                         T.C. Memo. 2002-40



                     UNITED STATES TAX COURT



            CAPITAL VIDEO CORPORATION, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

                 KENNETH GUARINO, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 4094-00, 4096-00.      Filed February 11, 2002.


     James P. Redding and Brian C. Newberry, for petitioners.

     Michael P. Breton, for respondent.



                         MEMORANDUM OPINION


     SWIFT, Judge:   These cases are consolidated for trial,

briefing, and opinion.   Respondent determined deficiencies in

petitioners’ Federal income taxes and accuracy-related penalties

as follows:
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Capital Video Corp.
    Taxable Year                  Accuracy-Related Penalty
      Ending       Deficiency            Sec. 6662(a)
   Feb. 29, 1996    $116,950               $23,390


Kenneth Guarino
                                  Accuracy-Related Penalty
         Year     Deficiency             Sec. 6662(a)
         1996      $312,874                $34,515


     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

     After concessions, the primary issue for decision involves

whether petitioner Capital Video Corp. (Capital Video) may deduct

as ordinary and necessary business expenses $515,038 in legal

fees paid to defend its sole shareholder, petitioner Kenneth

Guarino (Guarino), against various criminal indictments.


                           Background

     The facts of these cases were submitted fully stipulated

under Rule 122, and the stipulated facts are so found.

     At the time the petitions were filed, Capital Video’s

principal place of business and Guarino’s primary residence were

located in Cranston, Rhode Island.

     On February 27, 1979, Capital Video was incorporated, and

thereafter, Capital Video was engaged in the sale of pornographic
                               - 3 -

videotapes and related products out of its office in Rhode

Island.   Capital Video’s taxable year ended on the last day of

February.

     During the 1980s and early 1990s, Capital Video and Guarino

made “tribute” payments to Natale Richichi (Richichi), a capo in

the Gambino crime family, in excess of $1,728,000 in exchange for

protection provided by the Gambino crime family to Capital Video

against extortion from other organized crime families.

     Also, during these same years Guarino conspired with

Richichi to obstruct the Internal Revenue Service in the

assessment and collection of Richichi’s Federal income taxes

relating to the tribute payments Richichi received from Capital

Video and Guarino.

     Guarino’s conspiracy and obstruction relating to the above

tribute payments included manipulating the accounting records of

Capital Video, skimming cash from peep show machines to provide

cash for the payments made to Richichi, and filing false Forms

1099 relating to the payments made to Richichi.

     During 1992, 1994, and 1995, Guarino, Richichi, and other

individuals were indicted on various Federal criminal charges

relating to the above activities.   Guarino was indicted in the

U.S. District Court for the District of Nevada and charged with

conspiracy to impede, impair, and obstruct the lawful functions

of the Internal Revenue Service and to evade the Federal income
                               - 4 -

tax liabilities of Richichi under 18 U.S.C. sec. 371 (2000).

Guarino was also charged with conspiracy to bribe a union

official under 18 U.S.C. sec. 1954 (2000), with interstate

transportation of obscene material through use of a common

carrier under 18 U.S.C. sec. 1462 (2000), and with aiding and

abetting an offense against the United States under 18 U.S.C.

sec. 2 (2000).

     On March 1, 1996, an election was made on behalf of Capital

Video with the Internal Revenue Service for Capital Video to be

taxed pursuant to subchapter S of the Internal Revenue Code.

     On January 10, 1997, Guarino pled guilty to one count of the

above indictment against him relating to the conspiracy to

obstruct the lawful functions of the Internal Revenue Service and

to evade Richichi’s Federal income tax liabilities.

     On April 25, 1997, pursuant to the plea agreement, Guarino

was sentenced to 16 months in prison, and he was fined $250,000.

As part of Guarino’s guilty plea, Guarino accepted the

Government’s allegation that he aided and abetted a fraud on the

Internal Revenue Service.

     During calendar years 1995 and 1996, Capital Video paid

legal fees in the amounts of $250,034 and $517,038, respectively,

to provide legal representation for Guarino in connection with

the above criminal charges.   Of the above $517,038 in legal fees
                                - 5 -

paid by Capital Video in 1996, $423,101 was paid after

February 29, 1996, when Capital Video elected to be taxed as an

S corporation.

