timing of deduction, litigation

Technical topics regarding tax preparation.
#1
JAD  
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I am trying to figure out the standards for determining the amount to deduct when the underlying issue is being litigated. When a taxpayer pays an expense, he is not entitled to a deduction if he has a right to reimbursement at the time that the expense was incurred. It is as though he has loaned money to the entity that will ultimately reimburse him.

Client incurs expenses, and there are several different claims against client's insurer. In looking at the case law, I see only black and white results. Either the taxpayer is entitled to his deduction because it seemed clear that he did not have insurance coverage, Varied Investments, Inc. v. United States , 31 F.3d 651, 653 (8th Cir. 1994) or no deduction is allowed until the litigation is resolved. (PLR 200725031 as an example)

Is there ever the situation where the taxpayer and his attorney apply an "anticipated chances of success" to the amounts at issue to determine the deduction? For example, expense is $500,000, we think there is a 50% chance we will win this lawsuit, so we will capitalize $250,000 and deduct $250,000. I think not - I have not seen this, but it seems logical to me.

Does anyone have experience with determining the deductible portion of an expense being litigated, and how did you handle the issue?

Thanks.
 

#2
Nilodop  
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Do your facts fit the contested liability rules of reg. 1.461-2?
 

#3
JAD  
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My read of this regulation is that it does not apply to my client's situation. The reg would apply if there were an issue as to whether or not the expense was my client's responsibility. It is his responsibility. The next step is his contract with his insurance carrier - that is what is uncertain. Must the insurance carrier reimburse him? That is what is being litigated.
 

#4
Pitch78  
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Did you mean CCA 200725031 https://www.irs.gov/pub/irs-wd/0725031.pdf

That goes through the factors. The issue is whether the taxpayer has a "reasonable prospect of recovery."
 

#5
Nilodop  
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Maybe the reasonable prospect of recovery should be tested in a way similar to the test for an "open transaction".
 

#6
JAD  
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Thank you both.

Pitch78, I have become very familiar with that document. The list of evidence that the IRS considers on page 9 is helpful. My questions are

1. is there ever a chance of recovery applied to the situation, as a percentage, or is it a black and white determination (sort of like the factors for determining independent contractor status. There are 20 factors, but at the end of the day, we conclude either employee or IC status.) I had originally thought there would be a judgment call (say, we think we have a 40% chance of prevailing in court) but the cases that I have read so far seems to indicate that it is black or white: if we think we have coverage, we cannot deduct any of our costs. If we think the insurance company will win, then we deduct all costs (although if you really think that, then why incur the legal fees?)

and

2. What are the rules for determining the deductible vs capitalized portion of the legal fees? It is logical to say that they follow the treatment of the underlying claim, but is there a position to be taken where we determine the likely portion that the court will order reimbursed and currently deduct the remainder?

I obviously want to stay within the law. I also do not want to tell my client that we must capitalize all costs if there is authority allowing for a judgement of the chances of prevailing.
 

#7
Pitch78  
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As far as 1, goes, yes it is the black and white determination. I know of no rule applying a percentage. Plus, even if you claimed $1M but expected only $500k, you still could not deduct until you know the amount of the recovery. As the courts note, the fact that a lawsuit was filed shows the taxpayer has some prospect of recovery. And the prospect can change over time. If you file suit and the next year the insurance company goes into receivership with nothing expected to be distributed, you can take the loss at that time.

On 2, it is the underlying claim, but if you can show that the "capitalized" claim was thrown in to have a better position in settlement (happens all the time - which is why punitive damage claims are sometimes added), then I think you have a chance.
 

#8
JAD  
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Helpful. Thanks. I think that my biggest weakness in research is when I have a preconceived idea of what would be logical.
 

#9
Pitch78  
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JAD wrote:Helpful. Thanks. I think that my biggest weakness in research is when I have a preconceived idea of what would be logical.



Understatement of the year. Happens all the time.
 

#10
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Can JAD tell us what the facts are in this case…all I’ve gathered is that the taxpayer paid some expenses and is suing the insurer. What is this, property damage?
 

#11
JAD  
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ongoing operations are not without impact to the land. Clean up costs. Litigation is re insurer's share of the responsibility.
 

#12
Nilodop  
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I assume your facts come under 162 rather than 165. That linked CCA is, in my opinion, weak in its 162 analysis and conclusion. It is not, of course, authoritative.
This advice may not be used or cited as precedent.
. But it deserves parsing.

RR 79-263 - "knows he will be reimbursed". You don't know.
Charles Baloian case - "when the right has matured without further substantial contingency". You have contingency.
Manocchio, Glendinning, and Webbe - "written agreements specifically providing that the taxpayers’ expenses were to be reimbursed or written statements from a third party authorizing the taxpayer to incur the expenses". insurance policy does not fit those descriptions.
RR 78-388 - "moving expenses for which the taxpayer has a fixed right of reimbursement". Not comparable to your insurance policy. Former is objective, latter subjective.
Levy - 'owner nonetheless agreed to pay and requested that the bills be forwarded. The taxpayer instead paid for additional repairs and notified the owner, but received no reimbursement". No pre-authorization in the insurance policy.
There follows this paragraph, which gets very little credence or weight, but it should.
If the right to reimbursement is not fixed, the deduction may be allowed. See George K. Herman Chevrolet, Inc. v. Commissioner , 39 T.C. 846, 853 (1963) (taxpayer had no right to reimbursement at the time the expenses were incurred); Allegheny Corporation v. Commissioner , 28 T.C. 298, 305 (1957), acq. , 1957-2 C.B. 3 (deduction not precluded by contingent possibility of future reimbursement from assets of debtor of legal fees and costs for representation in bankruptcy proceeding). In Electric Tachometer Corporation v. Commissioner , 37 T.C. 158, 161-162 (1961), acq. , 1962-2 C.B. 4, the taxpayer was allowed a deduction in the year expenses were paid for moving machinery as the result of a condemnation action because there was no fixed right of reimbursement but only an indefinite and general right to recover its expenses. The court concluded that, although the taxpayer had a general right to reimbursement of moving expenses, conflicting evidence at hearings to determine the amount of compensation indicated the lack of definiteness of the taxpayer’s right. In Varied Investments, Inc. v. United States , 31 F.3d 651, 653 (8 th Cir. 1994), a taxpayer was allowed a deduction under section 162 in the taxable year it transferred money to a trust to provide for the satisfaction of a judgment after three insurers denied liability, even though the taxpayer recovered some insurance proceeds in subsequent years.
.

They pre-determined their desired result. At least, I think they did.
 

#13
Pitch78  
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JAD, Nilodop has made a good point regarding 162. I was focused on 165 because you mentioned the "anticipated chances of success". If 162 applies, then the test is a bit different and the IRS/Courts have not settled on exact what the "right to reimbursement means for 162 purposes. As the TAM notes, an expectation of reimbursement may be enough. But, it also notes that the right to reimbursement has to be fixed, and not contingent. If 162 applies, I think you can justify the deduction.
 


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