                           T.C. Memo. 1997-547



                         UNITED STATES TAX COURT



    STEPHEN F. SCOFIELD AND NANCY E. SCOFIELD, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



       Docket No. 14305-95.                   Filed December 11, 1997.



       Stephen R. Klorfein and Benjamin I. Fink, for petitioners.

       Lourdes Gonzalez de Mendoza, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


       COLVIN, Judge:   Respondent determined deficiencies in

petitioners' income taxes and additions to tax as follows:

                                     Additions to tax

                           Sec.            Sec.          Sec.
Year      Deficiency    6651(a)(1)    6653(a)(1)(A) 6653(a)(1)(B)
1985       $56,672          --
                                                         1
1986         6,343       $18,577         $5,511
                                        2
                                                       2
1987          90,373      23,940         4,788
1988         148,173       7,409


                                   Additions to tax
                           Sec.           Sec.         Sec.
              Year      6653(a)(1)     6653(a)(2)      6661
                                            3
              1985       $2,843                       $14,115
              1986                                       --
              1987                                     22,319
              1988        7,409                        21,078
       1
           Fifty percent of the interest due on $6,343.
       2
           Fifty percent of the interest due on $90,373.
       3
           Fifty percent of the interest due on $56,672.

       After concessions, the issues for decision are:

       (1)    Whether petitioners may deduct $750,000 petitioner-

husband paid in 1988 to settle civil litigation related to his

guarantee of the debt of Northeast Cellulose, Inc. (Northeast),

claims of creditors of Northeast, and his bankruptcy proceedings.

We hold that they may not deduct the portion (50 percent) of the

settlement payment attributable to petitioner's guaranty of

Northeast's line of credit because his dominant motive for making

the guaranty was to protect his investment in Northeast.        We also

hold that they may deduct the portion (50 percent) attributable

to claims of Northeast's creditors (other than the bank to which

petitioner made the guaranty), subject to the 2-percent limit in

section 67, because petitioner's payment to settle claims of

Northeast's creditors other than the bank originated in his

conduct as an officer or employee of Northeast and in action

taken by him as an investor-shareholder of Northeast.
                                   3

     (2)    Whether petitioners may deduct legal expenses of

$10,243 in 1986, $59,352 in 1987, and $104,156 in 1988.       We hold

that they may, subject to the 2-percent limit in section 67.

     Unless otherwise indicated, section references are to the

Internal Revenue Code.    Rule references are to the Tax Court

Rules of Practice and Procedure.

                         I.   FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.

A.   Petitioners

     Petitioners Stephen F. Scofield (petitioner) and Nancy E.

Scofield (Mrs. Scofield) are married and lived in Marietta,

Georgia, when they filed their petition.     Petitioners have been

married since 1981 and have four sons.

     Petitioner graduated from Syracuse University in 1968 with a

degree in economics.     He started to work in the newsprint

industry that year.    He worked for Great Northern Paper Co.

(Great Northern) from 1968 to June 1972, primarily in sales

positions.    Petitioner then worked for about 4 years as sales

manager for Eastern Color Printing Co. (ECP), a printing

business.

B.   Petitioner's Businesses

     1.     Unidyne

     Petitioner left ECP around 1976 to start a company which he

named Unidyne, Inc. (Unidyne).     Unidyne was in the paper
                                  4

recycling business.    Lawrence McKee (McKee) was also associated

with Unidyne.    Unidyne stopped doing business in 1977.

     2.     Northeast Cellulose, Inc.

     In 1977, petitioner (and apparently McKee) started a company

called Northeast Cellulose, Inc. (Northeast).    Northeast

brokered, bought, and sold newsprint.    Northeast sold commercial

printing paper, magazine paper, and newsprint to retailers and

printers.

     Petitioner was an officer and director of Northeast.      He

owned 50 percent of the stock of Northeast, a Massachusetts

corporation.    Petitioner invested about $4,000 for his Northeast

stock.    McKee was Northeast's other 50 percent stockholder and

was president of Northeast.

     Petitioner worked about 25 hours per week for Northeast in

1978 and 1979.    Among his other duties, petitioner maintained

Northeast's customer and mill contacts.    Northeast did not pay a

salary to petitioner in 1979.1

     Northeast earned a commission on its sales.    Paper mills

typically paid a commission to Northeast of 3 percent, after

freight and related costs.    At first, Northeast acted as a

broker.    Eventually, however, it took title to the paper, which

required it to establish lines of credit.



