                        T.C. Memo. 1997-536



                      UNITED STATES TAX COURT



         HAROLD LEVINSON ASSOCIATES, INC., Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 9575-95.                     Filed December 3, 1997.



     Richard M. Gabor, for petitioner.

     Gary W. Bornholdt, for respondent.




                        MEMORANDUM OPINION

     RAUM, Judge:   The Commissioner determined deficiencies in

petitioner's Federal income taxes for the taxable years ending

January 31, 1990, and January 31, 1991, in the amounts of

$179,860 and $1,349, respectively.   The remaining issue for

consideration is whether an amount paid to settle a lawsuit is a
                               - 2 -


deductible business expense under section 162(a)1 or a

nondeductible capital expenditure pursuant to section 263.     This

case was submitted on the basis of a stipulation of facts.

     Petitioner, Harold Levinson Associates, Inc., (petitioner)

is a New York State corporation whose principal place of business

when the petition in this case was filed was Plainview, New York.

During and throughout the fiscal year ended January 31, 1990,

Edward Berro and Rita Berro each owned 50 percent of petitioner's

common stock.   Together, they owned all of the common stock in

petitioner during and throughout the taxable year ended January

31, 1990.   The relationship of Edward and Rita Berro is not

disclosed in the record.

     In or about November 1987, petitioner, Edward Berro, and

Rita Berro, entered into an option agreement with Mark Goldman

and Barry Feldman (the optionees), whereby each of the optionees

was granted an option to purchase 24.5 percent of the common

stock of petitioner at an agreed upon exercise price.    In return,

the optionees made efforts to cause petitioner to become an

authorized cigarette stamping agent (New York Stamp Tax Agent) or

the equivalent thereof for the sale of cigarettes in the State of

New York.   Once acquired, a New York Stamp Tax Agent license


     1
        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.
                                - 3 -


lasts indefinitely.   Neither Mark Goldman nor Barry Feldman was

ever employed by petitioner.

     Pursuant to the terms of the Option Agreement, the exercise

price for the option to purchase the 24.5-percent interest in

petitioner was to be determined by the tangible net worth of

petitioner on the exercise date of the option.    The optionees had

the right to exercise the option for a period of 60 days after

the date on which petitioner became a New York Stamp Tax Agent.

The options granted pursuant to the Option Agreement were to

expire in or about April 1989, subject to extension for two

additional 3-month periods.    On or about March 17, 1989, Mark

Goldman exercised his rights under the Option Agreement to extend

for two additional 3-month periods the terms of the Option

Agreement.

     On or about September 13, 1989, petitioner was granted a

license as a New York Stamp Tax Agent.    Petitioner's acquisition

of a New York Stamp Tax Agent license has resulted in a

substantial increase to petitioner's gross sales, as evidenced by

petitioner's Forms 1120 U.S. Corporation Income Tax Return for

the taxable years ended January 31, 1991, and January 31, 1992.

     On or about October 23, 1989, Mark Goldman notified

petitioner, Edward Berro, and Rita Berro, of his intent to

exercise his rights under the Option Agreement.    On or about

November 20, 1989, Goldman's request to exercise the option was
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rejected.   In or about December 1989, Goldman filed a verified

complaint in the Supreme Court of the State of New York

initiating litigation (the litigation) against petitioner, Edward

Berro, and Rita Berro.   The complaint alleged that petitioner and

the Berros failed to honor the terms of the Option Agreement.

Goldman sought specific performance under the terms of the Option

Agreement, requesting that petitioner and the Berros be ordered

to deliver the 24.5-percent equity interest in petitioner at the

agreed upon exercise price.   He also sought monetary damages in

excess of $3 million.

     On or about April 27, 1990, petitioner, Edward Berro, Rita

Berro, and Mark Goldman, entered into an agreement settling the

litigation.   As stated in the settlement agreement, petitioner

concluded that it was impracticable and hazardous to the

continued viability of petitioner to permit Goldman to exercise

his option and become a shareholder in petitioner.   Pursuant to

the terms of the settlement agreement, Mark Goldman is required

to release petitioner and the Berros from any claims asserted in

connection with the litigation.   Petitioner is required to pay

Mark Goldman the sum of $1 million in annual payments of $83,200

in satisfaction of all claims asserted in connection with the

litigation.

