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Law Fees Not Deductible

A corporation paid an annual retainer of $100,000 to a law firm that specializes in corporate takeovers. The corporation thereby obtained the firm's expertise and precluded the firm from accepting the corporation's competition as clients. The agreement gave the corporation the right to use the firm for general legal services and to offset any nontakeover fees against the retainer.

For the next seven years, the law firm received the retainer but performed virtually no legal services for the corporation. However, in one year, the law firm rendered $265,000 in legal services to the corporation in its acquisition of another company. In its billing, the firm credited the corporation with the amount of the retainer to offset its charges.

For tax purposes, the corporation capitalized $165,000 as part of the acquisition cost and deducted the $100,000 that the law firm had retained. The Federal Circuit Court of Appeals held that a taxpayer couldn't currently deduct a retainer fee that was applied to a capital acquisition. Using the "origin-of-claim" doctrine, it said the entire retainer was a nondeductible prepayment that had to be capitalized (Dana Corp. v. United States (Fed. Cir., 4/7/99)).

Entrepreneur Wins Battle Over Pay

William Rogers turned down a million-dollar job to start his own medical management services corporation. He worked 12-hour days, made all major decisions in the company and did all the company's strategic planning. His salary rose from $67,000 in 1986 to $928,000 in 1989.

In 1990 he was paid $4.4 million; however, the IRS and the Tax Court determined that only $400,000 of Rogers' salary could be deducted as reasonable compensation in that year.

The Sixth Circuit Court of Appeals reversed the Tax Court's ruling and held that the entire $4.4 million was reasonable compensation. In its decision, the Sixth Circuit compared Rogers' salary to that of other executives. It also acknowledged his accomplishments and the risks he assumed in forming his corporation. It concluded that the $4.4 million was reasonable because it did not exceed the amount needed to remedy prior years of underpayment (Alpha Medical, Inc. v. Commissioner (6th Cir., 4/19/99)).

Lawyer's Workpapers Are Discoverable

A taxpayer, who was both a lawyer and an accountant, provided legal representation to and prepared the individual and business tax returns for Randolph and Karin Lenz.

The IRS began investigating the Lenzes and their company. It issued summonses directing the couple to hand over hundreds of documents, including workpapers used in preparing their tax returns. The Lenzes refused, claiming the documents were protected by either attorney-client or work-product privilege, or both.

The Seventh Circuit Court of Appeals held that neither attorney-client nor work-product privilege protects documents a lawyer/CPA creates while preparing tax returns for clients. According to the court, dual-purpose documents (that is, documents used both in preparing tax returns and in litigation) are not protected. Thus, the court held that the workpapers of a lawyer providing both legal representation and accounting services are not privileged (Fredrick v. United States (7th Cir., 2/15/99)).  

Man Deducts Alimony in Annulment

Before the end of the six-month waiting period required by the divorce decree in his first marriage, Fred J. Pettid married for the second time. Ten years later, he attempted to void the marriage to his second wife. She countered his suit for annulment by charging him with fraud, breach of promise and intentional infliction of emotional distress.

Eventually, the Pettids, who had married in the state of Nebraska, settled the suit and the marriage was annulled. He agreed to give her various properties and to pay her $4,000 per month for 84 months.

When Pettid deducted the payments as alimony on his individual tax return, the IRS disallowed the deductions, saying the payments were nondeductible damages. In its ruling, the Tax Court held for Pettid, saying a man could deduct alimony paid to a woman to whom he was never legally married. The court's ruling was influenced by Nebraska law, which made little distinction between divorces and annulments (Fred J. Pettid v. Commissioner, TC Memo 1999-126).

—Michael Lynch, CPA, Esq., professor of tax accounting at Bryant College, Smithfield, Rhode Island.

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