Opinion
No. CV 01-1346-PHX-ROS
May 31, 2002
ORDER
Pending before the Court is Defendant's Motion to Dismiss (Doc. #5) filed September 18, 2001. Defendant also filed a Motion for Extension of Time (Doc. #7) to respond to Plaintiff's Complaint. Plaintiffs filed their Response (Doc. #9) on November 9, 2001, and Defendant filed no reply. For the reasons set forth below, the Court will deny Defendant's Motions.
The Court will deny as moot Defendant's Motion for Extension of time. Pursuant to Rule 12 of the Federal Rules of Civil Procedure, a Rule 12(b) motion extends the time for Defendant to file a responsive pleading until ten days after notice of the Court's decision denying the motion. See Fed.R.Civ.P. 12(a)(4)(A).
Background
On July 19, 2001, Plaintiffs filed pro se a Complaint against Defendant alleging that Plaintiffs "are entitled to recover from Defendant in the amount of $2,737.00 in overpaid income taxes plus applicable penalties and interest." (Compl. at 3). Plaintiffs contend that Defendant improperly disallowed a deduction claimed by Plaintiffs under 28 U.S.C. § 162 in a Claim for Refund submitted October 26, 2000. The basis for Plaintiffs' claimed refund was a deduction for legal expenses incurred during the 1987 tax year. In 1984, Plaintiffs had filed a libel suit against Andy LaLande in Mohave County Superior Court (CV84-22374). LaLande was Plaintiff Jerry bit's opponent in the Republican primary for the office of Supervisor of Mohave County. (See Libel Compl. at 2). Plaintiffs alleged that LaLande was responsible for campaign advertisements that were libelous and slanderous and "were such as to bring Jerry A. Holt into disrepute, contempt, ridicule and to constitute impeachment of his honesty, integrity, virtue or reputation." (Id. at 3).On January 21, 1999, Plaintiffs' accountant provided the Internal Revenue Service ("IRS") with information pertaining to Plaintiffs' claimed expenses, including legal and documentary support for Plaintiffs' position. (Compl. at 2). On July 21, 1999, the IRS mailed to Plaintiffs a letter disallowing Plaintiffs' claim, stating the following "(r]easons for disallowance":
Failure to provide itemized billing statements or receipts reflecting business purpose of expenditures claimed on the amended return and additional expenses presented during examination. Failure to provide documentation the expenses were personally paid by Jerry or Patricia Holt and were not a transaction of the corporation, Yankee Enterprises.
According to Plaintiffs, Yankee Enterprises, Inc. is Plaintiffs' "wholly-owned corporation." (Resp. at 1).
(Compl. at 3, Exh. G). On July 19, 2001, Plaintiffs timely filed the present Complaint. On September 18, 2001, Defendant filed its Motion to Dismiss.
Discussion
I. Legal Standard
In resolving a motion to dismiss for failure to state a claim under Rule 12(b)(6) of the Federal Rules of Civil Procedure, "[a]ll allegations of material fact are taken as true and construed in the light most favorable to the nonmoving party." Smith v. Jackson, 84 F.3d 1213, 1217 (9th Cir. 1996). "A complaint should not be dismissed unless a plaintiff could prove no set of facts in support of his claim that would entitle him to relief." Parks Sch. of Bus., Inc. v. Symington, 51 F.3d 1480, 1484 (9th Cir. 1995). "The federal rules require only a 'short and plain statement of the claim showing that the pleader is entitled to relief.'" Gilligan v. Jamco Dev. Corp., 108 F.3d 246248 (9th Cir. 1997) (quoting Fed.R.Civ.P. 8(a)). "The Rule 8 standard contains a powerful presumption against rejecting pleadings for failure to state a claim." Id. at 249 (quotation marks omitted). Indeed, though "it may appear on the face of the pleadings that a recovery is very remote and unlikely[,] . . . that is not the test." Id. (quoting Scheur v. Rhodes, 416 U.S. 232, 236 (1974)). "The issue is not whether the plaintiff will ultimately prevail but whether the claimant is entitled to offer evidence to support the claims." (Id.) (quoting Scheur, 416 U.S. at 236). Finally, it is well established that pro se complaints, "however inartfully pleaded[,] are held to less stringent standards than formal pleadings drafted by lawyers[.]" Hughes v. Rowe, 449 U.S. 5, 9 (1980) (quotation marks omitted). "Such a complaint should not be dismissed for failure to state a claim unless it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief." Id. at 10.
