Cavanaugh Deduction Denied for CEO Misconduct Settlement Payments

In Cavanaugh v. Commissioner, the Fifth Circuit Court of Appeals addressed the deductibility of settlement payments made by a corporation to avoid liability arising from the misconduct of a shareholder-employee.1 Affirming the Tax Court ruling from 2012, the Fifth Circuit held that the settlement payments at issue in Cavanaugh were not deductible under IRC § 162(a) because the claims were not proximately related to the corporation’s profit-seeking activities. Although the facts of the Cavanaugh case are somewhat extreme, the decision could have implications for taxpayers confronted with similar claims, including sexual harassment, which, in the wake of the #MeToo movement, are on the rise. Cavanaugh is thus instructive in this regard.

Background on the Cavanaugh Case

James Cavanaugh, Jr. was the Chief Executive Officer and sole-shareholder of Jani-King International, Inc. (“Jani-King”), which is taxed as an S-corporation. According to its website, “Jani-King is the world’s largest commercial cleaning franchise company with more than 120 support offices in 10 countries.”2 Cavanaugh owned a home on the Caribbean island of St. Maarten.3 For Thanksgiving in 2002, Cavanaugh and three others traveled there for vacation. The individuals accompanying Cavanaugh included his current girlfriend, Colony Anne Robinson (“Robinson”), his bodyguard, Ronald Walker (“Walker”), and his former girlfriend, Erika Fortner (“Fortner”). Both Walker and Fortner were Jani-King employees; Robinson was not. On November 28, 2002, Robinson went into cardiac arrest and died. Her untimely death was likely caused from ingesting large amounts of cocaine.4

Robinson’s mother filed suit against Cavanaugh and Jani-King alleging, among other things, negligence, assault and battery, conspiracy, and wrongful death.5 The suit alleged that Jani-King contributed to Robinson’s death through the actions of its employees (i.e., Cavanaugh, Walker, and Fortner) and that Cavanaugh, Walker, and Fortner were acting in the course and scope of their employment when they provided Robinson with the cocaine that caused her death.6

Jani-King’s counsel concluded that Robinson’s mother would likely not prevail but advised Jani-King’s board of directors that an adverse outcome was possible.7 Based on the “substantial possibility of a negative impact on the company’s relationship with its franchisees and the company’s business,”8 Jani-King’s counsel advised the company to settle. Although Cavanaugh denied the allegations as frivolous, he offered to pay up to $250,000 towards the cost of his own defense. Ultimately, the parties settled for $2.3 million paid over the course of two years. Cavanaugh contributed $250,000.00 towards the settlement but was later reimbursed by Jani-King for his portion of the settlement.9

Jani-King deducted the settlement payment, the payments made to reimburse Cavanaugh, and the legal expenses related to the lawsuit as business expenses on its 2005 and 2006 returns. “[D]espite having paid $2.3 million ostensibly to avoid protracted litigation and the attendant negative publicity, Cavanaugh decided to fight for the deductions.”10

Tax Court Proceedings

The ultimate issue in Cavanagh was whether the settlement payment, the amounts paid to reimburse Cavanaugh, and the related legal expenses were deductible under section 162(a). As the Tax Court noted, an expense is deductible under section 162(a) only if the all four of the following requirements are met:

  1. The expense is be paid or incurred during the taxable of year;
  2. The expense is ordinary;
  3. The expense is necessary; and
  4. The expense relates to a trade or business.11

In Cavanaugh the first three requirements were not at issue. As the Court noted, litigation fees and expenses are considered “ordinary” within the meaning of section 162(a) under well- established precedent,12and the expenses were “necessary” because they were “appropriate and helpful,” which, as the Tax Court noted, is how that term has been defined for purposes of section 162(a).13 The parties stipulated to the payment of the expenses. The only question was whether the expenses had a sufficient nexus to the business so as to satisfy the fourth requirement.

To determine whether legal fees and expenses incurred in defending or settling a lawsuit are related to the taxpayer’s business, Court’s usually apply the origin of the claim test articulated by the Supreme Court in United States v. Gilmore.14 Under the origin of the claim test, the deductibility of legal fees and expenses depends on the origin and nature of the underlying claim. Legal fees and expenses are deductible only if the claim arises in connection with the profit seeking activities.15 The consequences to the taxpayer are irrelevant.

Cavanaugh contended, however, that the origin of the claim test did not apply and that the controlling precedent was Kopp’s Co., Inc. v. United States.16 In Kopp’s, the son of a lumber company president crashed a car owned by the company and injured the driver of another car. The driver sued the son, his father, and the company. The case later settled, and the company deducted its share of the legal fees. IRS challenged the deductions, and the case eventually wound up before the United States Court of Appeals. The Fourth Circuit allowed the deduction principally because the Company was directly exposed to the risk of a judgment as a result of being named in the lawsuit.

Although the Tax Court had previously cited Kopp’s as authority for the position that Gilmore does not apply to a corporation engaged in exclusively in business activities, it noted that the Fourth Circuit’s analysis has been roundly criticized for focusing on the consequences of the claim,17 as opposed to the origins of the claim, as required by the Supreme Court in Gilmore, and since the case was not appealable to the Fourth Circuit, the Court was not required to apply Kopp’s to the facts of this case.18

Applying Gilmore, the Tax Court found that Cavanaugh did not show that the lawsuit brought by Robinson’s mother arose in connection with Jani-King’s profit-seeking activities. Although the lawsuit was brought against both Cavanaugh and Jani-King, the origin of the claim was that Jani-King employees provided Robinson with the cocaine that caused her death. Providing cocaine did not further Jani-King’s business in any way. The Tax Court also found that Jani-King was not obligated to reimburse Cavanaugh for his part of the settlement expenses. Therefore, the reimbursement was not allowable as a deductible business expense.

