                        T.C. Memo. 2005-276



                      UNITED STATES TAX COURT



                  STEPHANIE JANE HAUGE, Petitioner v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 21324-03.                  Filed November 29, 2005.



     Joseph Wetzel and Russell A. Sandor, for petitioner.

     Wesley F. McNamara, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     COLVIN, Judge:   Respondent determined a $203,201 deficiency

in petitioner’s income tax for 1997.1



     1
       In the notice of deficiency upon which this case is
based, respondent also determined a deficiency in petitioner’s
Federal income tax for 1999. Petitioner did not challenge
respondent’s determination for 1999 in this proceeding.
                                 -2-

     Petitioner held a 99.5-percent partnership interest in O.M.

Cook Co. (OMCC), a partnership engaged in the business of grass

seed production.    In the notice of deficiency, respondent

disallowed (1) a $625,000 deduction that OMCC claimed with regard

to the settlement of a lawsuit, and (2) an $83,202 deduction that

OMCC claimed for legal and professional fees related to the

lawsuit.    In the lawsuit, which the United States brought to

recover unpaid debts incurred by another farming partnership, the

United States sought recovery against OMCC’s assets and

petitioner’s nonbusiness assets.

     The issue for decision is whether OMCC or petitioner may

deduct or must capitalize all or part of the $625,000 settlement

payment and the $83,202 payment for legal and professional fees.

We hold that OMCC may deduct a portion of each payment and that

petitioner must capitalize the remaining portions of both

payments.

                          FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.2

Petitioner resided in Independence, Oregon, when she filed the

petition.




     2
        Unless otherwise indicated, section references are to the
Internal Revenue Code as amended and in effect during the year in
issue and Rule references are to the Tax Court Rules of Practice
and Procedure.
                                -3-

A.   Owen M. Cook and Cook Farms Partnership

     Owen M. Cook (Owen) conducted farming operations in the

Willamette Valley of Oregon for many years.    Owen and his wife

Mildred had five children.

     Owen initially retired from farming in 1972 when he was 62

years old.   Owen then leased his wheat farm to two of his sons,

Bob and Byron, who with Byron’s wife, Ann, formed a farming

partnership known as Cook Farms.   Cook Farms initially was

successful and leased or purchased additional land to expand its

business.

     Cook Farms’ business suffered in the latter part of the

1970s because of events beyond its control, such as adverse

weather, higher fertilizer costs, and lower wheat prices.     From

1979 to early 1981, Cook Farms (with Bob, Byron, and Ann as

coobligors) borrowed nearly $1 million (the farm loans) under

programs administered by the U.S. Department of Agriculture (the

Agriculture Department).   Cook Farms remained unprofitable, and

the farm loans were not repaid as they came due.    By June 1982,

the Agriculture Department suggested that Cook Farms, Bob, Byron,

and Ann should sell their assets and use the proceeds to repay

the farm loans.   In May 1983, Cook Farms offered to pay $5,000 to

the Agriculture Department in compromise of the unpaid farm

loans.   In a letter to the Agriculture Department dated May 9,

1983, Bob, Byron, and Ann indicated they might file for
                                 -4-

bankruptcy under chapter 7 of the Bankruptcy Code if they could

not compromise the farm loans.   Cooks Farms cooperated with the

Agriculture Department in the liquidation process.   Most of the

delinquent farm loans remained unpaid when the Agriculture

Department finished liquidating Cook Farms’ assets around 1986.

B.   Stephanie Jane Hauge

     Petitioner earned a master’s degree in school administration

and education and held various full-time positions in the local

school system from 1976 through 1987.    Petitioner began attending

law school in 1987 and received a law degree in 1990.

     Petitioner met Owen’s son Bob in the summer of 1981.

Petitioner and Bob began living together in 1981 and were married

in 2001.

C.   Formation of OMCC, Owen’s Transfers of Assets to Petitioner,
     and Petitioner’s Real Estate Purchases

     On August 30, 1981, Owen and petitioner formed OMCC as a

general partnership to produce grass seed.   Owen and petitioner

each held a 50-percent interest in OMCC.   Owen had many years of

farming experience, and petitioner handled administrative,

record-keeping, and personnel matters.   OMCC’s articles of

co-partnership provided that, if Owen or petitioner died, his or

her interest in the partnership would become the sole property of

the surviving partner.   Bob and Byron have been employees of OMCC

since 1982.
                                -5-

     OMCC leased all of the land that it farmed.     OMCC became

highly profitable.   By 1997, OMCC farmed approximately 3,800

acres.