II. Analysis
Defendant's Motion to Dismiss reiterates the two grounds for denying relief articulated by the IRS in its July 19, 1999 Notice of Disallowance. According to Defendant, Plaintiffs are: (1) attempting to claim a deduction for legal expenses actually incurred by another taxpayer — Yankee Enterprises; and (2) attempting to claim a nondeductible personal expense as a deductible business expense. For their part, Plaintiffs contend that the accounting procedures that structure the relationship between Plaintiffs and Yankee Enterprises, together with the "general rules of principal-agent common law," establish that "payments by Yankee for the benefit of the plaintiffs are deductible in the year paid." (Resp. at 2). In addition, Plaintiffs maintain that because their claimed damages in the libel suit against LaLande consisted of the loss of income to Jerry Holt's real estate appraisal business, the legal fees are properly regarded as a business expense. (Resp. at 3-4).
A. Plaintiffs' Deduction for Expenses Paid by Yankee Enterprises
Pursuant to 28 U.S.C. § 162, "deductions for expenses can be taken only by the party who actually 'paid or incurred' them." United States v. Cocke, 399 F.2d 433, 447 (5th Cir. 1968) (quoting 28 U.S.C. § 162 (a)). "There are no provisions in the tax laws whereby one taxpayer can deduct from his gross income expenses incurred and defrayed by another." H.W. Nelson Co. v. United States, 308 F.2d 950, 954 (Ct.Cl. 1962).
Defendant contends that the checks submitted by Plaintiffs to substantiate their litigation expenses were drawn on the account of Yankee Enterprises, thereby establishing that Yankee Enterprises, not Jerry and/or Patricia Holt, "paid" the litigation expenses. Accordingly, to the extent that such expenses were deductible, Yankee Enterprises, not Plaintiffs, was entitled to deduct them.
Plaintiffs contend that their "earnings were deposited into this [Yankee Enterprises bank] account, and the plaintiff's [sic] personal expenses were paid out of this account in 1987." (Resp. at 1-2). Plaintiffs also attached to their Complaint documents purporting to show how the account was established and maintained. (See Compl., Exh. E). According to Plaintiffs, "[u]nder the general rules of principal-agent common law, it would appear that plaintiffs have met their burden that payments by Yankee for the benefit of the plaintiffs are deductible in the year paid." (Id. at 2).
The Court recognizes that "[g]enerally, a district court may not consider any material beyond the pleadings in ruling on a 12(b)(6) motion." Hal Roach Studios. Inc. v. Richard Feiner Co., 896 F.2d 1542, 1555 n. 19 (9th Cir. 1990). "However, material which is properly submitted as part of the complaint may be considered." Id.; see also Parks Sch. Bus Inc. 51 F.3d at 1484 ("When a plaintiff has attached various exhibits to the complaint, those exhibits may be considered in determining whether dismissal was proper without converting the motion to one for summary judgment."). Because the relevant exhibits are attached to, and incorporated into, Plaintiffs' Complaint, the Court has considered them in resolving Defendant's Motion to Dismiss.
Although Plaintiffs cite no authority for the principal-agent doctrine as it applies in the context of taxation, the Court cannot say that the doctrine does not apply to the facts of this case. Indeed, "courts, although maintaining the legal fiction of a distinction between stockholder and corporation, may, in considering both income and deductions, reach the conclusion that a corporate entity was the agent of the principal in receiving income." Factor v. Comm'r of Internal Revenue, 281 F.2d 100, 110 (9th Cir. 1960). Plaintiffs are thus entitled to offer evidence to support their claim that the principal-agent doctrine justifies their deduction for legal expenses nominally incurred by Yankee Enterprises. In light of the "powerful presumption against rejecting pleadings for failure to state a claim," Gilligan, 108 F.3d at 249, Defendant has not established "beyond doubt that the [Plaintiffs] can prove no set of facts in support of [their] claim which would entitle [them] to relief." Hughes, 449 U.S. at 10.
Here, as elsewhere, Defendant's failure to file a reply rebutting Plaintiffs' arguments substantially weakens its case for dismissal.
B. Plaintiffs' Deduction for Legal Fees Incurred in the Libel Suit
Pursuant to 28 U.S.C. § 162, a taxpayer may claim "as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." 28 U.S.C. § 162 (a). Legal fees incurred by a taxpayer are deductible as a business expense where "directly connected with, or . . . proximately result[ing] from, his business." Kornhauser v. United States, 276 U.S. 145, 153 (1928); see also Butler v. Comm'r of Internal Revenue, 17 T.C. 675, 679 (1951) ("[P]ayment in settlement of a suit for breach of trust or mismanagement of funds by a fiduciary, where the threatened litigation is bona fide, is deductible in those instances where the threatened litigation arises either out of the business of the taxpayer or some transaction he has entered into for profit."). Because "an income tax deduction is a matter of legislative grace," however, "the burden of clearly showing the right to the claimed deduction is on the taxpayer." INDOPCO. Inc. v. Comm'r of Internal Revenue, 503 U.S. 79, 83 (1992). Moreover, the taxpayer bears the burden of substantiating the amount of a claimed deduction. See Hradesky v. Comm'r of Internal Revenue, 65 T.C. 87, 89 (1975). "If the trier of fact finds that the litigation is not directly connected with the business of the taxpayer, then the expense is a nondeductible personal item." Comm'r of Internal Revenue v. Shapiro, 278 F.2d 556, 558 (7th Cir. 1960).
