Category: Deductions & Credits; Partnerships & LLCs
Subject: Payment to Protect Business Reputation
Title: Discussion of Deductibility of Payments
IRC Sections: 162
Filename: 1302.html
Date Produced: 03/94

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Individual taxpayer, TP, is a general partner in various investment limited partnerships. TP is also an officer/shareholder of a number of corporate general partners of investment limited partnerships. TP was involved in promoting/syndicating the investments. The investment limited partnerships have failed and a number of investors are threatening legal action. In addition, a number of CPAs and attorneys provided services to the various entities involved and are now due to be paid. TP plans to pay significant sums of money to the investors. TP also intends to make good the amounts due to the CPA's and attorneys.

The issue is whether TP can deduct any or all of these payments personally.

Discussion
Ordinarily, payment by a partner or officer/shareholder of expenses of the partnership or corporation would be considered a de facto capital contribution to the respective entity. As such, the payments would not be personally deductible by the officer/shareholder or partner. There is, however, a body of case law allowing deductions to taxpayers in such situations under the theory that the taxpayer made the payments in order to protect his own business reputation. In other words, the courts found that there was a proximate relationship between the payments and the taxpayer's own trade or business (as distinct from that of the entity). See, for example, Dunn & McCarthy, Inc. v. Comr., 43-2 USTC ¶9688 (CA-2, 1943), ; Allen v. Comr., 60-2 USTC ¶9759, (CA-7. 1960); and Marks v. Comr., 27 TC 464.

As I understand it, TP contends that his payments are made to protect his own business reputation and to maintain the goodwill of his own customers. It seems to me that if TP's contentions ultimately stand up to scrutiny, the amounts in question are deductible as business expenses under §162 based on the cases cited above as well some 40 or 50 similar cases. This conclusion, however, is deceptively simple. The presumption is that TP would be able to produce evidence to demonstrate compellingly that the payments in question were motivated by the need to protect his business reputation for the sake of TP's own trade or business, and not the trade or business of the various entities involved. In our discussions, you have indicated a preference not to engage in further fact finding at this point. No one--including TP--can predict with any degree of certainty whether he would be able to carry the burden of proof. Accordingly, no one can predict with certainty whether a deduction for the payments in question would be sustained if challenged by the IRS.

The amount of money expected to be repaid to investors and professionals is quite significant, as I understand it in excess of $1 million. It seems likely that a deduction of that magnitude could invite IRS scrutiny. Accordingly, it seems likely that TP could be called upon to produce evidence to support his contention that the payments were made to protect his own business reputation. Based on the foregoing, it seems to me that while TP's deduction of the amounts in question are supportable as a matter of law, the ultimate outcome if the deduction were questioned turns on TP's ability to prove his motivation for making the payments in the first instance. Since the factual side of the determination is extremely unpredictable, it seems to me that TP should be strongly advised that there is significant risk with respect to the position that the amounts in question are deductible as ordinary and necessary business expenses.