                            T.C. Memo. 2000-106



                          UNITED STATES TAX COURT



           THOMAS F. AND TOYIA A. NOONS, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 11163-98.                       Filed March 28, 2000.



     James A. Cerks, for petitioners.

     Susan M. Pinner, for respondent.



                MEMORANDUM FINDINGS OF FACT AND OPINION


     JACOBS, Judge:    Respondent determined a $35,080 deficiency in

petitioners’ 1993 Federal income tax and a $2,490 addition to tax

pursuant   to   section     6651(a)(1).   The   deficiency   arises     from

respondent’s reclassification of a $197,234 legal fee deduction

petitioners claimed on Schedule C as a Schedule A deduction.            As a
                                         - 2 -

consequence    of       this   reclassification          (1)    the    amount   of   the

deduction     was       reduced    because      of      the    2-percent     floor     on

miscellaneous itemized deductions pursuant to section 67(a), and

(2) petitioners became subject to the alternative minimum tax.

     Petitioners filed their joint 1993 tax return late.                             They

offered no evidence, and made no reference in their posttrial

briefs,   regarding       their       liability    for    the    section    6651(a)(1)

addition to tax for failure to timely file a return. Consequently,

we deem petitioners to have conceded this matter, and therefore the

only issue for decision is whether the $197,234 in legal fees is

deductible    as    Schedule      C    business      expenses    or    as   Schedule    A

miscellaneous itemized deductions.                Resolution of this issue turns

upon whether the legal fees were incurred by Thomas F. Noons

(petitioner)       in    connection      with     his    trade    or    business,      as

petitioners maintain, or were incurred for the production of

income, as respondent maintains.

     All section references are to the Internal Revenue Code as in

effect for the year in issue.

                                  FINDINGS OF FACT

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

stipulation of facts and the exhibits submitted therewith are

incorporated herein by this reference.
                                - 3 -

     Petitioners resided in Houston, Texas, at the time they filed

their petition.   For the year at issue, they were husband and wife;

they divorced in 1995.

Petitioner’s Employment: 1983-88

     Petitioner emigrated to the United States from Great Britain

in 1983.   Almost immediately he obtained employment with Mainland

Savings Association (Mainland), a savings and loan association

located in Houston, to computerize their commercial lending and

service operations.      Later, after demonstrating an ability to

manage complex real estate investment transactions, he became head

of Mainland’s commercial lending branch, charged with overseeing a

$1.5 billion commercial loan portfolio.     Petitioner’s employment

with Mainland ended in early 1986 after Mainland was placed in

receivership by the Federal Savings and Loan Insurance Corporation

(FSLIC).    Thereafter, he began to explore different business

opportunities in which to invest.       He attempted to establish a

chain of Fuddrucker restaurants in the United Kingdom.      He also

attempted to develop a wildlife safari park in Jamaica.     Neither

venture materialized.

     In May 1986, petitioner was approached by Eastdil Realty, Inc.

(Eastdil), a real estate investment bank based in New York that

specializes in managing large (typically over $400 million) real

estate portfolios for major corporations and others, and was
                                       - 4 -

offered employment to assist Eastdil in establishing a southwest

office.

       Petitioner was permitted to engage in real estate activities

on his own behalf. Petitioner focused his efforts on acquiring and

selling selected nonperforming secured promissory notes.                   In this

respect,     petitioner        spent   many    hours    perusing    real    estate

offerings, obtaining lists of nonperforming assets, performing on-

site    inspections,      interviewing         the    management    of     targeted

properties, and doing financial projections.

Forum 303 Note and Its Acquisition

       In early 1988, C. Marshall Rea (Mr. Rea), an attorney, and

petitioner caused a corporation, known as AMI Resources, Inc.

(AMI), to be formed under the laws of the State of Texas in order

to purchase a note, dated December 1, 1982, executed by Forum 303,

Ltd., in the original principal amount of $4 million (the Forum 303

note) that was held by FSLIC as receiver for Mainland.                    The Forum

303 note was secured by a deed of trust that constituted a second

lien on a shopping center located at Forum Drive and Highway 303 in

Dallas, Texas.      Under the terms of the note, Forum 303, Ltd., was

required to make monthly payments of $36,667, with a balloon

payment of $3,878,597 due in January 1993.