     1
       The record does not indicate whether Northeast paid a
salary to petitioner in any other year.
                                   5

     In 1978 and 1979, Northeast established a line of credit

with Guaranty Bank & Trust Company (the bank) in Massachusetts.

McKee signed a guaranty dated March 3, 1978, for the line of

credit.    Northeast used its assets as collateral for the loan.

In December 1979, the bank lent about $1.2 million to Northeast

on the line of credit.    Petitioner signed a guaranty with the

bank around January 11, 1980.    Northeast used its line of credit

with the bank to take title to paper when it was advantageous to

do so.

     Northeast had retained earnings of $107,058.15 on December

31, 1978, and $183,747.33 on December 31, 1979.    At the end of

1979, petitioner submitted a financial statement to the bank in

which he estimated that the value of his interest in Northeast as

a going concern was about $1 million.

     Zayre Corp. (Zayre) was a customer of Northeast.    Northeast

contracted to sell paper to Zayre.     Consolidated Newsprint, Inc.

(CNI) produced and sold paper for newsprint and newsprint

advertising and contracted to regularly sell products to

Northeast.

     3.    Sigma General, Inc.

     Petitioner owned all of the stock of Sigma General, Inc.

(Sigma), a New Hampshire corporation he formed in 1978.    Sigma

placed orders for printing advertising material to be distributed

by newspapers.    In 1979, Sigma placed orders totaling about $10

million.     Petitioner estimated that the value of his interest in
                                    6

Sigma was about $500,000 early in 1980.2     At that time, Sigma had

four or five employees.      From late 1980 to 1981, petitioner was

Sigma's only employee.      Sigma was sometimes a customer of

Northeast.

     Sigma paid petitioner a salary of $143,333 in 1979.

     Sigma ceased doing business in September 1981.

     4.      Norcel, Inc.

     In May 1980, petitioner incorporated a company called

Norcel, Inc. (Norcel).      He was Norcel's only officer, director,

and shareholder.

     5.      Wingfoot Corp., Ltd. and Alar, Ltd.

     Petitioner was a stockholder and officer of Wingfoot Corp.,

Ltd. (Wingfoot), a Canadian corporation.      He did not earn a

significant amount of income from Wingfoot in 1978 and 1979.

     Petitioner started a company in Hamilton, Bermuda, named

Alar, Ltd., at a time not stated in the record.

C.   Northeast's Collapse

     1.      Cessation of Northeast's Business Activity

     Petitioner resigned as an officer from Northeast on June 20,

1980.     In mid-1980, Northeast ceased doing business.

     2.      Creditors' Agreement

     On August 11, 1980, the bank, CNI, Zayre, and Meredith-

Burda, Inc. appointed Virginia Norkevicius (Norkevicius) as


     2
       The record does not indicate how petitioner used this
estimate.
                                 7

nominee to receive and hold Northeast's assets.    Norkevicius was

a vice president of the bank.   For purposes of distributing the

remaining assets of Northeast, Northeast's creditors agreed, in

August 1980, that Norkevicius would distribute money that she

recovered as follows:   the first $200,000 was to be distributed

to the bank, and the next $1.6 million was to be given 50 percent

to the bank and 50 percent to the other parties.   This agreement

was based on how much Northeast owed to each party.   Norkevicius

had collected $726,000 when the agreement was signed.

D.   Calta, Inc.

     After Northeast and Sigma collapsed, petitioner began

working for a company that Mrs. Scofield had formed called Calta,

Inc. (Calta), a Massachusetts corporation.   Calta was in the

printing business.   When petitioners moved to New Hampshire in

1981, she reincorporated Calta in New Hampshire.   Petitioner

worked for Calta from 1981 to 1983 and received a salary of about

$5,000 a month.

E.   Petitioner's Litigation Relating to Northeast

     Petitioner incurred legal expenses as a defendant in

lawsuits brought by the bank, Northeast, CNI, Zayre, and

Norkevicius (as nominee), and in related bankruptcy proceedings.