     Owen suffered a stroke in 1989.     Thereafter, he

substantially reduced his work on behalf of OMCC.     Owen

transferred various assets to petitioner in 1989 and 1990.       In

1989, he transferred to petitioner a remainder interest in

several pieces of real estate that he owned, reserving life

interests in those properties for Mildred.     On January 1, 1990,

Owen transferred to petitioner nearly his entire partnership

interest in OMCC, thereby increasing her interest in OMCC from 50

percent to 99.5 percent.   Owen died in 1992.    At that time,

Mildred received Owen’s .5-percent interest in OMCC.

     Between December 1987 and February 1996, petitioner

purchased commercial real estate properties and several large

tracts of farm land from third parties.     Petitioner leased farm

land to OMCC.

D.   Farm Loan Lawsuit

     1.   Proposed Compromise

     In October 1990, the Agriculture Department agreed with Cook

Farms to settle the outstanding farm loan debt of more than $1.6

million (including accrued interest) in exchange for $75,000 to

be remitted in four installments.     Cook Farms paid the first

installment but did not pay any other installments.       As a result,
                                 -6-

the Agriculture Department revoked the settlement agreement and

reinstated the full amount of the farm loan debt.    Cook Farms

made no further attempts to repay the farm loan debt.

     2.     The Lawsuit

     On February 5, 1996, the United States, acting through the

Agriculture Department (hereinafter the Government), filed a

complaint against Bob, Byron, Ann, and Cook Farms in the United

States District Court for the District of Oregon (the farm loan

lawsuit).    United States v. Cook, No. CV96-172-RE (D. Or.).     As

stated in the complaint, the Government sought a judgment that

Bob, Byron, Ann, and Cook Farms were obliged to repay the full

amount of the farm loan debt with interest.

     On September 13, 1996, the Government filed an amended

complaint naming petitioner as a defendant to the farm loan

lawsuit and expanding its legal theories for recovery.    The

amended complaint included additional counts titled “Conspiracy”,

“False Claims Act”, “Fraudulent Conveyance”, and “Unjust

Enrichment”.   The Government alleged:   (a) Bob and Byron were

secret partners in OMCC; (b) Owen and petitioner conspired with

Bob and Byron to defraud and hinder the Government in its efforts

to collect the unpaid farm loans by organizing OMCC and holding

all business and personal assets in the names of OMCC or

petitioner; (c) Bob and Byron made false statements to the

Government by failing to disclose their partnership interests in
                                -7-

OMCC and other real property interests; (d) Bob, Byron, Owen, and

petitioner fraudulently conveyed certain assets and used OMCC’s

ongoing business operations to conceal Bob’s and Byron’s

interests in OMCC; and (e) all the defendants were unjustly

enriched by the foregoing actions.    The Government requested,

inter alia, that the District Court:    (a) Enter an order setting

aside the alleged fraudulent conveyances of property involving

OMCC and directing an accounting of Bob’s and Byron’s interests

in OMCC; and (b) impose a constructive trust on all the

defendants’ property to the extent of their unjust enrichment or

the interest of the United States.    Petitioner filed an answer

and affirmative defenses denying that she had engaged in the

alleged conspiracy or any fraudulent conveyances.

     On April 9, 1997, the District Court granted partial summary

judgment for the Government on count I and held that Bob, Byron,

Ann, and Cook Farms were liable for the full amount of unpaid

farm loans, plus interest.

     On June 16, 1997, the Government filed a second amended

complaint.   In it OMCC was not named as a defendant, but the

Government requested that the District Court enter a judgment

against petitioner and OMCC, jointly and severally, for the full

amount of the farm loan debt.
                                 -8-

E.   Effect of the Lawsuit on the Business Reputation of OMCC and
     Petitioner

     Before the Government filed the farm loan lawsuit, the

Agriculture Department conducted an investigation in an effort to

identify all assets owned by Bob, Byron, Ann, petitioner, and

OMCC.   During the investigation and the ensuing litigation, the

Government issued numerous subpoenas to various individuals and

businesses in the Willamette Valley farming community.    The

investigation resulted in adverse publicity for petitioner and

OMCC.   During that time, two landowners terminated land leases

with OMCC, and an equipment dealer stopped selling farm equipment

to OMCC.   During 1997, 1998, and 1999, OMCC’s gross receipts from

farming were $1,414,767, $1,085,209, and $837,388, respectively.

