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Litigation Expense Deductibility: New Appellate Court Decision
The Fifth Circuit Court of Appeals recently issued a decision that explains some of the requirements for deducting litigation expenses. The facts of the case are bizarre, but the controlling legal principles are not. James A. Cavanaugh, Jr. v. Commissioner of Internal Revenue, No. 18-60299 (March 29, 2019).
In a nutshell, the taxpayer was the sole shareholder of a company that was a commercial cleaning franchisor (Company). In November 2002, the taxpayer traveled on vacation with his girlfriend and two employees of his company to the Caribbean island of St. Maarten, where he owned a home. One of the employees was a bodyguard and the other was a former girlfriend. On Nov. 28, 2002, the taxpayer's current girlfriend died at the residence, likely from a cocaine overdose. The family of the decedent sued the taxpayer and the Company for wrongful death, claiming they facilitated her access to and ingestion of the cocaine that led to her death.
As the litigation progressed, the Company's board of directors met with the taxpayer and its litigation counsel to discuss the status of the litigation. The taxpayer agreed to contribute $250,000 to his own defense costs, even though he believed the claims against him were frivolous, and counsel explained that the case against the Company was weak, but that it should settle because of the possibility of a negative outcome and the prevailing consensus that the case could have a “negative impact on the company's relationship with its franchisees and the company's business.”
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