     In connection with the settlement of the litigation,

petitioner claimed a lawsuit settlement deduction in the amount
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of $529,000 on its Form 1120, U.S. Corporation Income Tax Return,

filed for the taxable year ended January 31, 1990.   The $529,000

deduction claimed for that year represented the net present value

of the $1 million lawsuit settlement.2

     On March 7, 1995, respondent issued petitioner a statutory

notice of deficiency asserting deficiencies in income tax for the

taxable years ended January 31, 1990, and January 31, 1991.      The

deficiency for the taxable year ended January 31, 1990, is based

upon the disallowance of the $529,000 lawsuit settlement

deduction claimed on petitioner's return for that year.3   The

     2
       According to the stipulation of facts, the Berros
collectively owned 100 percent of the stock in petitioner "during
and throughout the taxable year ended January 31, 1990." Yet,
the Option Agreement provides that the optionees have the option
to purchase the stock "from the Company". Moreover, petitioner,
rather than the Berros, deducted the settlement amount on its
return. Thus, there is confusion in the record as to whether the
Berros or petitioner was to be the seller of the stock under the
Option Agreement. Further, what we have here is a troubling
obvious contradiction, particularly in view of provisions in the
Option Agreement contemplating a change in the number of shares
outstanding "in order that each Optionee [Gloldman and Feldman],
upon exercise of his Option shall be entitled to purchase that
number of shares of Common Stock necessary to acquire a 24.5%
equity" interest in petitioner. And the confusion is further
compounded by the fact that there are strong indications in the
record that there was actually a change in the number of shares
outstanding because of the situation concerning Feldman, the
other optionee. Indeed, the record shows that Feldman actually
acquired shares representing a 24.5-percent equity interest in
petitioner.
     3
       Since respondent's present theory for disallowing the
settlement deduction was raised in the Amendment to Answer to
Amended Petition, respondent bears the burden of proof with
respect to that theory. Rule 142(a). However, the point was not
                                                   (continued...)
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deficiency for the taxable year ended January 31, 1991, is based

upon the disallowance of a $3,967 insurance deduction claimed on

petitioner's return for that year.       Petitioner concedes the

deficiency determination for the taxable year ended January 31,

1991, in the amount of $1,349.

     Section 162(a) allows as a deduction "all the ordinary and

necessary expenses paid or incurred during the taxable year in

carrying on any trade or business".       But section 263(a) prohibits

deductions for "Any amount paid out * * * for permanent

improvements or betterments made to increase the value of any

property or estate."   Section 1.263(a)-2(c), Income Tax Regs.,

provides examples of capital expenditures, including "The cost of

defending or perfecting title to property."

     In United States v. Gilmore, 372 U.S. 39 (1963), the Supreme

Court held that whether litigation expenses are "business" or

"personal" is determined by looking to "the origin and character

of the claim with respect to which an expense [is] incurred".

Id. at 49.   This doctrine was amplified in Anchor Coupling Co. v.

United States, 427 F.2d 429, 433 (7th Cir. 1970), cert. denied

401 U.S. 908 (1971):

     Taxpayer argues that Gilmore is inapplicable because we
     are asked here to determine whether a settlement
     constitutes an ordinary and necessary business expense

     3
      (...continued)
argued on brief, and nothing appears to turn on the burden of
proof in this factually fully stipulated case.
                                - 7 -


     or a capital outlay and not whether a payment is a
     deductible business expense. We disagree. Although
     the two questions are admittedly different,
     substantially the same problems arise in each
     determination. Thus in both cases the court must
     determine the tax consequences of monetary outlays made
     in connection with contesting a claim on the taxpayer's
     assets. * * *


To determine the origin of the claim, the Court must consider

"the issues involved, the nature and objectives of the

litigation, the defenses asserted, the purpose for which the

claimed deductions were expended, the background of the

litigation, and all facts pertaining to the controversy."      Boagni

v. Commissioner, 59 T.C. 708, 713 (1973)); Saltzman v.