     Capital Video was not named as a defendant in the above

criminal case, and Capital Video was not legally required to pay

the legal fees of Guarino.

     For its taxable year ending February 29, 1996, Capital Video

timely filed its Federal Corporation Income Tax Return,

and Capital Video deducted thereon as ordinary and necessary

business expenses the $343,971 it had paid during its taxable

year ending February 29, 1996, as legal fees in connection with

the above criminal charges against Guarino.

     For its short taxable year March 1 to December 31, 1996,

Capital Video timely filed its Federal Income Tax Return for an S

Corporation, and Capital Video deducted thereon as ordinary and

necessary business expenses the $423,101 it had paid during its

short taxable year as legal fees in connection with the above

criminal charges against Guarino.

     On his 1996 individual Federal income tax return, Guarino

did not include in his reported income any portion of the

$343,971 in legal fees paid by Capital Video during its 1996

taxable year.    Also (as a result of the $423,101 in deductions

claimed by Capital Video on its 1996 Federal Income Tax Return

for an S Corporation), Guarino’s share of the ordinary income of
                                - 6 -

Capital for Cap Video for the period March 1 to December 31, 1996

(as reported on Guarino’s 1996 individual Federal income tax

return) was reduced by $423,101.

     In respondent’s notice of deficiency mailed to Capital Video

for Capital Video’s taxable year ending February 29, 1996,

respondent disallowed the full $343,971 claimed ordinary and

necessary business deduction relating to Guarino’s legal fees.

     In respondent’s notice of deficiency mailed to Guarino for

1996, respondent:    (1) Treated the full $343,971 in legal fees of

Guarino that Capital Video paid during Capital Video’s taxable

year ending February 29, 1996, as a constructive taxable dividend

to Guarino, and (2) increased by $423,101 Guarino’s share of

Capital Video’s taxable ordinary income for the period March 1 to

December 31, 1996.    Both of respondent’s adjustments mentioned in

this paragraph resulted in increases to Guarino’s taxable income

for 1996 in the full amounts of those adjustments.

     Prior to trial, respondent conceded that $250,034 of the

above legal fees relating to Guarino that were deducted on

Capital Video’s tax return for its taxable year ending

February 29, 1996, was paid by Capital Video in 1995 and

therefore that $250,034 should not be charged to Guarino as

taxable dividend income for 1996.   As a result of respondent’s

concession (of the $343,971 in total claimed legal fees that

respondent treated as a constructive dividend taxable to Guarino
                                - 7 -

for 1996) only $93,936 remains in issue as an adjustment to

Guarino’s income for 1996.   The table below summarizes the

adjustments respondent made that are still in dispute:


                                Capital Video             Guarino
                                 Year Ending           Calendar Year
      Adjustment              2/29/96   12/31/96           1996

Legal fees disallowed        $343,971     $423,101

Dividend income                                          $ 93,936

Subchapter S income                                       423,101


                             Discussion


Capital Video’s Claimed Deduction of Guarino’s Legal Fees

     Generally, taxpayers may not deduct expenses of another

person and may not deduct expenses that are personal in nature.

Deputy v. du Pont, 308 U.S. 488, 494 (1940); Johnson v.

Commissioner, 72 T.C. 340, 348 (1979).

     Where expenses of another are paid in order to protect a

taxpayer’s business, the taxpayer, in limited circumstances, may

be allowed to deduct the expenses.      Lohrke v. Commissioner, 48

T.C. 679, 684-685 (1967).    Also, legal fees paid relating to

criminal charges against a taxpayer may be deductible where the

alleged criminal activity sufficiently relates to the taxpayer’s

business.   Commissioner v. Heininger, 320 U.S. 467, 474 (1943).

The origin of the criminal charges to which the legal fees
                               - 8 -

relate, rather than the potential consequences of a conviction on

the underlying charges, generally will control whether the legal

fees qualify as business expenses.     United States v. Gilmore, 372

U.S. 39, 48 (1963).

