Settlement payment held deductible under sec. 162(a).

• Author: Taylor, II, French L.

In Chief Industries, Inc., TC Memo 2004-45, the Tax Court recently held that a taxpayer's settlement payment to its former chief executive officer (CEO) to terminate an employment agreement and other business-related claims, concurrently with the redemption of the CEO's outstanding shares, was deductible under Sec. 162(a). The court found that the settlement payment and the redemption payment should be regarded separately. While the years at issue preceded the effective date of the new regulations under Sec. 263(a) (TD 9107), the decision provides an interesting and not uncommon fact pattern involving Sees. 162(a) and (k), and 263(a).

Background

In 1993, the taxpayer's board of directors voted to replace the principal founder of the company as chairman of the board and CEO; shortly after this vote, the founder and the taxpayer entered into an employment agreement, under which the founder could use the title "chairman of the board emeritus" but could not exercise managerial authority. Subsequently, the founder and the board engaged in a prolonged series of disputes--including litigation--to control the taxpayer. Because of the substantial risk, time and expense revolved in the litigation against its founder, the board pursued settlement negotiations, beginning in 1995. In 1996, the parties reached an agreement under which the taxpayer, and the new chairman and CEO, purchased all of the founder's stock in the taxpayer for $37,223,114; the taxpayer also transferred to the founder a value of $3,082,710 in settlement of existing and potential disputes and in relinquishment of the founder's rights under the employment agreement.

The taxpayer deducted $3,082,710 as an ordinary and necessary business expense, reflecting the payment as "lawsuit settlement cost" on its return. The IRS disallowed the deduction, asserting that the payment was capital or, alternatively, that it was connected with the taxpayer's reacquisition of its stock.

Tax Court's Analysis

The court first examined the amount in dispute under Sec. 162(a), citing Lincoln Savings & Loan Ass'n, 403 US 345 (1971) and other authorities for the premise that an item, to be deductible under that provision, must be (1) paid or incurred during the tax year, (2) for carrying on any trade or business, (3) an expense, (4) a necessary expense and (5) an ordinary expense. The Service argued that the settlement payment was made in connection with acquiring a capital asset (i.e., the stock...