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You can be engaged in an unlawful business practice and still remove defense costs from your taxable income.
Robert Willens, CFO.com | US
March 28, 2011
Believe it or not, corporate executives found guilty of embezzlement or records falsification can in some cases take a tax deduction for their legal fees. Take the case of Daniel L. Gordon. Hired in 1998 by Merrill Lynch to start an energy trading division called Global Energy Markets, Gordon became president of GEM in 2000.
Gordon was directed to buy insurance to hedge some energy obligations Merrill had assumed under a long-term call agreement with Williams Energy Marketing and Trading Company. After unsuccessful attempts to locate a willing partner, Gordon falsely reported to Merrill that he had located an offshore fund willing to enter into a transaction that would hedge the Williams trade for $43 million.
Merrill wired about $43 million to the account of an entity known as Falcon Energy Holdings at a private Swiss bank. One month later, Gordon transferred about $33 million from Falcon's account to other bank accounts he personally controlled.
During 2000, Gordon and other Merrill employees falsified GEM's books and records to make it appear more profitable to potential buyers. In January 2001, Allegheny Energy Supply Co. acquired GEM, and Gordon became president of AES LLP.
On December 19, 2003, Gordon pleaded guilty to a three-count "information," a formal accusation by a government attorney that the defendant committed a misdemeanor. The information had charged him with wire fraud, money laundering, and conspiracy to falsify books and records. Gordon paid $319,754 in legal fees. At issue in the 2009 case, Gordon v. United States, is whether Gordon can claim an income-tax deduction for these legal fees. In part, these fees were found to be deductible.
How could that be? Under Section 162(a) of the Internal Revenue Code, a taxpayer is allowed to deduct the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. An expense is ordinary if it relates to a transaction that happens commonly or frequently in the type of business involved. An expense is necessary if it is "appropriate and helpful" for the development of the business.
Gordon asserted that he was entitled to a tax deduction under Section 162 for the legal fees paid in connection with his defense against the information. For his argument, Gordon's lawyers relied on a previous U.S. Supreme Court case, Tellier v. Commissioner. In that case, the taxpayer was a securities dealer who sought a deduction for legal fees he incurred during his unsuccessful defense against charges of violating the fraud section of the Securities Act of 1933 and mail fraud.
In the Tellier case, the Second Circuit found that the legal expenses were directly connected with carrying on his business and that legal expenses for an unsuccessful defense connected with the carrying on of a trade or business are ordinary and necessary. The defendant then argued that the legal fees were not deductible as a matter of "public policy."
The Supreme Court, however, held in that case that allowing a deduction does not offend public policy because income taxes are not a "sanction against wrongdoing" and no public policy is offended when a person is faced with serious criminal charges and employs a lawyer to help in his defense.
Gordon contended that his legal fees were directly connected with carrying on his trade or business because they stemmed from his employment and profit-seeking activities when he was the president of GEM and AES.
The charges in the information, however, arose from two separate and unrelated schemes; an embezzlement scheme and a record-falsification scheme. Those schemes, the court concluded, must be analyzed separately.
Courts have consistently found that expenses arising from embezzlement are not sufficiently related to carrying on a trade or business to qualify as a business expense. Here, the embezzlement scheme was related to Gordon's trade or business only because Gordon stole from his employer; it didn't arise out of or closely result from his employment as president of GEM or AES. Thus, the court ruled that the legal fees for Gordon's defense against charges arising out of the embezzlement scheme were not business expenses.
Gordon testified that his supervisors directed him to falsify records. The government had offered no evidence to dispute that testimony. Actions taken at the direction of one's supervisors are, undoubtedly, connected with business activities.
Moreover, even if Gordon had not been directed to falsify documents, his actions, the court found, still maintain the necessary business connection. The Tellier case makes it abundantly clear that tax deductions for business expenses are not limited to expenses incurred in the course of lawful business activity.
Gordon's participation in the record-falsification scheme was connected with and closely resulted from his employment at Merrill because the scheme was intended to further the firm's business interests by enabling GEM to command a higher purchase price. Merrill thus directly benefited from the scheme, and any personal benefit Gordon may have derived resulted from his status as a Merrill employee. This, the court concluded, is different from the embezzlement scheme, which was harmful to Merrill and beneficial to Gordon only in his personal capacity rather than his employee capacity.
Therefore, the legal fees incurred in defending against the records-falsification part of the information were found to be deductible under Section 162(a) as ordinary and necessary business expenses.
Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.