F.   Settlement Agreement

     On December 19, 1997, the Government entered into a

settlement with OMCC and all of the defendants in the farm loan

lawsuit.   In the settlement:   (1) The parties agreed that

petitioner would cause to be paid to the United States the sum of

$625,000 within 120 days; (2) the Government released the

defendants and OMCC, and the defendants and OMCC released the

Government, from all civil claims, demands, rights, and causes of

action of whatever kind related to the subject of the action; (3)

the parties agreed that (a) nothing in the agreement was an

admission of any liability or wrongdoing by any party or person

released herein, all of which parties and persons thereby
                                 -9-

expressly denied fault and liability; (b) the agreement was a

release and settlement of disputed claims; (c) the payment was

provided solely to buy peaceful continued business operations for

petitioner and to avoid further litigation; and (d) nothing in

the agreement was a release of any claim against the defendants

under the Internal Revenue Code; (4) the Government agreed not to

criminally prosecute the defendants, to refrain from any further

investigation of the claims raised in the lawsuit, and to release

claims for suspension or debarment by the Agriculture Department

against the defendants and OMCC; and (5) Bob, Byron, Ann, and

Cook Farms stipulated that they had no interest in petitioner’s

property or assets or in OMCC.

G.   Payment of the Settlement and Legal and Professional Fees

     On December 23, 1997, petitioner and Mildred, as general

partners of OMCC with a 99.5- and a .5-percent interest,

respectively, each signed and submitted to The Commercial Bank

(the bank) written authorization for OMCC to borrow up to $1

million.   On December 23, 1997, petitioner and OMCC, identified

in the loan documents as coborrowers, borrowed $550,000 from the

bank.   As security for this loan, petitioner, as grantor,

transferred to the bank a deed of trust on her residence.    In

addition to the loan described above, OMCC borrowed $75,000 from

the bank pursuant to a line of credit.   Late in December 1997,
                                 -10-

petitioner caused $625,000 to be electronically transferred to

the Government as required under the settlement agreement.

        During 1997, OMCC paid a total of $83,202 in legal and

professional fees related to the farm loan litigation to two law

firms:     Donaldson, Albert, Tweet, Connolly, Hanna, & Muniz

(Donaldson, Albert) and Stewart, Sokol & Gray (Stewart, Sokol).

Donaldson, Albert billed OMCC, whereas Stewart, Sokol billed

petitioner.     During 1997, OMCC paid $26,584.16 to Donaldson,

Albert and $56,617.84 to Stewart, Sokol.

H.   OMCC’s and Petitioner’s 1997 Tax Returns and the Notice of
     Deficiency

     On its Form 1065, U.S. Partnership Return of Income, for

1997, OMCC deducted, inter alia, $625,000 for “litigation” and

$87,490 for “legal and professional”.     OMCC reported a net farm

loss for 1997 of $354,477 and that petitioner made a $25,876

capital contribution to the partnership during 1997.

     OMCC issued to petitioner and Mildred separate Schedules

K-1, Partner’s Share of Income, Credits, Deductions, etc., for

1997.     OMCC allocated ordinary losses of $352,705 to petitioner

and $1,772 to Mildred.     On her Form 1040, U.S. Individual Income

Tax Return, for 1997, petitioner reported net farm rental income

of $195,298, offset by the $352,705 partnership loss allocated to

her by OMCC, resulting in a loss of $127,997 for the year.
                                 -11-

                                OPINION

A.      Contentions of the Parties

        Petitioner individually, and as a 99.5-percent partner of

OMCC, contends that either OMCC or petitioner may deduct the

$625,000 settlement payment and the $83,202 in legal fees

associated with the farm loan litigation because those amounts

were paid to protect OMCC’s ongoing business operations and its

reputation.3

        Respondent asserts that OMCC may not deduct the $625,000

settlement because, according to respondent, petitioner, not

OMCC, made the settlement payment.4       Alternatively, respondent

contends that neither OMCC nor petitioner may deduct the

settlement payment or the legal fees in dispute because those

payments were capital expenditures made to defend or perfect

petitioner’s title to property.      Sec. 1.263(a)-2(c), Income Tax

Regs.

