IRS Allows Deduction for Payments for Preferred Stock Used to Settle Bank’s Lawsuits

In a private letter ruling released on April 29, the IRS’ Office of Chief Counsel allowed a private bank catering to high-wealth individuals to deduct as ordinary and necessary trade or business expenses the payments it made to settle lawsuits arising from criminally fraudulent activities by one of the bank’s fund managers (PLR 201117007).

The private bank offers traditional banking services, as well as asset management and investment advisory services, and allows its clients to invest in shares of several investment funds. One of those funds suffered losses (and ended up in bankruptcy) as a result of criminally fraudulent activities by the fund’s manager.

Four class action lawsuits were filed as a result, naming the bank as defendant, and alleging violations of the Securities Exchange Act of 1934, negligent misrepresentation, breach of fiduciary duty, gross negligence, and unjust enrichment. The bank (and its foreign parent bank) settled these lawsuits by paying cash to another subsidiary of the foreign parent, which then transferred preferred stock to the bank’s clients entitling the holders to annual cash distributions. The bank received no reimbursement from insurance in connection with payments made under the settlement.

The bank sought a ruling from the IRS that these payments would be deductible under Sec. 162 as ordinary and necessary business expenses and that no portion would be characterized as a capital expenditure under Sec. 263.

The IRS looked to the origin of the claim to determine whether the payments qualified as ordinary and necessary business expenses. Under the origin of the claim doctrine, announced by the Supreme Court in Gilmore, 372 U.S. 39, 49 (1963), “the origin and character of the claim . . . rather than its potential consequences . . . is the controlling basic test of whether the expense [is] business or personal.”

The IRS determined that the claims alleged in the lawsuits arose from services rendered as part of the bank’s private banking business. Generally, amounts paid to settle lawsuits are deductible if the acts that gave rise to the litigation were performed in the ordinary course of the taxpayer’s business. The IRS also determined that the settlement was adopted to protect the bank’s reputation and maintain its business. Therefore, the IRS ruled that the payments were ordinary and necessary expenses of the bank’s trade or business and deductible under Sec. 162.

The IRS also examined whether any portion of the payments would have to be capitalized under Sec. 263 rather than currently deducted. Regs. Sec. 1.263(a)-4 requires taxpayers to capitalize separate and distinct intangible assets. However, the IRS determined that the payment of preferred stock to the settling clients did not create a separate and distinct asset, financial interest or future benefit, so the bank is not required to capitalize any portion of its payment to the settling clients.