufactured the cast stone and that RFI improperly installed it. The homeowners also alleged that Ferguson, as the majority stockholder and principal of RFI and Pinnacle, misrepresented those entities' expertise in manufacturing and installing cast stone. The homeowners sought to hold Ferguson jointly and severally liable with RFI and Pinnacle for negligence, deceit, constructive fraud, and deceptive trade practices.

In 2011, the homeowners, Ferguson, RFI, and Pinnacle agreed to settle the lawsuit. Under the settlement, Ferguson transferred nine parcels of real estate to the homeowners and gave the homeowners a check drawn on his personal bank account. Pinnacle treated the check and the fair market value of the transferred real estate (collectively, the settlement payment) as a loan from Ferguson, but no written loan documents were prepared and no interest was accrued. Pinnacle had no sales or gross receipts in 2012, and Ferguson shut it down later that year. Ferguson assumed Pinnacle's liabilities regarding the recorded loan, essentially relieving Pinnacle of the obligation to repay him.

On its 2011 tax return, Pinnacle claimed deductions for ordinary business expenses, including legal fees, the settlement payment, and an ordinary loss from the deemed sales of the three parcels transferred to the homeowners. Ferguson reported a passthrough loss from Pinnacle on his 2011 tax return and carried it forward to 2012. The IRS issued a notice of deficiency to Ferguson for 2011 and 2012, disallowing the passthrough loss deduction from Pinnacle. Instead, the IRS treated the settlement payment as an unreimbursed employee business expense pertaining to Ferguson's employment with RFI.

Ferguson challenged the notice in the Tax Court. He argued that Pinnacle properly deducted the settlement payment and that he was entitled to his pro rata share of the deduction. He claimed that the homeowners' lawsuit was attributable to Pinnacle, and the payment of the settlement by Ferguson should be treated as a loan or capital contribution. Alternatively, Ferguson contended that the settlement payment was deductible on Schedule C as an ordinary and necessary expense. The IRS countered that Pinnacle could not deduct any costs pertaining to the lawsuit because it did not pay or incur them.

Analysis

The Tax Court held that Ferguson could not deduct the settlement payment on Schedule C because, under U.S. v. Gilmore, 372 U.S. 39 (1963), the origin of the underlying claims in the lawsuit was the work performed by RFI and Pinnacle, both of which filed corporate returns for 2011. The court noted that the homeowners' primary grievance related to the cast stone work, which was performed and/or supervised by RFI and Pinnacle. The court also noted that Ferguson was not a party to the contract with the homeowners. The Tax Court held that Ferguson's payment of the settlement was not a loan to Pinnacle because no loan documents were prepared and there was no fixed repayment date or schedule and Ferguson knew that Pinnacle would be unable to repay him when he funded the settlement. Accordingly, Ferguson failed to show a debtor-creditor relationship with Pinnacle, in the court's view.

The Tax Court determined that the lawsuit was attributable partially to RFI and partially to Pinnacle so it allocated 50 percent of the settlement payment to each entity. The court deemed 50 percent of the settlement payment an expense of Pinnacle. Pinnacle was therefore allowed to deduct that amount, and Ferguson was entitled to his pro rata share of any loss produced by the deduction. With respect to the other 50 percent that was an expense of RFI, the court noted that it would normally hold that this portion was not deductible to Ferguson but rather a capital contribution to the C corporation. However, because the IRS conceded that Ferguson could deduct amounts paid on RFI's behalf as unreimbursed employee business expenses, the court allowed Ferguson to deduct 50 percent of the settlement payment as such an expense.

For a discussion of deduction issues relating to S corporation shareholders, see Parker ¶31,945. For a discussion of unreimbursed employee business expenses, see Parker ¶85,105.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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