        3
       Petitioner argues that the burden of proof in this case
should be shifted to respondent under sec. 7491(a). On the basis
of the stipulation of facts and the evidence presented at trial,
we decide this case according to the preponderance of evidence
without regard to the burden of proof.
        4
       Respondent contends petitioner may not argue that she
(instead of the partnership) may deduct the settlement payment
because that would be a new theory raised for the first time
after trial. We disagree. Petitioner raised the matter in her
petition, which gave respondent fair notice. See Rule 31(a).
Respondent is not prejudiced because whether petitioner may
currently deduct or must capitalize the settlement payment does
not require the presentation of any new or different evidence.
                               -12-

B.   Whether OMCC or Petitioner Paid the $625,000 Settlement

     Respondent contends that petitioner paid the settlement

because (1) petitioner provided collateral for the $550,000 loan,

and (2) OMCC failed to properly account for the $625,000 as a

partnership debt on its books and records.

     Bank records show that late in December 1997:   (1)

Petitioner and Mildred executed an authorization permitting OMCC

to borrow up to $1 million; (2) petitioner and OMCC signed as

coborrowers on a bank loan in respect of $550,000 of the $625,000

amount that was paid to the Government; and (3) OMCC obtained the

$75,000 balance of the $625,000 settlement payment by borrowing

against a line of credit.

     We disagree with respondent’s assertion that petitioner paid

the entire $625,000 settlement.   Although the bank had a right to

foreclose on petitioner’s property in the event of a default on

the $550,000 loan, there is no indication that a default occurred

or that petitioner thought it ever would occur.   We also are not

persuaded that OMCC’s failure to account for the bank loan as a

partnership debt shows that petitioner paid the $625,000

settlement.   Although evidence that OMCC failed to properly

account for the bank loan in its books and records is relevant to

the question whether petitioner or OMCC made the settlement

payment, OMCC’s book entries are not conclusive on the point.

See Estate of Freeman v. Commissioner, T.C. Memo. 1966-42.     In
                               -13-

our view, the fact that OMCC and petitioner jointly borrowed

$550,000 of the funds used to pay the settlement is compelling

evidence that OMCC and petitioner joined in paying that portion

of the settlement.

     OMCC was as much a target of the Government’s efforts to

collect the unpaid farm loans as petitioner.   The Government

requested that the District Court enter a judgment against OMCC

and petitioner, jointly and severally, for the full amount of the

unpaid farm loans, and OMCC was a party to the settlement

agreement that ended the farm loan litigation.

     Considering the claims that the Government made against

petitioner and OMCC in the farm loan litigation (discussed in

detail below at par. C-2) and the bank loan records identifying

petitioner and OMCC as co-borrowers on the $550,000 loan, we

conclude that petitioner and OMCC each paid one-half of $550,000

of the $625,000 settlement payment.   We also conclude that OMCC

paid the remaining $75,000 of the $625,000 settlement payment

inasmuch as it borrowed that amount against its own line of

credit.   Thus, we conclude that petitioner paid $275,000 of the

$625,000 settlement payment and that OMCC paid the remaining

$350,000.

C.   Whether OMCC and Petitioner May Deduct Their Shares of the
     Settlement Payment

     We next consider how much (if any) of its $350,000 payment

OMCC may deduct under section 162 or must capitalize, and how
                                 -14-

much (if any) of her $275,000 payment petitioner may deduct or

must capitalize.

