Bad News: Big Payment to Settle Overdose Case

More Bad News: No Tax Deduction Allowed

The Tax Court has concluded that an S corporation couldn't deduct its payment of legal fees and settlement costs arising out of a lawsuit against it and several of its employees based on the employees' conduct during a holiday weekend in which another employee died after using cocaine.

Here's what happened: Jani-King International, Inc. (Jani-King) is a successful janitorial-services franchisor. For the 2002 Thanksgiving holiday, James Cavanaugh (the CEO) vacationed at his villa in St. Maarten with his girlfriend and Jani-King employee, Colony Anne (Claire) Robinson. They were accompanied by Cavanaugh's bodyguard, and another Jani-King employee. The parties agreed that the trip was for pleasure and not to conduct or further any Jani-King business.

While on the trip, Robinson suffered fatal cardiac arrest after ingesting a large amount of cocaine. In August of 2003, Robinson's mother sued both Cavanaugh and Jani-King (alleging that its employees were all acting within the scope of their employment), seeking damages for her daughter's wrongful death and under other causes of action.

Jani-King was concerned that its reputation would be tarnished if the case dragged on or became more notorious. The board of directors worried not only about losing the case, but the prospect that Jani-King franchisees would also resort to litigation if they thought the suit would hurt their businesses. Jani-King settled the suit for $2.3 million. Cavanaugh contributed $250,000 in his individual capacity, which Jani-King reimbursed him for.

On its 2005 and 2006 tax returns, Jani-King deducted the settlement amount (including the amount it reimbursed Cavanaugh) along with its own attorney's fees as ordinary and necessary business expenses. On audit, IRS challenged the deductions.

The Decision: The Tax Court concluded that Jani-King couldn't deduct the settlement costs or legal fees because none of the Jani-King employees' conduct on the Thanksgiving weekend, whether proven or alleged, arose from Jani-King's profit-seeking activities. The employees were engaged in non-profit-seeking activities that didn't arise from or further Jani-King's business, and were far from any company property.

While noting that in the case of the bodyguard it was conceivable that Jani-King determined his security duties furthered its business objectives, the Court found that since the record contained no evidence as to his specific duties at Jani-King, it was difficult to conclude that he was acting within his business duties while on vacation in St. Maarten.

Here's the hard part: Jani-King could not have been liable unless the employees were acting in the scope of their employment. If that's the case, how would the settlement not be a business payment?

Even if the employees weren't in the scope of employment, Jani-King's desire to protect its reputation and end a lawsuit should have been enough for deductibility.