Disallowed Idemnity Deduction Blues

BY EDWARD J. SCHNEE

From time to time, corporate officers and shareholders agree to indemnify their corporations for certain expenses and losses. The taxpayer would prefer to claim an ordinary loss deduction instead of a capital loss or, worse, a nondeductible payment. The Sixth Circuit Court of Appeals recently denied such a claim.

Isaac Tigrett II was in the business of developing and promoting restaurant and entertainment venues. After founding and building the Hard Rock Café chain, he developed the House of Blues concept. As CEO of HOB Entertainment Inc., Tigrett sought in 1996 to open a temporary House of Blues at the Olympic Games in Atlanta. The corporate board initially was not in favor, until Tigrett promised to indemnify the corporation for up to $5 million of any losses. The House of Blues opened but was shut down for 4 1/2 days after the bombing of Centennial Olympic Park by Eric Rudolph. The corporation lost $10 million, and Tigrett paid the $5 million. The district and appellate courts upheld the government’s position that the payment was designed to generate a future benefit of an initial public offering of HOB stock and denied it as an ordinary loss or expense.

The Sixth Circuit looked at the guarantee and payment as a single transaction and regarded Tigrett’s concern for his business reputation as a capital asset for which payments to preserve and protect were nondeductible. Also, the payment was not “ordinary” within the meaning of trade or business expenses in section 162, the court said. Tigrett argued alternatively for a loss under section 165(c). This argument also failed, since the U.S. Supreme Court has held that voluntary payments of another’s loss are gratuities, not debts or losses [ Putnam v. Commissioner , 50 AFTR 502 (1956)]. They are either a contribution to the capital of the corporation or a capitalized payment to protect an individual’s business reputation, the court said. It is extremely doubtful that any future taxpayer will be able to obtain an ordinary loss for a similar indemnity agreement.

Isaac B. Tigrett II v. U.S. , 99 AFTR 2d 2007-501.

Prepared by Edward J. Schnee , CPA, Ph.D., Hugh Culverhouse Professor of Accounting and director, MTA Program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

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