       Mr.   Rea   was   the    president     and    sole   shareholder    of   AMI;

petitioner was the secretary and a director of the company.

       Petitioner’s brother, Phillip Noons (P. Noons or his brother),
                                  - 5 -

was employed by FSLIC as an asset manager.          Through his brother,

petitioner became aware of the existence of the Forum 303 note.         On

February 24, 1988, AMI submitted a bid of $690,000 for the Forum

303 note.   On February 25, 1988, P. Noons prepared a memorandum to

his superiors at FSLIC in which he determined the value of the

Forum 303 note to be $683,356; consequently, he recommended that

AMI’s bid be accepted.      P. Noons did not inform his supervisors

that his brother (petitioner) would be involved in the purchase of

the note.   Nor did P. Noons indicate that he had overstated the

amount of   the   first   lien   on   the   underlying   shopping   center.

Accepting P. Noons’ recommendation, FSLIC approved the sale of the

Forum 303 note to AMI.

     To finance the transaction, petitioner borrowed against his

personal assets approximately $600,000 from National Westminister

Bank in London, England. Petitioner deposited the proceeds of this

loan into a trust account in St. Peter’s Port, Guernsey (Unicorn

Trust).1

     Unicorn Trust lent AMI $690,000.        As collateral for the loan,

Mr. Rea pledged all of his stock in AMI to Unicorn Trust.              The

$690,000 was not directly transferred from Unicorn Trust to AMI.

Rather, the $690,000 was first deposited in AMI’s bank account



     1
           Petitioner was both the grantor and a beneficiary of
the Unicorn Trust. He intended to make the individual who had
raised him and was his legal guardian one of the beneficiaries of
the trust.
                                - 6 -

located in the Cayman Islands (AMI Offshore).    From AMI Offshore,

the funds were transferred to AMI’s bank account at Texas Commerce

Bank in Houston (AMI Domestic).    AMI purchased the Forum 303 note

using the funds deposited with AMI Domestic.

Subsequent Forum 303 Note Transactions

     Forum 303, Ltd., began making monthly payments on its note to

AMI beginning on March 28, 1988.    Monthly payments for May, June,

and July totaling $105,101 were deposited into the AMI Domestic

account.   Thereafter, the funds were routed through AMI Offshore

to the Unicorn Trust account in Guernsey.       Although Forum 303,

Ltd., continued to make monthly payments to AMI, no funds were

transferred to the Unicorn Trust account after July 1988.

     On November 9, 1988, Mr. Rea rescinded the Forum 303 note

transaction and received $376,664 (the remaining unpaid amount on

the note) from FSLIC.   (Apparently AMI had the right to rescind the

transaction at any time.)   Mr. Rea did not inform petitioner that

the transaction was being rescinded.     Instead of repaying Unicorn

Trust, Mr. Rea kept the proceeds.

     In 1992, petitioner, on behalf of Unicorn Trust, sued Mr. Rea

for failing to repay the loan owed by AMI to Unicorn Trust.      In

1997, petitioner had the case dismissed without prejudice after

deciding the debt was not collectible.     AMI never filed corporate

tax returns reporting income from the Forum 303 note.
                              - 7 -

Petitioner’s Indictment

     Petitioner and his brother were indicted in 1989 in connection

with the acquisition of the Forum 303 note.        The indictment

alleged, inter alia, that petitioner and his brother conspired to

defraud FSLIC by causing it to sell the Forum 303 note to AMI at a

price far below its actual net realizable value.      On March 23,

1993, the indictment was dismissed for lack of sufficient evidence

after the Government admitted that its key witness, who petitioner

alleges was Mr. Rea, was untruthful. In defending himself from the

indictment, petitioner paid $197,234 in legal fees.      It is the

classification of these fees that is the subject of the instant

dispute.

Petitioner’s Business Endeavors

     a.    Preaccident

     In February 1988, petitioner began negotiations to buy a

portfolio of commercial loans from Killeen Savings & Loan, a

Cleveland, Texas, bank.   The transaction was to be completed by

July 1988.