The Fifth Circuit

The Fifth Circuit largely agreed with the Tax Court’s analysis of the case.

The Court began its analysis by declining to apply Kopp’s in situations where a corporation is named in the underlying suit. The Court noted that Kopp’s and cases following it directly conflict with Gilmore‘s command to look to the origin of the underlying claim, as opposed to the consequences of the litigation,19 and since Gilmore is Supreme Court precedent, it was controlling.

The Court noted that, under Gilmore, the Court must first “identify the claim that gave rise” to the legal fees and expenses in question, and then ” ‘determine whether the claim was proximately related to the trade or business of’ Jani-King.”20The Tax Court found that the origin of the claim related to Jani-King’s employees providing Robinson with cocaine, and that providing cocaine did not relate to Jani-King’s profit seeking activities. Because the Tax Court did not commit clear error, the Fifth Circuit refused to overturn this finding.21

The Court rejected the argument that, because Jani-King engages exclusively in profit seeking activities, it’s employees were necessarily acting in furtherance of those activities if they were acting in the course and scope of their employment as alleged in the complaint.22 Citing the Seventh Circuit’s decision in Northwestern Indiana Telephone Co. v. Comm’r and the Tax Court’s decision in Synanon Church v. Comm’r, the Court noted that it was possible for the employees to be acting in the course and scope of employment without being engaged in profit seeking activities on behalf of Jani-King.23 The Court also noted that Cavanaugh’s analysis would ignore the facts and allegations of the underlying claim and look solely to the theory of liability.24

Finally, the Court held that the Tax Court did not err in disallowing the deductions attributable to Jani-King’s reimbursement of Cavanaugh’s portion of the settlement. The Court noted that, although the bylaws of the corporation provided for indemnification of directors, officers, and employees under certain circumstances and required it under others, Cavanaugh did not show the requirements for indemnification were met.25 Citing the Supreme Court’s decision in Welch v. Helvering, the Court noted that paying another person’s debt is not an ordinary and necessary business expense, and while the Tax Court has recognized a limited exception that applies when a payment is made to protect the taxpayer’s own trade or business, that exception does not apply to Cavanaugh because he did not allege that the reimbursement payment was necessary to protect his trade or business.26 Rather, he merely alleged the settlement was necessary to protect Jani-King’s business. 27

Take-Away

Business should not assume that expenses or fees incurred to defend or settle litigation are automatically deductible under section 162(a). As the opinions of the Tax Court and the Fifth Circuit indicate, those expenses may be deducted only if they relate to claims arising from a business’s profit making activities. While the Cavanaugh involved some extreme facts, it is a good example of how origin of the claim test applies. Taxpayers facing similar claims should be aware of the case and take it into account in evaluating settlement positions.28

Brandon C. Dixon, J.D., LL.M.

Brandon is a native of Franklin, Kentucky. He also lectures frequently on topics related to trusts and estates, probate, and tax. View Full Profile.

Footnotes

  1. Cavanaugh v. Comm’r, No. 18-60299 (5th Cir. March 29, 2019) (unpublished), aff’g, T.C. Memo 2012-324.
  2. Jani-King International, Inc., About Us (available at https://www.janiking.com/about-jani-king/).
  3. Cavanaugh, No. 18-60299, slip op. at 2.
  4. Id.
  5. Cavanaugh v. Comm’r, T.C. Memo. 2012-324 at *3.
  6. Cavanaugh, No. 18-60299, slip op. at 2.
  7. Id.
  8. Id.
  9. Id. at 2-3.
  10. Cavanaugh, No. 18-60299, slip op. at 3.
  11. Cavanaugh, T.C. Memo. 2012-324 at *3.
  12. See id. at 8 (citing Commissioner v. Tellier, 383 U.S. 687, 690 (1966).
  13. See id (citing Tellier, 383 U.S. at 689).
  14. 372 U.S. 39, 49 (1963).
  15. Id.
  16. See Kopps’ Co., Inc. v. United States, 636 F.2d 59 (4th Cir. 1980).
  17. Cavanaugh, T.C. Memo. 2012-324 at **8-9.
  18. Cavanaugh, No. 18-60299, slip op. at 4.
  19. Cavanaugh, No. 18-60299, slip op. at 4.
  20. Id. at 6 (quoting Peters, Gamm, West & Vincent, Inc. v Comm’r, 71 T.C.M. (CCH) 2789, 1996 WL 182545, at *5 (T.C. 1996)).
  21. Cavanaugh, No. 18-60299, slip op. at 6.
  22. Id. at 7.
  23. See Northwestern Indiana Telephone Co. v. Comm’r, 127 F.3d 643 (7th Cir. 1997) and Synanon Church v. Comm’r, T.C. Memo 1989-270.
  24. Cavanaugh, No. 18-60299, slip op. at 9.
  25. Id. at 10.
  26. See Id. at 10,  Welch v. Helvering, 290 U.S. 111, 114 (1933), Cavanaugh, No. 18-60299, slip op. at 11 (citing Lohrke v. Comm’r, 48 T.C. 679, 684-685 (1967))
  27. Cavanaugh, No. 18-60299, slip op. at 11
  28. Cavanaugh, No. 18-60299, slip op. at 11.