     1.   Principles for Deducting Legal Fees and Expenses Under
          Sections 162 and 212 and the Origin of the Claim
          Doctrine

     A taxpayer who is carrying on a trade or business may deduct

ordinary and necessary expenses incurred in connection with the

operation of the business.   Sec. 162.   Similarly, ordinary and

necessary expenses incurred in connection with an activity

conducted for the production or collection of income, or for the

management, conservation, or maintenance of property held for the

production of income, are deductible if the taxpayer itemizes his

or her deductions.   Sec. 212.   To be deductible under section 162

or 212, an expense must be directly connected with or proximately

result from the taxpayer's business or an activity conducted for

the production or collection of income.    Kornhauser v. United

States, 276 U.S. 145, 153 (1928); Madden v. Commissioner, 514

F.2d 1149, 1150 (9th Cir. 1975), revg. 57 T.C. 513 (1972);

Stevens v. Commissioner, T.C. Memo. 1999-259.

     Personal, living, and family expenses, on the other hand,

generally may not be deducted.    Sec. 262(a).   In addition,

expenses that would otherwise be deductible under section 162 or

212 are not currently deductible if they are capital.     Secs. 263,

261, 161; Woodward v. Commissioner, 397 U.S. 572, 575-576 (1970);

BHA Enters., Inc. v. Commissioner, 74 T.C. 593, 599 (1980).
                              -15-

     Whether legal fees and expenses are deductible under section

162(a) or 212, or nondeductible under section 262(a) or 263,

depends on the origin of the underlying claim, not on its

potential effects on the fortunes of the taxpayer.   See United

States v. Gilmore, 372 U.S. 39, 51 (1963) (holding that the

taxpayer was not entitled to deduct legal expenses incurred in

divorce proceedings in which his spouse sought a share of his

controlling interests in three corporations because his spouse’s

claims stemmed from the marital relationship, not from income-

producing activity); see also Woodward v. Commissioner, supra at

577-578; Redwood Empire Sav. & Loan Assn. v. Commissioner, 628

F.2d 516, 520 (9th Cir. 1980), affg. 68 T.C. 960, 976-979 (1977);

Madden v. Commissioner, supra at 1151;5 Reed v. Commissioner, 55

T.C. 32, 39 (1970).

     Legal expenses and settlement costs incurred in defending

against claims that would injure or destroy a business are

ordinary and necessary business expenses.   Commissioner v.

Heininger, 320 U.S. 467, 471-472 (1943); N. Am. Inv. Co. v.

Commissioner, 24 B.T.A. 419, 420 (1931).

     Litigation may be rooted in both the defense or perfection

of title (nondeductible expenditures) and in the management of a



     5
      In Madden v. Commissioner, 514 F.2d 1149 (9th Cir. 1975),
revg. 57 T.C. 513 (1972), the Court of Appeals for the Ninth
Circuit, the court to which an appeal in this case would lie,
applied the origin-of-the-claim test to determine whether
litigation costs are currently deductible or capital in nature.
                               -16-

property or business (deductible expenditures), and, as a result,

an allocation between the two may be appropriate.    DeMink v.

United States, 448 F.2d 867, 869 (9th Cir. 1971); see Boagni v.

Commissioner, 59 T.C. 708, 713-714.

     2.   Whether the Entire Settlement Payment Must Be
          Capitalized

     Petitioner contends that the $625,000 payment is deductible

whether it was paid by her or OMCC.   Respondent contends that the

entire payment is a nondeductible capital expense.   We agree with

petitioner in part in that we conclude that OMCC may deduct its

share of the settlement payment under section 162.   We agree with

respondent in part in that we conclude that petitioner must

capitalize her share of the settlement payment.

     In identifying the origin of the claim that led to the

settlement payment, we consider the Government’s original and

amended complaints in the farm loan litigation and the settlement

agreement.   The Government’s original complaint was directed at

Cook Farms and its partners and sought a judgment requiring them

to repay all of the farm loan debt with interest.    In the amended

complaint, the Government added petitioner as a defendant and

added allegations of conspiracy and fraudulent conveyance.    The

Government alleged:   (a) Petitioner had engaged in a conspiracy

to hinder and delay the Government's effort to collect the farm

loans in that Bob and Byron were secret or dormant partners in

OMCC; and (b) Bob, Byron, Owen, and petitioner fraudulently
                               -17-

conveyed certain assets and used OMCC’s ongoing business

operations to conceal Bob’s and Byron’s interests in OMCC.     The

Government filed a second amended complaint requesting that the

District Court enter a judgment against petitioner and OMCC,

jointly and severally, for all of the farm loan debt.

