Fifth Circuit holds settlement payments unrelated to business not deductible

Tax Hot Topics newsletterThe 5th Circuit Court of Appeals recently held in Cavanaugh v. Commissioner (No. 18-60299) that a settlement payment made by an S corporation with respect to a lawsuit stemming from the overdose of the sole shareholder’s girlfriend was nondeductible. This decision illustrates a circuit split on the treatment of settlement payments for lawsuits against a corporation for activities not related to the business of the corporation.

The case involved James Cavanaugh, Jr., the CEO and sole shareholder of Jani-King International, Inc. (Jani-King), a commercial cleaning company operating as an S corporation. Cavanaugh’s girlfriend, having allegedly been provided drugs by an employee of Jani-King, died in a drug overdose on a Caribbean vacation. The girlfriend’s family sued Cavanaugh and Jani-King, alleging that her death was caused by the Jani-King employees acting in the course and scope of their employment. The parties settled the lawsuit for $2.3 million.

When determining whether litigation expenses, including settlement payments, were “incurred in carrying on a trade or business,” courts generally look to the origin of the claim from which the expenses arose. This approach comes from the case United States v. Gilmore, 372 U.S. 39 (1963), in which the Supreme Court held that deductibility “depends on whether or not the claim arises in connection with the taxpayer's profit-seeking activities,” not on the “consequences” to the taxpayer “from a failure to defeat the claim.”

In an earlier case, the 4th Circuit considered but factually distinguished Gilmore in its decision in Kopp's Co. v. United States, 636 F.2d 59 (4th Cir. 1980). In Kopp’s, the son of a lumber-company president used a company car loaned to him by his father. The son crashed the company car into another car, seriously injuring the other driver. The injured driver sued the son, the company's president and the company itself. The company settled and deducted its share of the settlement and legal fees. The 4th Circuit agreed that it could, because unlike the taxpayer in Gilmore, the taxpayer in Kopp’s was named in the suit, and thus the company had “direct exposure to the risk of a monetary judgment.”

In Cavanaugh, the taxpayer argued that Jani-King’s settlement payment should be deductible under Kopp’s because Jani-King was directly named in the lawsuit. The 5th Circuit disagreed and refused to follow the 4th Circuit’s decision in Kopp’s. The 5th Circuit held for the IRS and against the taxpayer, stating that it believed Kopp’s directly conflicted with the Supreme Court’s decision in Gilmore. In its holding, the 5th Circuit stressed that Jani-King’s alleged provision of drugs to Cavanaugh’s girlfriend was not done with a corporate profit-seeking motive and was not proximately related to any specific Jani-King business activity.  

The 5th Circuit’s decision in Cavanaugh creates a split between circuit courts. In the 4th Circuit, any settlement paid by a corporation in which the corporation is named as a defendant appears to be a deductible business expense under the Kopp’s decision. In the 5th Circuit, on the other hand, such a settlement payment is deductible under Cavanaugh only if the actions that gave rise to the lawsuit were proximately related to the business of the corporation.

Brian Keith
Managing Director, Washington National Tax Office
T +1 202 861 4116

Evan Adams
Tax - Manager, Washington National Tax Office
T +1 202 521 1591

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