Kopp's Company, Inc. v. United States

636 F.2d 59, 46 A.F.T.R.2d (RIA) 6018, 1980 U.S. App. LEXIS 12894

• Court: Court of Appeals for the Fourth Circuit
• Decided: October 23, 1980
• Docket: 79-1405
• Status: Published

Opinions

ALBERT V. BRYAN, Senior Circuit Judge:

Appellant, Kopp’s Co., Inc. (the Company), contends that the trial court erred in disallowing the Company’s deduction, as ordinary and necessary business expenses under Section 162(a) of the Internal Revenue Code, of the cost of settlement of a tort action and related legal fees. A refund was sought of $28,935.67, representing income taxes of $25,472.00 together with interest thereon of $3,463.67 which it had paid after the IRS rejected the deductions on its Federal income tax return for the year ending March 31, 1973. Tried non-jury in the United States District Court for the District of Maryland, final judgment with opinion denying the refund was passed and the Company appeals. We reverse.

This case was heard on a stipulation of facts with supporting exhibits, and on briefs and oral arguments. As recited in the trial court’s opinion and now summarized, the facts are these. The Company is a Maryland corporation engaged in the lumber and building supply business. Its sole shareholders are Earl and Jean Kopp, who also serve as officers and directors. Their son Wayne has been employed by the Company since January, 1963, except for the period of 24 months from September, 1966, to September, 1968, spent in military service.

On November 17, 1967, while at home on leave and making personal and permissive use of a Company-owned car, Wayne was in an accident in Maryland which rendered Warren T. Danner, the driver of the other vehicle involved, a quadraplegic. In the previous five years, Wayne had been convicted of speeding 10 times and had been a party to 3 minor accidents. His license had been suspended briefly in Maryland and had been revoked in Virginia. Earl Kopp was aware of his son’s driving record.

At the time of the accident, the Company and Kopp carried automobile liability policies to the face value of $100,000. Wayne and Jean, his mother, had no such insurance; Wayne had no assets. Earl’s assets, aside from his interest in the Company, totalled $75,000. The Company’s book value in 1970 approximated $250,000.

Danner, the victim of the accident, filed suit in 1969 against the Company, Earl, Jean and Wayne Kopp in Maryland for damages of $4.2 million. The institution of the suit led the Company’s bank to freeze its credit line and to demand security upon an unsecured note; major suppliers of the Company similarly expressed concern, and the Company’s financial statement thereafter carried a notation of this contingent liability.

To relieve its financial stress, the Company reached an out-of-court settlement with Danner, under the terms of which the Company’s liability insurer was to pay Danner $102,000 and the Company was to pay Danner $50,000 borrowed from the Company’s bank. In addition, the Company incurred $3,068 in legal fees. The compromise was effectuated in every particular prior to March 31, 1973.

In its Federal income tax return for the taxable year ending March 31, 1973, tjae Company deducted the $50,000 settlement and the $3,068 legal fee as- ordinary and necessary business expenses under Section 162 of the Code. The IRS disallowed the deduction, assessing an income tax deficiency of $28,935.67, including interest. The Company paid the deficiency, filed for a refund and subsequently instituted this action.

Appellant argues that the payments made in satisfaction of the Danner suit and the related legal fees are properly deductible under Section 162(a) because they were made in order to protect the credit standing and financial durability of the Company. In rejecting this premise the District Court looked to United States v. Gilmore, 372 U.S. 39, 83 S.Ct. 623, 9 L.Ed.2d 570 (1963). We conclude, however, that the “origin of the claim” doctrine established there should not bar deductibility in this case.

In Gilmore, the Supreme Court stated:

[T]he origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test of whether the expense was “business” or “personal” and hence whether it is deductible or not

372 U.S. at 49, 83 S.Ct. at 629.

That decision dealt with the expense incurred by an individual taxpayer in defending against his wife’s suit for divorce. The expense was declared non-deductible, even though, if his wife’s property claims had succeeded, the taxpayer might have lost his controlling stock interests and official positions in the corporations from which he derived most of his income. In refusing the deduction, the Court concluded that “the wife’s claims stemmed entirely from the marital relationship, and not, under any tenable view of things, from income-producing activity.” Id. at 51, 83 S.Ct. at 631.

The claim with respect to which the Company incurred the expenses it seeks to deduct here, however, was not merely a personal claim only tangentially threatening to corporate assets. On the contrary, and importantly, Danner named the Company as a party defendant to his suit, thereby directly bringing the business into the litigation and jeopardizing its assets. Like the Court in Dolese v. United States, 605 F.2d 1146, 1151 (10th Cir. 1979), cert. denied, 445 U.S. 961, 100 S.Ct. 1647, 64 L.Ed.2d 236 (1980), we see the Company’s direct exposure to the risk of a monetary judgment significant in distinguishing the instant litigation from that of Gilmore.

The factual stipulation before us reveals that the Company was advised by its general counsel that, at trial, it likely would be found liable for negligent entrustment of the company car to Wayne. See Maryland v. O’Brien, 140 F.Supp. 306 (D.Md.1956); Curley v. General Valet Service, Inc., 270 Md. 248, 311 A.2d 231 (1973); Snowhite v. State, 243 Md. 291, 221 A.2d 342 (1966); Rounds v. Phillips, 168 Md. 120, 177 A. 174 (1935). The Company, therefore, was confronted with more than a remote threat to its assets or operations arising from a costly judgment against Wayne; it incurred the expense at issue to avert direct liability under a claim alleging that the Company itself acted negligently, in permitting Wayne to operate its car. The outlay made by Kopp’s Co., Inc., in resolving the Danner suit thus conforms with the guidelines for deductibility put forward in Gilmore. We set aside the judgment on appeal. Reversed.