Sole shareholder's legal expenses.

• Author: Laffie, Lesli S.
• Position: Tax evasion

The Tax Court, in Lenward C. Hood, 115 TC No. 14, held that a corporation's payment of its sole shareholder's criminal legal expenses was a nondeductible constructive dividend to the shareholder.

The taxpayer (formerly a sole proprietor) incorporated a food, paper and plastic goods business in 1988; he was the sole shareholder and integral to the business's success. There was no written agreement between the taxpayer and the corporation as to the latter's assumption of assets and liabilities stemming from the pre-existing sole proprietorship.

In 1990, the taxpayer was indicted for tax evasion, as he had failed to file sole proprietorship returns for 1983 and 1984. He was eventually acquitted; the corporation paid his $103,188 in legal fees and deducted the cost on its 1991 return.

The IRS later determined that the corporation was not entitled to deduct the legal fees; further, the taxpayer received a constructive dividend of $86,279 on the corporation's payment of such fees.

The Tax Court first noted that, on virtually the same facts, it held in Jack's Maintenance Contractors, Inc., TC Memo 1981-349, rev'd, 703 F2d 154 (5th Cir. 1983), that such fees were deductible. However, the Fifth Circuit later reversed, holding that the...