     In Lohrke v. Commissioner, supra, we adopted a two-prong

test for analyzing whether a taxpayer may deduct legal expenses

of another.   First, we analyzed whether the purpose or motive of

the taxpayer in paying another person’s legal expenses was to

protect or promote the taxpayer’s business, and second, we

analyzed whether the expenses constituted ordinary and necessary

business expenses of the taxpayer’s business.

     In their arguments herein, petitioners argue that the motive

or purpose of Capital Video in making the “tribute” payments to

Richichi was to protect and promote the business of Capital

Video, that Guarino’s conspiracy to evade the income taxes of

Richichi (the charge to which Guarino pled guilty) was directly

related to the “tribute” payments and to the related protection

from extortion that Capital Video received, and therefore that

Guarino’s legal fees relating to the conspiracy charge should

qualify as deductible business expenses of Capital Video.1

     Respondent argues that petitioners have not established that

Guarino’s conspiracy to evade Richichi’s income taxes was



1
     Petitioners make no argument that the legal fees in dispute
related to the various criminal charges against Guarino that were
dropped as part of the plea agreement.
                               - 9 -

sufficiently related to the protection of Capital Video’s

business.   Respondent contends that therefore the legal fees paid

by Capital Video relating to the conspiracy do not qualify as

business deductions of Capital Video.   We agree with respondent.

     We emphasize that the legal fees in dispute were paid to

cover the legal fees of Guarino in connection with his criminal

conspiracy activities relating to Richichi’s income tax

liabilities.   They were not paid as part of the “tribute”

payments to obtain protection from Richichi.   There is no

evidence herein that indicates that Richichi would not have

provided the protection to Capital Video if Guarino had not

participated in the conspiracy relating to Richichi’s taxes and

if Capital Video had not paid Guarino’s legal fees.   In fact, the

legal fees in dispute were paid by Capital Video years after the

protection was provided by Richichi and years after the

conspiracy between Guarino and Richichi occurred.

     Apart from whether the tribute payments made by Capital

Video to Richichi were made to protect the business of Capital

Video, petitioners have not established that Guarino’s

participation in the conspiracy to avoid Richichi’s income taxes

and Capital Video’s payment of the legal fees in dispute had a

sufficient business relationship with the protection or promotion

of Capital Video’s business.
                               - 10 -

     The legal fees paid by Capital Video in its taxable year

ending February 29, 1996 ($343,971), and in its short taxable

year ending December 31, 1996 ($423,101), to defend Guarino

against the conspiracy charge are not deductible as business

expenses of Capital Video.


Constructive Dividend to Guarino

     A constructive dividend to a shareholder of a corporation

may occur where the corporation “confers an economic benefit on

* * * [the] shareholder without the expectation of repayment

* * * even though neither the corporation nor the shareholder

intended a dividend.”    Magnon v. Commissioner, 73 T.C. 980,

993-994 (1980).    Not every payment by a corporation, however,

which incidentally confers an economic benefit on a shareholder

is treated as a constructive dividend.    Hood v. Commissioner, 115

T.C. 172 (2000).    Generally, the test of whether a payment is to

be treated as a constructive dividend to a shareholder is whether

the payment primarily benefited the shareholder and whether the

payment was made for a valid business purpose of the corporation.

Loftin & Woodard, Inc. v. United States, 577 F.2d 1206, 1214 (5th

Cir. 1978).

     As we have held, petitioners have not established that

Capital Video made the payments of Guarino’s legal fees in

connection with the business of Capital Video.    Capital Video had

no obligation to make such payments.    The payment by Capital
                              - 11 -

Video of Guarino’s legal fees conferred a significant economic

benefit upon Guarino, Capital Video’s sole shareholder, without

an expectation of repayment and was not necessary for the

business of Capital Video (i.e., the payment of the legal fees

was not necessary for Capital Video to receive Richichi’s

protection from extortion).