     1.   Petitioner's State Court Proceedings

     On June 12, 1982, the bank, Northeast, CNI, Zayre, and

Norkevicius (as nominee), sued McKee, petitioner, Timothy Samway,

Robert E. Davis, Francoise Sterling, Sigma, and Wingfoot in the
                                  8

Superior Court of Worcester County, Massachusetts (docket no. 82-

22879).    The plaintiffs alleged that petitioner and the others

had:    (a) Conspired to terminate the business of Northeast and to

appropriate for themselves the business, goodwill, and assets of

Northeast; (b) created false invoices; (c) caused Northeast to

breach contracts with suppliers and thereby lose future profits;

(d) taken equipment and funds of Northeast; and (e) made

misrepresentations to Zayre which caused it to buy and

immediately pay for a million pounds of premium paper.

       In the complaint, the plaintiffs alleged that Northeast owed

them $2,958,720.24 when it stopped doing business.    They alleged

that, at the time the complaint was filed, Northeast owed

$561,530.53 to the bank, $406,812.39 to Zayre, and $946,132.33 to

CNI.    The complaint does not explain why those amounts totaled

less than the plaintiffs alleged Northeast owed when it stopped

doing business.    The plaintiffs alleged that petitioner was

liable for Northeast's debts to the bank because he and McKee had

signed guarantees.

       The bank also sued petitioner, McKee, McKee's wife, and

Northeast in the Superior Court of Worcester County,

Massachusetts, for the indebtedness of Northeast on the line of

credit (docket No. 82-22880).    We sometimes refer to these cases

as the Northeast litigation.

       Petitioner denied the allegations and made counterclaims,

cross-claims, and third-party claims.    He contended that the
                                  9

bank, without the approval of Northeast or knowledge of

petitioner, let McKee borrow money in Northeast's name that McKee

used for highly speculative investments unauthorized by Northeast

and for McKee's personal benefit.     He also claimed that McKee and

one of the bank's officers intentionally misrepresented

Northeast's financial condition to induce petitioner to sign the

guaranty to the bank, and he sought indemnification from McKee

and the bank officer.

     Petitioner initially contended during the Northeast

litigation that he had not guaranteed Northeast's indebtedness to

the bank and that he was not liable for payment on the guaranty.

However, in 1984, petitioner acknowledged that he had signed the

guaranty in January 1980 and was liable to the bank for payment

on the guaranty.

     Robert Williams represented petitioner in the Northeast

litigation.   These cases were settled in 1988.   See paragraph I-

E-3, below.

     2.   Petitioner's Bankruptcy Case

     In September 1983, petitioner filed a petition in the United

States Bankruptcy Court for the District of New Hampshire under

chapter 7 of the U.S. Bankruptcy Code, seeking a discharge of all

of his debts.   On the schedules filed with the Bankruptcy Court,

petitioner listed personal property having a value of $7,000 and

no real property.   Petitioner listed the following debts in his

bankruptcy petition:    (a) Warner & Stackpole ($7,000); (b)
                                 10

Haussermann, Davison & Shattuck ($6,910); (c) Northeast Cellulose

($18,879,963); (d) Guaranty Bank & Trust Co. v. Lawrence McKee,

Stephen F. Scofield and Kay L. McKee ($80,000); (e) Granby Press

v. Sigma General, Inc. ($178,000); (f) Calta, Inc. ($66,697); (g)

Guaranty Bank & Trust Co. for suit filed in 1982 (unknown

amount); and (h) Alar, Ltd. (unknown amount).

     Northeast and Norkevicius filed a complaint seeking to deny

petitioner's discharge (the adversary proceeding).    They alleged

that petitioner should be denied a discharge under section 7273

of the Bankruptcy Code because he committed certain acts intended

to hinder, delay, or defraud his creditors.    A trial in the

adversary proceeding was held in the United States Bankruptcy

Court for the District of New Hampshire on January 11, 12, and



     3
         11 U.S.C. sec. 727(a) (1994) provides, in part:

     Sec. 727.    Discharge

          (a) The court shall grant the debtor a discharge,
     unless--
               *     *     *     *     *     *     *

           (3) the debtor has concealed, destroyed,
     mutilated, falsified, or failed to keep or preserve any
     recorded information, including books, documents,
     records, and papers, from which the debtor's financial
     condition or business transactions might be
     ascertained, unless such act or failure to act was
     justified under all of the circumstances of the case;
                *     *     *     *     *     *     *
           (5) the debtor has failed to explain
     satisfactorily, before determination of denial of
     discharge under this paragraph, any loss of assets or
     deficiency of assets to meet the debtor's liabilities;
     * * *
                                 11

13, 1988.    Robert Williams, Thomas Keane, and Christopher W.

