McKay v. Comm'r of Internal Revenue
| Decision Date | 28 March 1994 |
| Docket Number | Nos. 3289–92,11987–92.1,s. 3289–92 |
| Citation | 102 T.C. No. 16,62 USLW 2620,102 T.C. 465 |
| Parties | Bill E. McKAY, Jr. and Lana S. McKay, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent. |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
P was an officer of A. A terminated P's employment. P filed a lawsuit in Federal district court against A for wrongful discharge, breach of employment contract, RICO, and punitive damages. The jury awarded P lost compensation in the amount of $1,602,103 and future damages of $12,846,209 that was trebled for A's violation of RICO. The jury also awarded P a total of $1,250,000 in punitive damages. After the award and final judgment were entered, the parties negotiated a settlement agreement under which A paid P $16,744,300 in extinguishment of P's claims. The agreement further provided that based on the jury's verdict and the value of the two claims, $12,250,215 of the proceeds was to be allocated to the wrongful discharge tort claim, and $2,044,085 was to be allocated to the breach of contract claim. None of the proceeds were allocated to RICO or punitive damages. R determined that the entire $16,744,300 was includable in gross income. Ps contend that $12,250,215 of the settlement proceeds was allocated to the wrongful discharge tort claim as part of a bona fide arm's-length settlement agreement and is therefore excludable from income under sec. 104(a)(2), I.R.C. Held: The settlement agreement is the result of the result of bona fide, arm's-length negotiations and accurately reflects the substance of the claims settled by P and A. Held, further, the $12,250,215 payment allocated to the wrongful discharge tort claim represents a payment for tort-type personal injury which is excludable from income under sec. 104(a)(2), I.R.C. Ps deducted more than $5 million in legal and litigation- related expenses incurred on account of P's lawsuit against A and other legal proceedings. Ps also claimed deductions for other business expenses incurred. R denied the deductions because Ps did not establish that they are entitled to deduct the expenses. Held: P may deduct $800,000 in legal expenses for a shareholder derivative action. Held, further, under sec. 265, I.R.C., P may deduct 26.8 percent (the percentage of the settlement proceeds allocable to taxable income) of legal expenses for the lawsuit against A. Held, further, Ps may not deduct other business expenses because Ps failed to meet their burden of proof under Rule 142(a), Tax Court Rules of Practice and Procedure. Held, further, Ps may not deduct in full interest expenses for money borrowed to pay some of P's legal expenses because it is “personal interest” under sec. 163(h)(1) and (2), I.R.C. Ps failed to file timely Federal income tax returns for taxable years 1984, 1985, and 1986 in order to prevent A from obtaining the information on the returns during discovery. R determined that Ps' excuse does not constitute reasonable cause. Held: Ps did not establish reasonable cause for ble cause for the delayed filing of their 1984, 1985, and 1986 tax returns because the deliberate failure to file in order to prevent a party-opponent from obtaining information during discovery does not amount to reasonable cause.
Scott R. Cox, Louisville, KY, for petitioners.
Aubrey C. Brown, Louisville, KY, for respondent.
Respondent determined the following deficiencies in and additions to petitioners' Federal income taxes:
+----------------------------------------+
¦Year ¦Deficiency ¦Additions to Tax ¦
+------+------------+--------------------¦
¦ ¦ ¦Section 6651(a)(1) ¦
+------+------------+--------------------¦
¦1983 ¦$ 14,588 ¦–0– ¦
+------+------------+--------------------¦
¦1984 ¦22,340 ¦$2,297 ¦
+------+------------+--------------------¦
¦1985 ¦29,156 ¦7,039 ¦
+------+------------+--------------------¦
¦1986 ¦30,527 ¦7,375 ¦
+------+------------+--------------------¦
¦1988 ¦3,571,867 ¦–0– ¦
+------+------------+--------------------¦
¦1989 ¦101,636 ¦–0– ¦
+----------------------------------------+
Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
After concessions,2 the issues we are asked to decide relate to the settlement of claims petitioner Bill McKay (hereinafter petitioner) made against Ashland Oil Company. The issues are: (1) Whether any portion of the settlement proceeds should be excluded from gross income pursuant to section 104(a)(2); (2) whether, and to what extent, legal and litigation-related expenses are deductible as ordinary and necessary business expenses under section 162; (3) whether petitioners paid $80,000 from an escrow account to a law firm for legal fees and costs during 1988; (4) whether petitioners are entitled to deduct other legal fees in the amount of $51,678 for taxable year 1988; (5) whether interest paid on loans incurred to pay legal expenses is deductible in 1988 under section 163; (6) whether petitioners are entitled to deduct $88,338 in expenses in taxable year 1989 for the maintenance and storage of business records; (7) whether petitioners are entitled to deduct certain other business expenses; and (8) whether petitioners are liable for additions to tax for failure to timely file their Federal income tax returns under section 6651 for taxable years 1984, 1985, and 1986.