Here, Defendant observes that Plaintiffs' "libel complaint made no mention of lost income or other business consequences flowing from the alleged libel." (Mot. at 4). According to Defendant, "[t]his strongly indicates that the expenses were not incurred for business purposes." (Id.).
Plaintiffs contend that they "sued [LaLande] in this state court action due to loss of earnings from the plaintiff-husband's long-term position in Mohave County, Arizona, as a professional real estate appraiser and real estate broker." (Resp. at 2-3). Plaintiffs note that the damage evidence at the state court trial focused on Jerry Holt's diminished income as an appraiser in the wake of the alleged libel. Attached to Plaintiffs Complaint in the present action is an "Income Analysis" adduced by Plaintiff in the state court action to substantiate his damages in terms of lost business revenue. The Income Analysis, and its role in the state court proceedings, supports Plaintiffs' allegation that the legal expenses incurred in the state court action arose out of, or in connection with, his business activities.
As noted above, because the Income Analysis and other exhibits are attached to, and incorporated into, Plaintiffs' Complaint, the Court has considered them in resolving Defendant's Motion. See Hal Roach Studios, Inc., 896 F.2d at 1555 n. 19.
Although the parties cite no authority that addresses whether litigation expenses incurred in connection with a libel suit are deductible as business expenses under 28 U.S.C. § 162, several courts have addressed the issue. "The courts have generally denied a deduction for the costs of prosecuting an action for libel or slander, even though the statements could be detrimental to the taxpayer's business." 39 A.L.R. Fed. 221 (1978); see, e.g., Lloyd v. Comm'r of Internal Revenue, 55 F.2d 842, 844 (1932) ("In practically every case where slanderous reports are circulated about an individual and damage his character or reputation, such reports affect indirectly . . . the business in which he is engaged. Any expense, however, incurred by him in defending his good name under such circumstances, cannot be said to be ordinary and necessary expenses incurred in carrying on his business."); Kleinschmidt v. Comm'r of Internal Revenue, 12 T.C. 921, 924 (1949) (holding that legal expenses incurred in connection with "libel suits . . . filed as the result of published statements made in the course of a political campaign" and "not made as an incident to earning income in the practice of law" were not deductible as business expenses).
Other courts, however, have determined that legal expenses incurred in prosecuting a libel suit are deductible business expenses if the taxpayer undertakes the suit to protect his professional reputation. See, e.g., Dyer v. Comm'r of Internal Revenue, 36 T.C. 456, 465 (1961) (holding that, because the petitioner testified that the purpose of his libel suit was to protect his reputation as a lawyer, "the $134.60 which petitioner incurred and paid in the libel suit was a business expense and is deductible under section 162"). More generally, "[e]xpenditures incurred by a taxpayer to protect his business reputation or avoid unfavorable business or commercial publicity have been regard[ed] as deductible." Marks v. Comm'r of Internal Revenue, 27 T.C. 464, 467 (1956) (distinguishing between a taxpayer's personal and professional reputation); Butler v. Comm'r of Internal Revenue, 17 T.C. 675, 681 (1951) (allowing deduction for legal expenses incurred by taxpayer motivated to enter settlement agreement "because of his fear of damage to his reputation as a public utility consultant or manager from unfavorable publicity which might result from continued litigation"); Helvering v. Cmty. Bond Mortgage Corp., 74 F.2d 727, 178 (2d Cir. 1935) ("In the instant case, the taxpayer's reputation was being injured by the conduct of its agent, and its primary motive in seeking cancellation of the contract was to prevent the loss of earnings. . . This we think was an expenditure ordinary and necessary in carrying on the business, and deductible from the respondent's gross income."). But cf. Welch v. Helvering, 290 U.S. 111, 115 (1933) (upholding disallowance of deduction for taxpayer's payment of debts of a bankrupt corporation because the expenses were incurred only to enhance the taxpayer's "own standing and credit").
The Court expresses no opinion regarding whether Plaintiffs' purported expenditures are deductible legal expenses under § 162. However, in light of the presumption against rejecting pleadings for failure to state a claim and the Court's liberal construction of Plaintiffs' pro se Complaint, Defendant has failed to establish that Plaintiff can prove no set of facts that would entitle them to relief. Specifically, because Defendant has failed to address the tax implications of the alleged principal-agent relationship between Plaintiffs and Yankee Enterprises and the alleged damage to Plaintiffs' business reputation as a result of the alleged libel, the Court cannot say that Plaintiffs' allegations, and supporting documentation, fail as a matter of law.
Accordingly,
IT IS ORDERED that Defendant's Motion to Dismiss (Doc. #5) is DENIED.
IT IS FURTHER ORDERED that Defendant's Motion for Extension of Time (Doc. #7) is DENIED as moot.