     In addition, in April 1998, petitioner and an associate agreed

to make an offer to purchase a four-story house in London, England,

intending to convert the property into apartments.    On April 20,

1988, petitioner sent a letter of intent to the property owner

enumerating the terms upon which he would purchase the property.
                                 - 8 -

One of the terms was petitioner’s inspection of the property before

closing.

     b.    Traffic Accident

     On June 16, 1988, petitioner was struck by a truck and

severely injured. He sustained face, neck, back, and leg injuries.

As a result of his injuries, he was classified as disabled by the

Social Security Administration.       Between 1988 and 1993, petitioner

underwent 15 operations and months of physical rehabilitation; he

was unable to work on a consistent basis.                  Petitioner required

additional operations in 1995 and 1996 to alleviate back pain

sustained as a result of the accident.

     Because of petitioner’s accident, he was unable to complete

the purchase of either the commercial loan portfolio from Killeen

Savings & Loan or the property in London.

     c.    Postaccident

     In 1995, petitioner formed a limited liability company (LLC),

called Flagship Home Builders (Flagship), in which he was a 50-

percent    limited   partner.   Flagship    was       in    the   business   of

constructing custom homes.      Petitioner did not purchase or sell

promissory   notes   with   respect   to   any   of    Flagship’s     business

transactions.

     In 1997, petitioner formed Heights Venture (Heights), an LLC,

in which he was a 1-percent general partner and an 80-percent

limited partner.      Heights was in the business of purchasing,
                                         - 9 -

managing,    and    renovating      apartment      complexes.       After   Heights

acquired an apartment complex and assumed the mortgage thereon,

petitioner bought the underlying mortgage note from the holder with

the intent of selling it at a premium.                 Since Heights’ inception,

petitioner has purchased seven discounted promissory notes; at the

time of trial, he had not resold any of them.

     Also in 1997, petitioner formed Museum Place (Museum), an LLC

in which he was a 1-percent general partner and a 40-percent

limited partner.2         Museum is in the business of purchasing and

renovating apartment properties.             Petitioner did not purchase or

sell promissory notes with respect to any of Museum’s business

transactions.

Petitioners’ 1993 Federal Income Tax Return

     Petitioners filed their 1993 Federal income tax return on

April 17, 1995.           On their return, petitioners deducted as a

Schedule C business expense legal fees totaling $197,234.

Notice of Deficiency

     In    the   notice    of    deficiency,      respondent    determined       that

petitioners’     legal    fees    were    not    deductible    as   a   Schedule    C

business    expense   but       rather    were   allowable     as   a   Schedule    A

miscellaneous      itemized      deduction.       As    a   consequence     of   this

recharacterization (1) the amount of the deduction was decreased


     2
          Petitioner owns 35 percent of Museum directly and 5
percent indirectly through petitioner’s control of British
American Properties of Houston, Ltd.
                                     - 10 -

because    of   the   section   67     floor    on   miscellaneous   itemized

deductions, and (2) petitioners became subject to the alternative

minimum tax under section 55.

     Because of petitioners’ failure to timely file their 1993

Federal income tax return, respondent determined that an addition

to tax pursuant to section 6651(a)(1) should be imposed.

                                  OPINION

     The issue to be resolved is whether legal fees petitioner

incurred in 1993 in defending himself from criminal charges are

deductible as a Schedule C business expense or as a Schedule A

miscellaneous itemized deduction.           If the fees are deductible as a

Schedule C business expense, then the $197,234 would be deductible

in full and petitioners would not be subject to the alternative

minimum tax.    If the fees are deductible as a Schedule A expense,

then the deduction would be subject to the floor limitation placed

on miscellaneous itemized deductions pursuant to section 67(a) and

petitioners would be subject to the alternative minimum tax.

     Section 162(a) allows a deduction for all “ordinary and

necessary expenses paid or incurred during the taxable year in

carrying on any trade or business”.            In order to be deductible on

Schedule   C,   an    expense   must   be     directly   connected   with,   or

proximately result from, a trade or business of the taxpayer.                See

Kornhauser v. United States, 276 U.S. 145, 153 (1928); O’Malley v.

Commissioner, 91 T.C. 352, 361 (1988), affd. 972 F.2d 150 (7th Cir.
                                    - 11 -

1992); Peters, Gamm, West & Vincent, Inc. v. Commissioner, T.C.

Memo. 1996-186.