Parker represented petitioner in the adversary proceeding.

     3.     The Settlement Agreement

     On April 7, 1988, Norkevicius (as nominee), the bank, CNI,

Zayre, and petitioner reached a settlement.    In the settlement,

the parties resolved all disputes and claims in the Northeast

litigation and the adversary proceeding.    Petitioner agreed to

pay to the plaintiffs $750,000, consisting of $300,000 when he

executed the agreement and $450,000 by May 16, 1988.    The parties

agreed that, if petitioner timely made the payments, the

plaintiffs would dismiss their claims and release all defendants

in the Massachusetts action (except McKee), and petitioner would

dismiss his counterclaims, cross-claims, and third-party claims.

The plaintiffs agreed that they would not object to any pleading,

action, or motion by petitioner to obtain a discharge in

bankruptcy or any other relief which he deemed appropriate in the

bankruptcy proceedings.

     Petitioner paid $750,000 to the plaintiffs in the Northeast

litigation in 1988.    On May 16, 1988, the Bankruptcy Court

approved the settlement agreement, dismissed the adversary

proceeding with prejudice, set aside the order for relief from

the voluntary petition, and dismissed the voluntary petition

without prejudice.    The Bankruptcy Court filed its order on May

26, 1988.    Petitioner did not obtain a discharge in bankruptcy.
                                  12

     Neither Northeast nor Sigma did business in 1988.

Petitioner worked in the paper and printing business before and

after these cases were settled.

     4.    Petitioners' Legal Fees and Federal Income Tax Returns

           a.   1986

     Petitioner paid legal fees of $10,243 relating to the

Northeast litigation and the adversary proceeding.   Petitioners

deducted those fees on the Schedule C for petitioners' paper and

printing business filed with their 1986 Federal income tax

return.   They reported no gross receipts and claimed a net loss

of $10,243 on Schedule C.

           b.   1987

     Petitioner paid legal fees in 1987 of $34,083 for the

Northeast litigation and $25,269 for the bankruptcy proceedings.

The bankruptcy legal fees included fees for:   A conference held

by the attorneys with Mrs. Scofield, the attendance by attorneys

at a deposition of Mrs. Scofield, compilation of bankruptcy

pleadings and memos, research regarding discharge and pleadings

in bankruptcy, attorney-client privilege in bankruptcy, defenses

to objection to discharge, fraudulent conveyance/alter ego

exposure, and reviewing Judge Lavien's ruling on alter ego and

concealment of assets.

     Petitioners deducted those fees ($59,352) on the Schedule C

for petitioner's paper and printing business filed with their
                                13

1987 return.   They reported no gross receipts and claimed that

they had a net loss of $59,352 on Schedule C.

          c.    1988

     Petitioner paid legal fees of $70,843 for the Northeast

proceedings and $33,313 in 1988 for the bankruptcy proceedings.

The bankruptcy legal fees included fees for:    Attorneys attending

the trial on the adversary proceeding in January 1988; research

on defenses to bankruptcy discharge under 11 U.S.C. section

727(a)(3) and (a)(5) (1994); compilation of bankruptcy pleadings

and memos, including objections to a motion for a Bankruptcy Rule

2004 examination and possible chapter 13 plan before discharge

ruling by the court; office conferences, telephone calls, and a

trip to New Hampshire to meet with Mrs. Scofield; reviewing Mrs.

Scofield's deposition; research on fraudulent conveyance

statutes; research on rights of the trustee as a lien creditor;

research on the statute of limitations for fraudulent conveyances

and statutes of limitations defenses under 11 U.S.C. section 546

(1994); and research on the ability to reach and apply proceeds

of fraudulent conveyances.

     Petitioners attached a Schedule C for petitioner's paper and

printing business to their 1988 tax return.    On it, petitioners

deducted legal and professional expenses of $104,156 and a bad

debt loss of $750,000.   They reported no income on the Schedule C

and a net loss of $854,156.   Petitioners attached to their 1988

tax return a copy of the settlement agreement which released them
                                   14

from liability for the Northeast litigation and adversary

proceeding.

