Understanding the "origin-of-the-claim" doctrine.

• Author: Schnee, Edward J.
• Position: Taxation

The "origin-of-the-claim" doctrine (OCD) has been developed and long-used by the courts to determine the nature, and hence the deductibility, of certain types of expenses. However, the courts themselves differ over the OCD's scope and application. This article examines a number of cases and rulings in this area and offers planning opportunities.

The "origin-of-the-claim" doctrine (OCD) has been used by many courts over the years, and has continued to evolve since its inception. This has led to questions about its proper role and use.

The conflict surrounding the OCD is exemplified by the cases of Kroy (Europe) Limited(1) and Fort Howard Corp.(2) Although the specific issue involved in those cases was resolved by the Small Business Job Protection Act of 1996 (SBJPA), Section 1704(p)(1) and (2), allowing the deduction of stock redemption expenses, these cases illustrate the difficulties encountered in applying the OCD. In each of these cases, the taxpayers had borrowed money to finance a stock redemption. The Service argued in each that the expenditure was nondeductible under pre-SBJPA Sec. 162(k), which prohibited a deduction for most stock redemption expenses.

In Kroy, the Ninth Circuit concluded that the expenses deducted were for investment banking and lending services, not the stock redemption; thus, they were deductible. In Fort Howard, the Tax Court concluded that the OCD did not apply; even if it did, the origin of the claim (OC) was the redemption, making the expenditures nondeductible.

These two cases illustrate the uncertainty surrounding the scope of the OCD and its application. This adversely affects taxpayers who rely on the OCD as support for their deductions and requires taxpayers to consider alternate support for their positions. To assist taxpayers in evaluating and using the OCD, this article reviews the OCD, focuses on its application in both individual and corporate contexts and highlights issues and planning opportunities.

The OCD

Initially, the courts determined the deductibility of an expenditure using the "primary purpose" test,(3) which required an examination of a taxpayer's motives and the predictable outcomes from his behavior. This test was criticized because it required the courts to apply subjective judgments and led to capricious results. To overcome these deficiencies, the Supreme Court created the OCD, in Gilmore.(4)

In that case, the taxpayer incurred legal fees incident to a divorce and property settlement. He deducted them on the grounds that his overriding concern was the protection of income-producing assets from his wife's claims; loss of the assets (stock) would have resulted in the loss of his livelihood.

In rejecting this argument and denying the deduction, the Supreme Court held that the focus is not on the consequences if the taxpayer failed to defeat his wife's claim, but rather, on the origin of the initial claim. According to the Court, if the expenditure arose in a business or profit-making activity, it was deductible; however, if it arose out of a personal activity, it was a nondeductible personal expense. Here, the OC was a divorce suit, a personal activity; hence, the legal expenses were nondeductible.

In Gilmore, the OCD was developed to address the question of business versus personal expenditures. Subsequently, in Woodwards and Hilton Hotels Corp.,(6) it was expanded to address when business expenditures have to be capitalized. In each of those cases, a corporation incurred litigation expenses related to the valuation of stock it was required to purchase. The taxpayer in each instance argued that, because the primary purpose of the expenditure was not to defend or protect title, the amount could be deducted, not capitalized.

However, according to the Supreme Court, the OC in each case was the acquisition of stock. Expenditures that are part of the acquisition process must be capitalized; thus, the taxpayers had to capitalize the litigation expenses.

Applying the OCD to a specific fact pattern is a two-step process.(7) First, the nature of the event or transaction that is the OC must be determined. Second, the tax consequences that flow from the origin must be determined. For example, the deductibility of accounting or legal fees is determined based on the expenditure's origin. If the expense is an ordinary and necessary business expense, it is deductible. However, if the expense was incurred to acquire a capital asset, it is nondeductible and will increase the taxpayer's basis in the asset.

Applications of the OCD

Since its creation, the OCD has been applied to numerous tax disputes. By reviewing the way the courts have applied it, the taxpayer will be able to determine when the OCD will be applied, its limits and the planning opportunities available.

Individual Taxation

Divorce: One significant area in which the OCD has been used is in the taxation of expenses related to a divorce. Because divorce is a personal activity, related expenses are nondeductible. The fact that the specific issue in question relates to valuation or allocation of income-producing property is immaterial.(8)

This rule extends to litigation over prenuptial agreements. In Favrot,(9) a district court held that because the taxpayer's claim could not have existed but for the marriage relationship, expenses to resist the claim were personal and nondeductible.

However, when the OC is the production of or the collection of amounts includible in gross income, the related expenses are deductible even if incurred in a divorce. In Wild,(10) the Tax Court permitted a deduction for the part of the taxpayer's legal expenses specifically allocated to the issue of alimony. The origin of this expenditure was the production of income; therefore, the expense was deductible under Sec. 212.

In general, taxpayers should not rely on Wild to deduct divorce expenditures, except for those incurred by a wife to obtain alimony. The Tax Court permitted the deduction based on Kegs...