"Not for Profit" ... Part 1

Barry v. Comm’r, T.C. Memo. 2017-237, 2017 WL 5899406 (2017)

(a) Facts: When the parties were divorced, the husband agreed to pay the wife $2,400 per month in alimony. Twenty-four years later, the husband filed an action against the wife in federal court for breach of contract, arguing that he had overpaid alimony and that the wife was required to return the overpayment. The action was dismissed quickly as time-barred.

On his 2013 tax return, the husband took a deduction of $34,250 for legal fees paid in the dismissed action. The IRS disallowed the deduction, and the husband petitioned for relief in the Tax Court.

(b) Issue: Was the husband entitled to claim the challenged deduction?

(d) Summary of Rationale: The husband argued that if he had prevailed in the dismissed action, the overpayments he recovered would have been taxable income. The husband, therefore, argued that his legal fees were expenses incurred “for the production or collection of income” under I.R.C. § 121(1).

The U.S. Supreme Court has held that attorney’s fees in a divorce case are generally not deductible expenses because they arise from the taxpayer’s marital relationship and not from any profit-seeking activity. United States v. Gilmore, 372 U.S. 39 (1963). Stated differently, taxpayers do not engage in divorce litigation to seek profit.

The husband argued that Gilmore was based only upon what is now § 212(2), allowing a deduction “for the management, conservation, or maintenance of property held for the production of income.” Barry, 2017 WL 5899406, at *2 n.4. The court disagreed, and Gilmore applies under § 212(1) as well. A divorce case is not a device “for the production or collection of income.”

The husband argued that case law under former I.R.C. § 71 allows alimony recipients to deduct legal fees under § 121(1) as an expense incurred to produce income. See, e.g., Wild v. Comm’r, 42 T.C. 706 (1964). But those cases relied in part upon a specific IRS regulation permitting such a deduction. Treas. Reg. § 1.262-1(b)(7). The same regulation refuses to create a broader exception. “Generally, attorney’s fees and other costs paid in connection with a divorce, separation, or decree for support are not deductible by either the husband or the wife.” Id. The court held that the rule stated in the Regulation applied and that the husband was not entitled to take the challenged deduction.

Observations:

The husband’s attempt to generate income by filing the contract action against the wife was a spectacular failure. It was dismissed for such a clear reason (failure to meet the statute of limitations) that it very possibly should not have been filed in the first place. “Deductions are allowable under sections 162 and 212 for activities in which the taxpayer engaged with the predominant purpose and intention of making a profit.” Bronson v. Comm’r, T.C. Memo. 2012‑17, 2012 WL 129803, at *4 (2012). Given how quickly the husband’s action failed, and how badly he lost, it is questionable whether he had a genuine purpose of making a profit, especially one that would justify incurring at least $25,000 in expenses for filing a time-barred action.

It is not necessary “under section 212 that actual income be produced or collected in the year of the deductible expense, so long as the outlay is proximately related to the hoped-for or expected income.” Caruso v. United States, 236 F. Supp. 88, 95 (D.N.J. 1964). Ventures that generate no income can generate expense deductions. But the clear weakness of the husband’s claim calls into question whether he intended to make a profit or whether his predominant purpose was to harass his former wife or to obtain a valuable tax deduction.

If the husband’s claim was factually correct, he was charged attorney’s fees of $34,250 for filing an action that was dismissed summarily on the ground that the statute of limitations had run. The court noted that the husband was able to document only $25,000 of this amount. Barry, 2017 WL 5899406 at *3 n.3. But even a fee of $25,000 for bringing a time-barred action was remarkable. “The requirement . . . that deductible expenses be ‘ordinary and necessary’ implies that they must be reasonable in amount[.]” Bingham’s Trust v. Comm’r, 325 U.S. 365, 370 (1945). There would seem to be a basis for doubting whether the fees at issue were reasonable.

Nevertheless, hard facts make bad law. The fact is, spouses attempting to collect alimony as a matter of first instance can take a deduction under § 212. Wild. The regulation admittedly limits that deduction only to spouses seeking alimony, but the broader question is whether the regulation is reasonable. Is collection of the overpayment of alimony really that different from the collection of alimony? Perhaps the question does not matter, because the argument for collecting overpayment is generally weak under state law. Perhaps the question especially does not matter on the facts of Barry, where the action was time-barred, the claim may well have been brought forth in bad faith, and the amount of fees spent was clearly excessive.

But the author cannot distinguish between alimony and the overpayment of alimony quite as readily as the court could. If the former can generate deductions, it is arguable that the latter can generate as well when the overpayment claim pursued is in good faith and the chances for success are reasonable. However, this was not the fact pattern in Barry.