                             II.   OPINION

A.   Whether Petitioners May Deduct $750,000 That Petitioner Paid
     To Settle Civil Litigation and Petitioner's Bankruptcy
     Proceedings

     1.   Whether Petitioner's Settlement Payment Was a Business
          Bad Debt

     Petitioners contend that they may deduct as a business bad

debt or as a business expense $750,000 they paid in 1988 to

settle the Northeast litigation and petitioner's bankruptcy

proceedings.

     A taxpayer may deduct debts that become worthless in the

taxable year.   Sec. 166(a)(1).    Section 166 distinguishes between

business and nonbusiness bad debts.     A business bad debt is a

debt created or acquired in connection with the taxpayer's trade

or business or a debt the loss from the worthlessness of which is

incurred in the taxpayer's trade or business.      Sec. 166(d)(2).

Nonbusiness bad debts of taxpayers other than corporations are

short-term capital losses.    Sec. 166(d)(1)(B).

     A taxpayer may deduct as a business bad debt a payment it

makes to discharge the taxpayer's obligation as a guarantor if:

(a) The taxpayer was engaged in a trade or business when he or

she made the guaranty, and (b) the guaranty was proximately

related to the conduct of that trade or business.      Jones v.

Commissioner, T.C. Memo. 1997-368; Weber v. Commissioner, T.C.

Memo. 1994-341; Smartt v. Commissioner, T.C. Memo. 1993-65; see
                                  15

Putoma Corp. v. Commissioner, 66 T.C. 652, 673 (1976), affd. 601

F.2d 734 (5th Cir. 1979); secs. 1.166-9(a), 1.166-5(b), Income

Tax Regs.    Whether the taxpayer is engaged in a trade or business

is a question of fact.    United States v. Generes, 405 U.S. 93,

104 (1972); sec. 1.166-5(b), Income Tax Regs.

     2.     Petitioner's Dominant Motive for Guaranteeing
            Northeast's Line of Credit

            a.   Background and the Parties' Contentions

     Whether a guaranty is proximately related to the taxpayer's

trade or business depends on the taxpayer's dominant motive for

becoming a guarantor when he or she made the guaranty.       United

States v. Generes, supra at 104; Harsha v. United States, 590

F.2d 884, 886-887 (10th Cir. 1979).      When a guarantor of a

corporate debt is a shareholder and employee of the corporation,

mixed motives for the guaranty are usually present; the critical

fact is which motive is dominant.      United States v. Generes,

supra at 100.    A motive is related to a trade or business when

the guarantor aims to increase or protect his or her salary from

the trade or business.    A motive is related to an investment when

the guarantor aims to increase or protect the value of his or her

stock in the debtor corporation.       Whipple v. Commissioner, 373

U.S. 193, 202 (1963).    Petitioner has the burden of proving that

his dominant motive in signing the guaranty was business related

rather than investment related.     United States v. Generes, supra

at 103; Estate of Mann v. United States, 731 F.2d 267, 273 n.8

(5th Cir. 1984); Miles Prod. Co. v. Commissioner, 457 F.2d 1150,
                                  16

1154 (5th Cir. 1972), affg. T.C. Memo. 1969-274.    Objective facts

weigh more heavily than the guarantor's statements of intent in

ascertaining his or her motive.     Kelson v. United States, 503

F.2d 1291, 1293 (10th Cir. 1974).

     Petitioners contend that they may deduct $750,000 as a bad

debt for payments petitioner made to settle claims against him as

guarantor of loans the bank made to Northeast.    Petitioners argue

that petitioner's dominant motive in guaranteeing the debt was to

secure or protect his trade or business of being an employee of

Northeast and his employability and reputation in the newsprint

industry rather than to protect his investment in Northeast.

Respondent contends that petitioner provided the guaranty

primarily to protect his investment in Northeast.

          b.   Whether Petitioner's Dominant Motive for the
               Guaranty Was To Benefit His Trade or Business or
               To Protect His Investment in Northeast

     Northeast paid no salary to petitioner in 1979.    He

guaranteed the $1.2 million line of credit to Northeast on

January 11, 1980, about the time that he estimated that his

investment in Northeast as a going concern was worth $1 million.