Some of the facts and certain documents have been stipulated for trial pursuant to Rule 91. The stipulations and accompanying exhibits are incorporated in this Opinion by this reference. Petitioners were residents of Kerrville, Texas, when they filed their petitions.
Petitioners are married and filed joint tax returns for the taxable years in issue. The instant case arises out of various legal proceedings involving petitioner and his former employer, Ashland Oil, Inc. (Ashland).
Petitioner is a chemical engineer with specialized knowledge of the petroleum industry. He began his career in the petroleum industry during high school when he worked part time at an oil refinery in Detroit, Michigan. Upon receiving a college degree in chemical engineering, petitioner worked for Universal Oil Products Company (UOP) where he became the youngest operating director in the history of UOP. After leaving UOP, petitioner took a position at Koch Refining Company (Koch) and was promoted to plant manager for all Minnesota activities. During 1976, Ashland recruited petitioner because of petitioner's expertise in the oil industry.
When Ashland first approached petitioner, petitioner was reluctant to take a position with Ashland because he was aware that Ashland allegedly had made various questionable disguised payments to domestic and foreign officials to secure oil during the 1960s and 1970s and had also made several illegal political contributions during the Watergate era. It was only after several of Ashland's senior officers guaranteed petitioner that such shady practices had stopped that petitioner agreed to make a career move to Ashland.
Petitioner's first position at Ashland was manager of process developments. Later, his job also encompassed helping Ashland's then Chief Operating Officer, Orin Atkins (Mr. Atkins), with oil acquisition activities. During 1979, petitioner was appointed president of Ashland Development, a wholly-owned subsidiary of Ashland which arranged all of its research and development. During 1980, petitioner's job expanded to include the handling of all crude oil supply acquisitions for Ashland.
During December of 1980, Mr. Atkins made arrangements for the payment of a $1.35 million bribe to Yehia Omar (Mr. Omar), an official of the Sultanate of Oman, for the purchase of its government's oil. Mr. Atkins insisted that petitioner provide for the transfer of the funds to a Swiss bank, but petitioner refused. Petitioner protested making the transfer because it was his belief that such a payment was a violation of the Foreign Corrupt Practices Act (FCPA) as well as a 1975 consent decree that Ashland had made with the Securities and Exchange Commission (SEC). Despite petitioner's persistent efforts to prevent the $1.35 million transfer, the payment was made.
Even after the payment was completed, petitioner continued to raise the issue of the payment's legality with Ashland's management. Petitioner soon learned that Ashland was trying to retrieve the $1.35 million bribe from Mr. Omar, but only by making a payment to Mr. Omar so that Mr. Omar would return the $1.35 million and rescind the earlier deal. Petitioner similarly objected to the latter payment and attempted to prevent it.
As a consequence of petitioner's demands that Ashland comply with the law, Mr. Atkins threatened to fire petitioner if he continued to challenge the disguised payments to Mr. Omar. Ultimately, during September 1981, Mr. Atkins was asked to leave Ashland, and he was replaced by John Hall (Mr. Hall). Mr. Hall assured petitioner that all disguised payments and bribes would stop. Despite Mr. Hall's assurances, Ashland continued to make disguised payments.
Because of the difficulties petitioner was having in his relationship with Ashland over the disguised payments, petitioner hired the law firm of Wilmer, Cutler, and Pickering (Wilmer, Cutler) to help him negotiate a satisfactory termination to his employment at Ashland. Petitioner and Ashland were unable to reach a termination agreement that was acceptable to both parties.
During October and November of 1982, the Internal Revenue Service (IRS) contacted petitioner and requested that he respond to certain inquiries called the “Five Questions” regarding some of Ashland's business transactions. Ashland pressured petitioner to sign predetermined responses similar to the responses that Mr. Hall had already...
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