Question

Our Understanding of the Facts: Mary Ryan is a well-known businesswoman in Harrisburg, Pennsylvania. Mary is the president and sole owner of an architectural firm, Ryan Architects, LLC (Ryan Architects). Ryan Architects is a single member Limited Liability Company which correctly reports its taxable income on Schedule C as if it were a sole proprietor. Mary has become known throughout the community for excellent work and honesty in her business dealings. Mary believes her reputation is an integral part of the success of Ryan Architects. Oil was found recently in the area around Harrisburg, and some geologists believe the reserves were large. A few well-respected business people organized Harrisburg Oil Company (HOC) to develop a few wells. Although some oil was extracted, HOC lacked the capital to develop the oil fields to their expected potential. After reading the geologist report, Mary felt that HOC was a good investment; therefore, she acquired 25% of HOC. A short time after Mary's acquisition, the price of oil decreased sharply. The decline in oil prices caused HOC to be unprofitable due to its high production cost. Three months later HOC filed for bankruptcy. The bankruptcy proceedings were reported in the local media. Many of HOC’s creditors were real estate developers that engage Mary’s architectural firm to provide designs. After HOC declared bankruptcy, Ryan Architects’ revenue noticeably decreased. Mary was convinced that her reputation had been damaged by her association with HOC and was the direct cause of the decline in her architectural firm’s business. Mary decided to use her architectural firm’s accumulated earnings to repay all of HOC’s creditors. The firm spent $1.5 million repaying HOC’s creditors. Assignment You are having a meeting with Mary. The meeting’s agenda includes advising Mary on the tax treatment of the $1.5 million payment to HOC’s creditors. In a properly structured tax research memorandum, document the advice you will be giving Mary regarding the tax treatment of the $1.5 million payment by Ryan Architects to HOC’s creditors. In your memo, you should cite only primary sources such as the Internal Revenue Code, Regulations, Court Cases, etc. A partial list of research sources includes: • IRC § 162 • Welch v Helvering 12 AFTR 1456 (54 S. Ct. 8), (S Ct, 11/06/1933) • William A Thompson, Jr, TC Memo 1983-487, PH TCM P 83487, 46 CCH TCM 1109

Answer 1

Internal Memorandum for advising Ryan Architects on tax treatment

Dear Ms. Mary:

I appreciate the opportunity to advise you regarding this tax matter. To ensure a complete understanding between us, I am stating the pertinent information about the advice that I will be rendering and the facts you provided to me.

Responsibilities

I use my judgment in resolving questions where the tax law is unclear or where conflicts may exist between the taxing authorities. Unless you instruct me otherwise, I resolve such questions in your favor whenever possible. However, the opinion I express does not bind the Internal Revenue Service (IRS). Thus, I cannot guarantee the outcome in the event the IRS challenges my opinion. You remain responsible for any tax or related liabilities resulting from an adverse IRS or judicial decision.

The law imposes various penalties when taxpayers understate their tax liabilities. Tax professionals also may be subject to penalties when an understated tax liability is based on a position that the professional recommends but has no realistic possibility of being sustained. A realistic possibility of success exists if the tax professional has a good faith belief that the position has at least a 1 in 3 chance of being sustained on its merits if challenged.

Issue & Analysis

Tax treatment of the $1.5 million payment by Ryan Architects to HOC’s creditors. Following are details to it.

Section 162 if they are ordinary, necessary and reasonable in amount. The general payment of another’s debts is not usually considered an ordinary and necessary business expense. The determination of whether a particular payment is ordinary and necessary, however, can be difficult. In the landmark case of Welch v. Helvering, 3, USTC ¶1164, 12 AFTR 1456 (UCCS, 1953), the Supreme Court discussed the meaning of the term “ordinary and necessary”. The court stated that while the payments to the corporation’s creditors were necessary (in that they were appropriate and helpful) for the development of Welch’s business, they were not ordinary. However, "expenditures incurred by a taxpayer to protect his business reputation or avoid unfavorable business or commercial publicity have been regarded as deductible." Marks v. Commissioner [Dec. 22,060], 27 T.C. 464, 467 (1956).

A payment to protect personal reputation is not deductible. Marks v. Commissioner, supra at 467. Only to the extent that any of the items paid in 1978 were "integral" to petitioner's business, Webb v. United States [82-2 USTC ¶ 9652], 560 F.Supp. 150, 158 (S.D. Miss. 1982), can we allow to petitioners a section 162 deduction.

We have found as facts that payments aggregating $ XX were made to protect the business reputations of petitioner and of Thompson & Litton. Petitioners were entitled to a deduction in the year 1978 in this amount.6 Petitioners have failed to show that the balance of the claimed deduction of $XX or payments to former creditors of Cardinal Gem amounting to $XX has the necessary connection to petitioner's business or to the business of Thompson & Litton to be deductible.

The record in fact establishes that payment was not integral to the business of Thompson & Litton. Welch v. Helvering, supra; Grauman v. Commissioner, supra; Cloud v. Commissioner [Dec. 33,641(M)], T.C. Memo. 1976-27

Conclusions and Recommendation

Ryan Architect should be permitted to deduct the amount paid to those creditors who are also customers of her architect’s business. However, Mary may not deduct the amount paid to the other creditors who are not customers of his real architect business.

Please let me know if you wish to discuss any of these issues further. I’ve certainly enjoyed working with you on this project and look forward to assisting you in the future when you need tax advice.

Regards