We think petitioner's willingness to work 25 hours a week for

Northeast for no salary shows that he wanted capital appreciation

from Northeast, not income.

     Petitioner argues that he guaranteed Northeast's line of

credit so that it would continue to operate, and that he would

have been substantially compensated by Sigma for work he was
                                17

doing for Northeast.   Petitioner did not show why his guaranty of

Northeast's line of credit enhanced his ability to earn a salary.

Northeast paid him no salary, and petitioner did not show why

Sigma could or would pay him a salary because of his guaranty.

Sigma was sometimes a customer of Northeast, but the record does

not show that Sigma depended on Northeast to the extent that

Sigma should expend funds to ensure that Northeast survived.

     Petitioners argue that it would not have been reasonable for

petitioner to guarantee a $1.2 million line of credit to protect

a $4,000 cash investment.   Petitioner cites three cases in which

courts have held that the dominant motive of a taxpayer who

personally guaranteed a loan to a company that far exceeded his

investment in the company was not to protect his investment:

Litwin v. United States, 983 F.2d 997 (10th Cir. 1993); Smith v.

Commissioner, T.C. Memo. 1994-640; Estate of Allen v.

Commissioner, T.C. Memo. 1982-303.   Petitioners' reliance on

those cases is misplaced.   Petitioner thought his interest in

Northeast was worth $1 million when he signed the guarantee,

which was almost as much as the line of credit he coguaranteed

with McKee.   He was drawing no salary from Northeast.   We believe

he guaranteed the line of credit to protect his investment in

Northeast, not to protect his job or salary.

     Petitioners argue that petitioner made the settlement

payment to reestablish his reputation in the paper and printing

industry so that he could continue to earn money from it.
                                  18

Petitioners' argument misses the mark.    We consider whether a

taxpayer's dominant motive in becoming a guarantor is proximately

related to his or her trade or business at the time of the

guaranty rather than when a payment in discharge is made.       United

States v. Generes, supra at 104; Harsha v. United States, supra.

Thus, we do not consider petitioner's motive when he made the

settlement payment.

       Petitioners cite Syracuse v. Commissioner, T.C. Memo. 1981-

340.    In Syracuse, we held that a debt is a business debt if the

dominant motive for creating or acquiring it is to benefit the

lender's trade or business.    Petitioners' reliance on Syracuse is

misplaced.     The taxpayer in Syracuse lent money to another

business to benefit his own business.    We found that the taxpayer

in Syracuse was in the landfill business and not merely

investigating and preparing to enter the business when he lent

the money.    Unlike the taxpayer in Syracuse who lent money to

benefit his trade or business, petitioner did not guarantee

Northeast's line of credit to enhance his trade or business.

             c.   Conclusion

       Petitioner's dominant motive for guaranteeing the bank line

of credit to Northeast was to enhance his investment in

Northeast, not his trade or business.    Thus, petitioners may not
                                19

deduct as a business bad debt that part of the settlement payment

attributable to petitioner's guaranty.

     3.   Whether Petitioners May Deduct the Settlement Payment
          under Section 162

     Petitioners argue in the alternative that they may deduct

under section 162 their payments to settle the Northeast

litigation and the adversary proceeding.    A taxpayer may deduct

ordinary and necessary expenses paid or incurred in carrying on a

trade or business.   Sec. 162(a).    Petitioners argue that O'Malley

v. Commissioner, 91 T.C. 352, 361-362 (1988), supports their

contention that they may deduct the settlement payment since they

paid it to settle an action against petitioner that proximately

resulted from his business activity.    We agree as to the portion

of the settlement not allocable to the guaranty because bad debts

cannot be deducted under section 162.    See Horne v. Commissioner,

59 T.C. 319, 336 (1972), affd. 523 F.2d 1363 (9th Cir. 1975);

Smith v. Commissioner, 55 T.C. 260, 267 (1970), vacated on other

grounds and remanded 457 F.2d 797 (5th Cir. 1972) (section 162

does not apply to debts resulting from a taxpayer's loan

guaranty).   The taxpayer in O'Malley made payments which were

directly connected with his trade or business as an employee of a

trucking company.    Similarly, petitioner's payment to settle

claims brought against him by Northeast's creditors other than

the bank originated in petitioner's conduct of his duties as an
                                  20

officer or employee of Northeast and in action taken by him as an

investor-shareholder of Northeast; they did not relate to

petitioner's guaranty of other debts.