     The Government claimed that petitioner was conspiring with

Bob and Byron to use OMCC’s farming operations to hide assets

that otherwise would have been available to the Government to

offset Cook Farms’s delinquent farm loans.    The Government

challenged petitioner’s title to real estate that she had

acquired with her distributive share of OMCC’s earnings.    In

addition, the Government viewed OMCC’s assets as potential

sources to repay the farm loans.

     The settlement agreement that ended the farm loan litigation

reveals that OMCC’s interests were taken into account when that

action was settled.   In particular, the settlement agreement

stated that OMCC and the Government released each other from all

civil claims related to the subject of the action and that the

Government would release claims for suspension or debarment by

the Agriculture Department against the defendants and OMCC.      The

settlement agreement also stated that the settlement payment was

intended solely to buy peaceful continued business operation for

petitioner and to avoid further litigation.
                                -18-

     Against this background, we conclude that OMCC paid its

share of the settlement payment to defend against the

Government's claims that its current business operations were

part of an ongoing conspiracy and that OMCC should be held

jointly and severally liable for approximately $2 million due on

the unpaid farm loans.    OMCC was not named as a defendant in the

farm loan litigation.    However, the second amended complaint and

the settlement agreement clearly show that the Government treated

OMCC as fair game in its hunt for assets to repay the delinquent

farm loans.   The settlement agreement provides that the parties

viewed the settlement as a means to ensure that OMCC could

continue its farming operations uninhibited by any further

litigation or adversarial administrative proceedings at the

Agriculture Department.

     As previously discussed, legal expenses incurred in

defending against claims that a business was being operated

fraudulently, i.e., claims that would injure or destroy a

business, are ordinary and necessary business expenses and need

not be capitalized.   See Commissioner v. Heininger, 320 U.S. 467,

470 (1943); Kornhauser v. United States, 276 U.S. at 153; N. Am.

Inv. Co. v. Commissioner, 24 B.T.A. at 420.    Under these

circumstances, we hold that OMCC’s payment of $350,000 of the

settlement payment was an ordinary and necessary business expense

under section 162.
                               -19-

     In contrast, we conclude that petitioner may not deduct her

$275,000 share of the settlement payment.   The Government’s

allegations in the farm loan litigation regarding the

circumstances of the transfer of Cook family assets to petitioner

(unlike the allegations relating to Cook Farms) represented a

direct attack on her title to real estate and other assets that

she had acquired in her own name over the years.   Consequently,

we conclude that petitioner paid her share of the settlement

payment to preserve or protect her title to real estate and other

personal assets against the Government’s claim that those assets

had been fraudulently conveyed to her.   Therefore, petitioner

must capitalize her share of the settlement payment.    See Madden

v. Commissioner, 514 F.2d at 1151; Reed v. Commissioner, 55 T.C.

at 39-40.

D.   Whether OMCC May Deduct Legal and Professional Fees It Paid
     in Connection with the Farm Loan Litigation

     OMCC paid $83,202 in legal and professional fees in

connection with the farm loan litigation.   Respondent contends

that OMCC may not deduct these legal fees because they were

incurred to defend and protect petitioner’s title to real estate

and, therefore, are capital expenditures.

     Our analysis regarding the deductibility of OMCC’s share of

the settlement payment also applies to the legal and professional

fees in dispute.   Thus, OMCC may deduct $26,584.16 in legal and

professional fees that it incurred defending against the lawsuit
                                 -20-

because those expenditures are an ordinary and necessary business

expense under section 162.    That is the amount of legal fees that

Donaldson, Albert billed to OMCC and that OMCC paid to that firm

during 1997.

     We agree with respondent that OMCC may not deduct the

portions of the legal and professional fees that it paid on

behalf of petitioner.   Stewart, Sokol billed petitioner

$56,617.84 for legal fees, and OMCC paid that bill in 1997.

Those fees were incurred to protect and defend petitioner’s title

to real estate and other personal assets that she acquired in her

own name over the years.   See, e.g., Hood v. Commissioner, 115

T.C. 172 (2000).   Petitioner may not currently deduct but must

capitalize her share of the legal and professional fees incurred

with regard to the lawsuit.

     To reflect the foregoing,

                                             Decision will be entered

                                        under Rule 155.
