When Embezzlers Can Deduct Legal Fees

You can be engaged in an unlawful business practice and still remove defense costs from your taxable income.

The Supreme Court, however, held in that case that allowing a deduction does not offend public policy because income taxes are not a “sanction against wrongdoing” and no public policy is offended when a person is faced with serious criminal charges and employs a lawyer to help in his defense.

Gordon contended that his legal fees were directly connected with carrying on his trade or business because they stemmed from his employment and profit-seeking activities when he was the president of GEM and AES.

The charges in the information, however, arose from two separate and unrelated schemes; an embezzlement scheme and a record-falsification scheme. Those schemes, the court concluded, must be analyzed separately.

Courts have consistently found that expenses arising from embezzlement are not sufficiently related to carrying on a trade or business to qualify as a business expense. Here, the embezzlement scheme was related to Gordon’s trade or business only because Gordon stole from his employer; it didn’t arise out of or closely result from his employment as president of GEM or AES. Thus, the court ruled that the legal fees for Gordon’s defense against charges arising out of the embezzlement scheme were not business expenses.

Gordon testified that his supervisors directed him to falsify records. The government had offered no evidence to dispute that testimony. Actions taken at the direction of one’s supervisors are, undoubtedly, connected with business activities.

Moreover, even if Gordon had not been directed to falsify documents, his actions, the court found, still maintain the necessary business connection. The Tellier case makes it abundantly clear that tax deductions for business expenses are not limited to expenses incurred in the course of lawful business activity.

Gordon’s participation in the record-falsification scheme was connected with and closely resulted from his employment at Merrill because the scheme was intended to further the firm’s business interests by enabling GEM to command a higher purchase price. Merrill thus directly benefited from the scheme, and any personal benefit Gordon may have derived resulted from his status as a Merrill employee. This, the court concluded, is different from the embezzlement scheme, which was harmful to Merrill and beneficial to Gordon only in his personal capacity rather than his employee capacity.

Therefore, the legal fees incurred in defending against the records-falsification part of the information were found to be deductible under Section 162(a) as ordinary and necessary business expenses.

Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.

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