     Respondent argues that, under section 263(a), petitioner may

not currently deduct the settlement payment because the

plaintiffs in the Northeast litigation alleged that he

misappropriated both tangible and intangible property.     We

disagree.    The creditors' claims against petitioner arose in the

ordinary course of their business with Northeast, not in the

process of acquiring or disputing who had title to a capital

asset.    In defending against the claims, petitioner was not

defending or perfecting his title to property.     See Cruttenden v.

Commissioner, 644 F.2d 1368, 1372-1374 (9th Cir. 1981), affg. 70

T.C. 191 (1978); Boagni v. Commissioner, 59 T.C. 708, 711-712

(1973).

     Respondent argues that petitioners may not deduct the

settlement payment as an ordinary and necessary expense because

the plaintiffs in those cases alleged that petitioner embezzled

from Northeast.    We disagree.   Zayre, CNI, and the other

creditors' allegations that petitioner had embezzled funds were a

small part of the Northeast litigation.     Petitioner denied and

defended against these allegations.     Petitioner did not admit

that those allegations were correct as part of the settlement or
                                 21

otherwise.   He settled the Northeast litigation to repay

Northeast's creditors (Zayre and CNI) for debts Northeast

incurred in the ordinary course of its trade or business and to

settle the bank's claim against him as a guarantor for Northeast.

We conclude that petitioner's payment to Northeast's creditors

other than his payment for the guaranty was an ordinary and

necessary expense.

     The claims brought against petitioner for actions he took

while he was an officer of Northeast and the allegations in the

adversary proceeding originated in petitioner's conduct of his

duties as an officer and employee of Northeast.   The settlement

payment reasonably and proximately related to his serving as an

officer of Northeast.   Petitioner's payment to settle claims

other than that relating to his guaranty to the bank was a trade

or business expense.    Thus, petitioners may deduct under section

162 that part of the payment petitioner made in the Northeast

litigation and adversary proceeding to settle the claims of

Northeast's creditors other than his payment for the guaranty.

O'Malley v. Commissioner, supra.

     A taxpayer may deduct a payment relating to his or her trade

or business of being a corporate employee even though the

taxpayer made the payment 3 years after the corporation stopped

operating.   Ostrom v. Commissioner, 77 T.C. 608, 613 (1981).
                                 22

Thus, even though Northeast had stopped doing business several

years before petitioner made the payments, petitioners may deduct

part of the settlement payment relating to petitioner's conduct

of his duties as an officer and employee of Northeast under

section 162 and relating to actions taken by him as an investor-

shareholder under section 212.   However, petitioners' deduction

is limited by section 67, under which expenses are deductible to

the extent that they exceed 2 percent of the taxpayer's adjusted

gross income.

     4.   Allocation of Settlement Payment Between Guaranty and
          Other Creditors' Claims

     We apportion petitioner's $750,000 settlement payment

between the claims of the bank relating to petitioner's guaranty

of Northeast's line of credit and the claims of Northeast's other

creditors.   The $750,000 was not all paid on the guaranty

because, when the complaint was filed, Northeast owed only

$561,530 to the bank.   Northeast's nominee had already collected

at least $726,000 on Northeast's debts when Northeast's creditors

agreed to allocate recoveries.   Under that agreement,4 the bank

could recover no more than $375,000 (50 percent of $750,000).      We

hold that petitioner may deduct 50 percent of the settlement

payment for the claims of Northeast's creditors other than the

bank, but must treat as a short-term capital loss 50 percent of

     4
       The creditors' agreement provided that the bank would
receive the first $200,000 collected by Northeast's nominee, and
50 percent of any other money collected. Northeast's nominee
collected at least $726,000, of which the bank presumably
received the first $200,000.
                                23

the payment for the claims of the bank relating to petitioner's

guaranty.