     We conclude that the payment by Capital Video of the $93,936

in Guarino’s legal fees should be treated as a constructive

dividend to Guarino.   As to the $423,101 in legal fees of Capital

Video that are disallowed herein as deductible business expenses

of Capital Video for its short taxable year ending December 31,

1996, such adjustment mechanically results in additional income

to Guarino in that same amount as a result of the corresponding

increase in Guarino’s share of the income of Capital Video, as an

S corporation.

     If respondent’s income adjustments against Guarino are

sustained herein, as we have done, then Guarino argues that for

1996 he should be entitled to additional miscellaneous itemized

business expense deductions (subject to the percentage

limitations applicable thereto) in the amount of the constructive

dividend and the additional income of Capital Video, as an S

corporation, that is to be charged to Guarino.   The apparent

basis for Guarino’s argument is that if he is to be charged with
                              - 12 -

a constructive dividend and with additional income from Capital

Video relating to the legal fees Capital Video paid, he should be

deemed to have incurred the legal fees, and the legal fees should

be treated as his miscellaneous business expenses.

     The analysis herein to the effect that the legal fees in

dispute do not constitute ordinary and necessary business

expenses of Capital Video also applies to Guarino’s argument that

the legal fees should be deductible ordinary and necessary

business expenses to him.   Guarino has not shown a sufficient

business nexus to the legal fees for the fees to qualify as

ordinary and necessary business expenses to him.2    We reject

Guarino’s argument as to his entitlement to miscellaneous

itemized business expense deductions relating to the legal fees

paid by Capital Video.


Sec. 6662 Penalties

     Under section 6662, a penalty of 20 percent is imposed on

any portion of an understatement of tax attributable to

negligence or to disregard of the rules or regulations.   For

purposes of section 6662(a), negligence constitutes a failure to

make a reasonable attempt to comply with the Internal Revenue

Code.   Sec. 6662(c).




2
     Petitioners make no argument that respondent has the burden
of proof under sec. 7491.
                              - 13 -

     Petitioners cite Jack’s Maint. Contractors, Inc. v.

Commissioner, T.C. Memo. 1981-349, revd. per curiam 703 F.2d 154

(5th Cir. 1983), and Hood v. Commissioner, 115 T.C. 172 (2000),

as substantial authority for petitioners’ treatment of the legal

fees paid by Capital Video.

     In Jack’s Maint. Contractors, Inc. v. Commissioner, supra,

we allowed a corporate taxpayer a deduction for its payment of

legal expenses of its shareholder relating to the shareholder’s

indictment for criminal tax evasion.   Reversing, the Court of

Appeals for the Fifth Circuit held that the legal fees were not

deductible because the legal fees were personal in nature and did

not qualify as an ordinary and necessary business expense of the

corporation.

     In Hood v. Commissioner, supra, we followed the Court of

Appeals for the Fifth Circuit’s reversal of Jack’s Maint.

Contractors, Inc. v. Commissioner, supra, and we disallowed a

corporation a deduction for legal fees the corporation had paid

relating to an indictment of its sole shareholder for tax

evasion.

     Significant to the penalties involved in these cases is the

fact that in Hood, decided in 2000, we declined to impose the

accuracy-related penalty for negligence.   We stated as follows:


     Given that * * * [the taxpayer’s] reporting position
     was consistent with our holding in Jack’s Maintenance
                              - 14 -

     Contractors, Inc. v. Commissioner, supra, we find there
     was no negligence or disregard of rules or regulations
     on the part of * * * [the taxpayer]. [Id. at 183.]


     We believe that for the same reason, petitioners herein

should be relieved of the section 6662 penalties.     Petitioners’

tax returns for the years in dispute were filed prior to our

opinion in Hood v. Commissioner, supra, which was filed in the

year 2000, and petitioners’ tax return preparer would have had

access to the same authority that the taxpayers in Hood had

access to.   In light of our holding in Hood v. Commissioner,

supra, we do not impose upon petitioners herein the accuracy-

related penalties relating to the disallowed legal fees paid by

Capital Video and relating to the additional dividend and income

adjustments made against Guarino.   We so hold.

     To reflect the foregoing,

                                         Decisions will be entered

                                    under Rule 155.
