Deductions: Business Expenses

By Robert Klein, CPA

The most frequent deduction taken by business persons and investors is that for "ordinary and necessary expenses paid or incurred in carrying on any trade or business" (Code Section 62(a)). Another common deduction is "loss incurred in a trade or business not compensated for by insurance or otherwise" (Code Section 165(c) (1)). An opinion by the United States Court of Appeals for the Sixth Circuit involving an outlay of $5 million by a restaurant developer and promoter provides a detailed analysis of the two deductions (which were denied to the taxpayer). Tigrett v. U.S. (05-66291) (6th Cir. 2007).

Background

Issac Tigrett is a developer and promoter of restaurant and entertainment venues. He created the original Hard Rock Cafe in London in 1971 and during the 1990s he sought to reproduce the success of the chain using a different music theme and with the cuisine of the American South. Between 1992 and 1997, he was chairman of HOB Entertainment, Inc., the corporation formed to develop the concept. During his term as CEO, he personally incurred the $5 million expense at the center of this litigation.

The directors of HOB were concerned that the project might not be successful; therefore, Tigrett and two others agreed they would contribute funds to cover any shortfall. Tigrett said he would contribute as much as $5 million. The first venue for the new company was the Atlanta Olympic Games. The explosion of a bomb at the site resulted in a $10 million loss for the operation, making it necessary for Tigrett to fulfill his $5 million obligation. The IRS rejected his claim for a loss deduction and he began the lawsuit. The federal district court ruled in favor of the IRS and Tigrett appealed to the Sixth Circuit.

No Ordinary Business Expense

The district court was satisfied that the $5 million payment was made in relation to Tigrett's business, but held the expense was not "ordinary." Said the Sixth Circuit, "An ordinary expense is generally one of common or frequent occurrence in the type of business involved … a capital expenditure is one made to create or enhance a separate and distinct asset, one that may be expected to yield benefits beyond the year in which the year is incurred." The distinction is fact-specific that may turn on "distinctions of degree rather than of kind."

Here, said the court, the contribution was in the nature of a capital expenditure because it is not common, in the restaurant and entertainment business, for a corporate officer to make a personal guaranty "several times his annual salary." In addition, the trial court ruled that the primary benefit sought by Tigrett was to build the HOB brand for a forthcoming public offering of shares. This points to a capital expenditure.

The Sixth Circuit also agreed with the trial court that the key fact was the assumption of the indemnification obligation in the first place rather than the subsequent actual payment. Tigrett had made clear that undertaking the obligation was done to protect his reputation as a promoter and developer—a "capital asset" said the court.

Not Business Loss

Tigrett also argued that the $5 million contribution was a loss incurred in a trade or business. The trial court again agreed that the payment was made in relation to his business of developing and promoting restaurant and entertainment venues, but concluded the payment was not a "loss" because it was made pursuant to the indemnification or contribution agreement entered into by Tigrett without consideration. Generally, the voluntary payment of another's loss, without any legal obligation to do so, does not qualify as a deductible loss.

Tigrett's argument was that while the contribution agreement was not the basis for the loss, the actual payment of the money pursuant to a legal obligation was a deductible loss. He cited Putnam v. Commissioner, 352 U.S. 82 (1956), where the Supreme Court said that a guarantor who pays a debt for another in compliance with a contract of guaranty sustains a deductible loss. Tigrett argued that when he made the payment, it was pursuant to a legally binding obligation.

However, the court ruled that Tigrett entered into the contribution agreement without consideration, assuming responsibility for a loss knowing that he would not be repaid. Thus the obligation was a gratuity and not a deductible loss. Alternatively, the repayment was an investment in a capital asset, i.e., Tigrett's reputation as an entrepreneur, which is not deductible as an ordinary business loss. The Sixth Circuit affirmed the decision of the district court denying the deduction.

Robert Klein, CPA, is a Tax Partner in the BDO Seidman’s Woodbridge, New Jersey office. He can be reached at (732) 750-0900

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