Other courts have permitted a more favorable outcome, allowing taxpayers to include in gross income only the net amount they received after deducting attorney’s fees. In either situation the nature of the attorney’s legal interest under applicable state law usually has been the determining factor. For example, based on state law the Ninth Circuit Court of Appeals has required the gross approach for California and Alaska taxpayers but allowed the net approach for an Oregon taxpayer (see Coady v. Commissioner, 2000-1 USTC 50,528; Benci-Woodward v. Commissioner, 2000-2 USTC 50,595; and Banaitis v. Commissioner, 2003-2 USTC 50,638).

Frank Biehl was an employee, officer, shareholder and director of North Coast Medical Inc. (NCM) in California. NCM terminated Biehl’s employment. Subsequently, he filed a wrongful termination suit against the company. After a jury gave Biehl a favorable verdict, the two parties reached a settlement. The agreement required NCM to pay him $799,000 in settlement of his employment-related claims and to make a direct payment of $401,000 to Biehl’s attorneys for their fees under a contingent fee agreement.

The taxpayer included only the $799,000 as gross income on his federal income tax return. The IRS disagreed. Biehl petitioned the Tax Court for relief. Since the Ninth Circuit had previously ruled California law required the gross approach, the taxpayer argued the $401,000 NCM paid to the attorneys represented a reimbursed employee business expense under an accountable plan. Biehl’s argument was based on (1) the presence of a shareholder agreement which required the losing party to pay the attorney’s fees of the prevailing party in any suit due to a breach of the agreement and (2) the fact the lawsuit arose out of the taxpayer’s former employment. Under this theory the $401,000 would have represented gross income; however, the amount paid to the attorneys would have been an above-the-line deduction. Thus the two sums would have offset each other, producing the same result as the net approach in which the taxpayer included only $799,000 in his gross income. The Tax Court rejected these arguments stating wrongful termination suits were not mentioned in the shareholder agreement and settlement of the suit did not satisfy the business connection test required for accountable plans. Biehl appealed to the Ninth Circuit.

Result. For the IRS. The Ninth Circuit agreed with the Tax Court that an expenditure represents a reimbursed employee business expense only if it first qualifies as a trade or business expense under IRC section 162. If it satisfies that test, section 162(a)(2)(A) requires the taxpayer to meet the business connection, substantiation and “return of excess amounts” tests. The Ninth Circuit agreed with the Tax Court that the amount paid to the attorneys was a deductible business expense since the expenditure had its origins in the taxpayer’s trade or business of being an employee. The Ninth Circuit also agreed with the Tax Court that Biehl did not satisfy the business connection test. The court said to satisfy that test the expenditure must have been incurred by the taxpayer in the performance of services as an employee. It was clear Congress intended the above-the-line tax deduction to be available only when there was a current employer-employee relationship. Also, the employee must incur the expenditure on the employer’s behalf, which implies a beneficial relationship between the expenditure and the employer. Since Biehl’s employment had ended long before he incurred the legal fees, the expenditure could not satisfy the business connection test even though it had originated from his employment. Because the expense failed this test, the taxpayer was not eligible for above-the-line treatment.

Frank Biehl v. Commissioner, 2004-1 USTC 50,109.

Prepared by Charles J. Reichert, CPA, CIA, professor of accounting at the University of Wisconsin, Superior.

Pieter Weyts is a citizen of Belgium. In June 1997 he graduated with a law degree from a university there. From June to August 1997 he worked in his father’s law firm. In August Weyts came to New York City to attend Columbia University School of Law. He received an LLM in corporate finance in May 1998. At that point he was advised to get a JD degree to increase his chances of obtaining employment. He enrolled in a joint JD/MBA program at Columbia and received one year’s credit for the work he had done for his LLM degree.

Weyts worked as a summer associate at Kelley Drye in 1999 and was admitted to the New York state bar in July. During the summer of 2000 he was employed as a summer associate at Davis Polk. He was paid for his work and also received three hours of education credit. Weyts deducted his education expenses on his 2000 tax return. The government denied the deduction.

Result. For the IRS. Education costs are deductible under IRC section 162 as ordinary and necessary expenses. However, a taxpayer must first establish that he or she is engaged in a trade or business. Weyts argued he was; the government disagreed.

Prior cases have established that employment as a law clerk before admission to the bar is not employment in a trade or business. In addition, admission to the bar is “not tantamount to being engaged in a trade or business of practicing law.” On the other hand, a short period of work after graduation with a JD degree and admission to the bar before enrolling in an LLM program is considered establishment of a trade or business. Weyts argued he fell within this last category.

The court disagreed. While working the summer after admission to the bar, Weyts was listed as a summer associate. He was unable to prove he was paid the same amount as regular new hires or that he was assigned the same work. Furthermore, he earned three hours of course credit. These factors were sufficient to overcome the presumption he was engaged in a trade or business as a result of having been admitted to the bar and working full-time at a law firm.

CPAs should advise taxpayers planning to get additional education to document that they have met the minimum education necessary for their field and to gain employment in a full-time paid position comparable to those who won’t be seeking further education. Specifically, a taxpayer should be able to prove he or she was paid the same as other employees and assigned comparable work. Positions as interns or summer associates probably will not be sufficient.

The court summarized its reasoning for denying the deduction by stating the “petitioner had an ‘uninterrupted continuity in his legal education.’” It is necessary to break the education cycle and engage in a trade or business before deducting education expenses. The fact the break is for only a short period of time will not deny the deduction. Still, an actual break must occur.

Pieter Weyts, TC Memo 2003-68.

Prepared by E dward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.