Ordinarily, deductible business expenses include payments to settle disputes. But the IRS is clear that it will allow the deduction only if the argument arose from a business-related activity. When it comes to your reputation, the line between business and personal is thin indeed. What controls the outcome are the particular circumstances as described in the stories below.
Off the Field for Football Star
The origin-of-the-claim test also tripped up pro football star Michael Hayden when he tried to deduct a payment made to quiet and resolve a sex scandal. While the former safety for the Los Angeles Raiders and co-captain for the Denver Broncos was negotiating a contract renewal with Denver, ex-girlfriend Michelle Moore filed a sexual assault charge against him for what happened when he visited her home in an unsuccessful attempt to make amends after they had an argument.
The Broncos became aware of the litigation and threatened to either trade or release him if the matter became public. To stop this, Michael paid Michelle $25,000 with the caveat of her dropping the charge and keeping quiet. In turn, the Broncos then signed him to a five-year contract.
Michael submitted a Form 1040 that included a deduction for the $25,000 by declaring it a professional development expense. His reasoning was that he paid her only because his job was in jeopardy.
The IRS tossed it out as a nondeductible personal expense, and the United States Tax Court agreed. The court upheld the claim that the origin of the charge leading to the payment came to be as a direct result of Michael’s personal relationship with Michelle, not because of his job as he claimed. The fact that the consequences of the allegations against the athlete were business related didn’t make the payoff deductible.
What does this have to do with your company?
Here are a few additional examples of how a company’s or person’s reputation and expenses paid to uphold that reputation may not be tax deductible.
When it comes to a person’s reputation, the line between business and pleasure is indeed very thin. The factors that control the outcome are the particular circumstances themselves.
For example, a federal appeals court refused to allow a write-off for the cost of settling a contested will, notwithstanding that the taxpayer settled to protect his reputation as a lawyer. The following case studies show the importance of drawing a line at your business.
Professional vs. Personal Attorney
Apparently, due to a close friendship, attorney William McDonald was named the major beneficiary in the will of one of his clients, who was an elderly widow. He hadn’t prepared the original will, but he did later draft a codicil that modified the will by including him among the beneficiaries, which was a decision that prompted some of the widow’s relatives to contest the will on the grounds that he allegedly exerted undue influence upon the woman.
The attorney agreed to an out-of-court settlement of $121,000. The agreement stated that “it appears the litigation of the issues would engender much publicity and would endanger the reputation of McDonald as an attorney.”
However, the court barred a business expense deduction for the $121,000. The proper standard for deductibility here, said the court, is the origin-of-the-claim test.
What was the origin of the lawyer’s rights under the will? Well, it was his personal relationship with the client, not his law practice. Consequently, it made no difference that his primary purpose in agreeing to the settlement was to protect his reputation as a lawyer.
Siding Against an Auto Dealer’s Claim
The Tax Court also sided with the IRS when it ruled against J. C. McCaa, an Arkansas auto dealer who disapproved of divorce and settled a claim for personal injuries resulting from him having struck the girlfriend of his married son. A skeptical court concluded that the payment was made to shield him and his family from potential scandal, not to avoid the cancelation of his dealer’s franchise.
Not a Landlord’s Business
William Harper, a school teacher and the owner of rental properties, fared no better when he took his chances with the Tax Court. He paid damages and legal expenses to settle an invasion-of-privacy suit brought against him by a female tenant.
She asserted that he installed a listening device in her apartment and then connected it to his office to spy on her. The suit, noted the court, might make it more difficult for him to do business in his community, but the payments weren’t deductible because they were made for his own personal protection.