Which expenses are business and which are personal? You might think it’s obvious, but your view and the IRS view may differ. These days business and personal can often seem mixed up, such as when you do entertaining, try to motivate employees, go on combined business and work trips, and more.
The IRS sometimes points an accusing finger at corporate conduct and denies tax deductions. In fact, even if the company is a named defendant, it may not be enough to make a settlement payment—or even legal fees—tax deductible. That’s what happened in Cavanaugh v. Commissioner. The events go back to 2002, but a 2019 Fifth Circuit tax decision gives it renewed interest. James Cavanaugh was CEO and sole shareholder of Jani-King, a successful janitorial-services franchisor. He vacationed in St. Maarten one Thanksgiving with his girlfriend, Jani-King employee, Claire Robinson. It wasn’t a business trip, but they were accompanied by Cavanaugh’s bodyguard, and another Jani-King employee.
While on the trip, Ms. Robinson suffered fatal cardiac arrest after ingesting a large amount of cocaine. Her mother sued Cavanaugh and Jani-King. Jani-King’s board worried that losing the case would trigger a backlash from franchisees. So Jani-King settled for $2.3 million. Cavanaugh contributed $250,000, which Jani-King reimbursed. Jani-King deducted all of it as a business expense.
The IRS challenged the deductions, but the Tax Court agreed with the IRS. Why? The employees were on vacation, not Jani-King business, and were far from company property. Still, other courts have allowed business deductions where the claims are at least part business, as in Kopp’s Co. v. United States. There, a company deducted a settlement after the CEO killed a child in a company car on the way to the office. But Cavanaugh’s case was different, the IRS and Tax Court said. Only the consequences of the suit, not its origin, were business-related. In fact, even naming Jani-King as a defendant didn’t automatically make legal fees or the settlement deductible. The deductibility of Jani-King’s payment turned on the claim that Jani-King employees negligently provided illegal drugs resulting in Robinson’s death, and whether its origin lay in Jani-King’s business.
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