B.   Whether Petitioners May Deduct Their Legal Fees

     Petitioners paid legal fees of $10,243 in 1986, $59,352 in

1987, and $104,156 in 1988 and deducted them on Schedules C of

their tax returns.   Respondent determined and contends that

petitioners may not deduct $25,269 in 1987 and $33,313 in 1988 of

these fees as ordinary and necessary business expenses under

section 162 because petitioner paid them in connection with his

bankruptcy.   Respondent also determined that legal fees of

$10,243 in 1986, $34,083 in 1987, and $70,843 in 1988 were

deductible from adjusted gross income subject to the limitations

of section 67, which allows miscellaneous itemized deductions to

the extent that they exceed 2 percent of adjusted gross income.

Petitioners argue that they may deduct the legal fees relating to

their bankruptcy because it resulted from Northeast's business

failure.

     Petitioners may deduct legal expenses if the origin of the

claims in the Northeast and adversary proceedings related to

petitioner's trade or business or the production of income and

was not primarily personal.   Woodward v. Commissioner, 397 U.S.

572, 577-578 (1970); Commissioner v. Tellier, 383 U.S. 687, 689

(1966); United States v. Gilmore, 372 U.S. 39 (1963).   The origin

of the claim is found by analyzing the facts, United States v.

Gilmore, supra at 47-48, and the basis of the transaction out of
                                 24

which the litigation arose.    Boagni v. Commissioner, supra at

713.

       Respondent argues that the legal fees relating to

petitioner's bankruptcy were nondeductible personal expenses.

Sec. 262.    Respondent also argues that petitioners may not deduct

attorney's fees related to the adversary proceeding because they

involved a challenge to petitioner's discharge for alleged

prepetition fraudulent conveyances.    See In re Collins, 26 F.3d

116 (11th Cir. 1994).    In Collins, the U.S. Court of Appeals for

the Eleventh Circuit held that a debtor could not deduct a

settlement payment and attorney fees resulting from a bankruptcy

trustee's challenge to the debtor's prepetition transfers to a

family trust in connection with the debtor's prior bankruptcy

case because the payments did not arise from the debtor's

income-producing activities.

       We disagree with respondent's contention that Collins

controls here.    The origin of the claim is not necessarily

established by allegations made to support a claim.    Peters,

Gamm, West & Vincent, Inc. v. Commissioner, T.C. Memo. 1996-186.

The origin of the claim in this case was petitioner's liability

for the debts of Northeast, not the allegation that petitioner

committed fraud.    Unlike the taxpayer in Collins, petitioner paid

the legal fees in dispute to defend against the claims of his

creditors in the Northeast litigation who opposed his discharge

in bankruptcy; as discussed above at paragraph II-A-3, the claims
                                 25

of petitioner's creditors, other than the bank, arose from his

income-producing activities.

     Respondent argues that petitioners' reliance on Dowd v.

Commissioner, 68 T.C. 294 (1977), is misplaced.   We disagree.    In

Dowd, we applied the origin of the claim doctrine in deciding

whether legal expenses of a bankrupt taxpayer were deductible

under section 162(a).   The taxpayer in that case filed a petition

in bankruptcy resulting primarily from his inability to repay

more than $400,000 of business-related debts.   The taxpayer

incurred court costs and litigation expenses to resolve a dispute

with his creditors under which he agreed to pay some of their

claims and they agreed not to oppose his discharge in bankruptcy.

We held that the taxpayer could deduct litigation expenses to the

extent that the creditors' claims were business related.   See Cox

v. Commissioner, T.C. Memo. 1981-552 (taxpayers could deduct

bankruptcy legal expenses attributable to their business since

their bankruptcy was proximately caused by their inability to pay

the debts of their business).

     Petitioner's bankruptcy legal expenses were attributable to

his business or investment since Northeast's failure forced him

to seek bankruptcy protection.   The debts listed in his

bankruptcy petition related almost exclusively to Northeast.     The

plaintiffs in the adversary proceeding were creditors of

Northeast.   Fees paid to file petitioner's bankruptcy petition

and legal fees paid to defend claims against petitioner in the
                                26

adversary proceeding had their origin in petitioner's conduct as

an employee and investor-shareholder of Northeast and thus

related to activities engaged in by petitioner to produce income.

Secs. 162, 212(1).   We hold that petitioners may deduct their

legal fees in 1986, 1987, and 1988 relating to petitioner's

Northeast litigation and adversary proceeding subject to the

limits of section 67.


                                          Decision will be entered

                                     under Rule 155.