       Section 212 allows an individual to deduct all ordinary and

necessary expenses paid or incurred in (1) producing income, (2)

managing,    conserving,     or    maintaining   property     held   for    the

production of income, or (3) determining, collecting, or refunding

a tax.

       Litigation expenses may be deductible under either section 162

or section 212.      See Guill v. Commissioner, 112 T.C. 325, 328-329

(1999); Davis v. Commissioner, T.C. Memo. 1999-250; Peters, Gamm,

West & Vincent, Inc. v. Commissioner, supra.                 Section 162(a)

governs the deductibility of litigation costs as a Schedule C

business expense, while section 212 governs the deductibility of

litigation costs as a Schedule A miscellaneous itemized deduction,

when   the   costs   are   incurred   as   a   nonbusiness    profit-seeking

expense. See Guill v. Commissioner, supra at 328.            Sections 162(a)

and 212 are considered in pari materia, except that section 162(a)

requires a trade or business, whereas section 212 requires the

pursuit of investing or profit making that lacks the regularity and

continuity of a business.         See United States v. Gilmore, 372 U.S.

39, 44-45 (1963); Guill v. Commissioner, supra at 328. Thus, in

order for    petitioner’s     legal   expenses    to   be   deductible     as a

Schedule C business expense, petitioners must demonstrate that in
                                       - 12 -

1993, petitioner was regularly and continuously engaged in a trade

or business involving the sale of promissory notes.

       Petitioners maintain that (1) during 1993 petitioner was

engaged   in    the   trade    or   business    of   acquiring    and   selling

underperforming promissory notes, and (2) the legal fees incurred

were    proximately     related     to   petitioner’s   trade     or    business

activities.     Respondent does not challenge petitioners’ contention

that the legal fees were related to the acquisition of the Forum

303 note.      Rather, respondent disagrees with the assertion that

petitioner was engaged in the trade or business of acquiring

promissory     notes.     In    this     regard,   respondent    alternatively

contends:      (1) Petitioner’s acquisition of the Forum 303 note was

an isolated investment transaction that does not rise to the level

of a trade or business; or (2) petitioner was acting within the

scope of his employment with AMI when he pursued the acquisition of

the Forum 303 note.           Under either position, respondent posits

petitioners’ legal fees would not be deductible under section

162(a). For the reasons that follow, we agree with respondent that

petitioner’s legal fees are not Schedule C business deductions.

       In our opinion, petitioner was not in the trade or business of

acquiring and selling real estate promissory notes.                He did not

regularly or continuously enter into the purchase and sale of these

types of promissory notes. Although we are mindful that on several

occasions between 1986 and 1988 petitioner attempted to acquire
                                      - 13 -

promissory notes, only once did he negotiate the purchase of an

instrument on his own behalf.          Moreover, as a consequence of his

accident,     petitioner     conducted     few,     if   any,    real    estate

transactions between 1988 and 1995.

      To be deductible as a Schedule C business expense, legal costs

must arise from, or be proximately related to, a business activity

of the taxpayer.          Petitioner and his brother were indicted on

account of events related to the acquisition of the Forum 303 note.

AMI   (not    petitioner)    acquired    the   Forum     303   note.    Although

petitioner obtained the financing for the acquisition, the purchase

agreement for the Forum 303 note explicitly states the purchaser of

the note to be “AMI Resources, Inc.”           Moreover, title in the note

passed from FSLIC to AMI.        As a result of the transaction, AMI was

entitled to all distributions made on the note and apparently had

the ability to rescind the transaction at any time; accordingly,

AMI, rather than petitioner, retained the incidents of ownership

from the acquisition of the Forum 303 note.              On the basis of the

record before us, we conclude that the Forum 303 note was purchased

and   owned    by   AMI    and   is   proximately    related    to     its   (not

petitioner’s) trade or business.

      To conclude, we sustain respondent’s determination that the

legal fees are deductible as a Schedule A miscellaneous itemized

deduction and as such generate the alternative minimum tax and are
                                 - 14 -

subject   to   the   2-percent   floor    on   miscellaneous   itemized

deductions.

     In reaching our conclusion herein, we have considered all

arguments presented and, to the extent not discussed above, find

them to be irrelevant or without merit.

     To reflect the foregoing,



                                                     Decision will be

                                               entered for respondent.