Commissioner, T.C. Memo. 1994-641.

     United States v. Wheeler, 311 F.2d 60 (5th Cir. 1962), is

instructive here.    The taxpayer owned controlling stock interests

in 3 corporations.   He first entered into negotiations to sell

the stock to an individual named Cage, but upon learning

(mistakenly) that Cage had lost interest, the taxpayer entered

into a sales agreement with Ainsworth.     Id. at 61.   After signing

the latter contract, the taxpayer discovered that Cage was still

interested in purchasing the stock.     The taxpayer also feared

that "Ainsworth would probably 'bleed' the corporate assets" dry.

To prevent that, the taxpayer refused to sell his stock.

Ainsworth sued, alleging breach of contract and requesting
                                 - 8 -


specific performance.    Id. at 62.   The taxpayer paid roughly

$57,000 to settle the litigation.        Id. at 61.

     The Fifth Circuit determined that the origin of the proposed

deduction was the suit for specific performance, which revolved

around the title to the stock.     Id. at 63.    The court concluded

that the settlement payments the taxpayer made were capital

expenditures.   Id. at 64; see Von Hafften v. Commissioner, 76

T.C. 831 (1981).

     The origin of the claim in the present case was the dispute

over title to 24.5 percent of petitioner's stock.       Mark Goldman

agreed to use his best efforts to cause petitioner to become a

New York Stamp Tax Agent.    In exchange, he was granted an option

to purchase 24.5 percent of petitioner's stock.       Petitioner

acquired a Stamp Tax Agent license in September 1989.       In a

timely manner, Mark Goldman gave notice that he intended to

exercise his option.    His request was rejected.

     In response, Goldman filed suit in the Supreme Court of the

State of New York.   In his verified complaint, he alleged:

     13. Plaintiff Goldman is ready, willing and able to tender
     the purchase price for the common shares of stock as set
     forth in the Option Agreement pursuant to paragraph 6
     thereof.

     14. The shares of stock in the Company are unique in that
     they represent an interest in a Company possessing a New
     York Stamp Tax Agents [sic] License.
                                - 9 -


Goldman sought specific performance, requesting that petitioner

and the Berros be required to deliver the 24.5-percent equity

interest in petitioner at the agreed upon exercise price.    He

also sought monetary damages in excess of $3 million.

     Petitioner, the Berros, and Goldman reached a settlement in

April 1990.   Goldman agreed to release all claims against

petitioner and the Berros and dismiss the litigation with

prejudice.    In return, petitioner was required to pay Goldman

$1 million in annual installments of $83,200.

     The issue involved in the Goldman litigation was the

ownership of the stock for which Goldman was willing to pay.      The

litigation was a suit for specific performance for title to the

stock.   The damages were based on the injury Goldman suffered

because he was denied access to the stock.    Petitioner and the

Berros protected their ownership of the stock by removing

Goldman's claim through the $1 million settlement.    As a whole,

it is clear that the initial litigation was a dispute over title

to 24.5 percent of petitioner's stock.    Since the settlement

amount was paid to defend and perfect title to stock, it is a

capital expenditure and thus nondeductible.    As indicated in

supra note 2, we are troubled by the question as to whose stock

(petitioner's or the Berros') is involved in light of the

possible contradictory state of the record.    But in view of the

explicit statement in the Option Agreement that the    optionees
                              - 10 -


would have the right to purchase stock "from the company", and

the fact that no issue has been raised by either party in that

connection, we address the issue as though the stock of

petitioner is involved just as the parties themselves have done.

     Petitioner contends that the settlement amount represents

lost compensation deductible under section 162(a).    According to

petitioner, Goldman saw the stock as a symbol of the accompanying

employment contract and compensation it entailed.    Petitioner

asserts that since petitioner is a closely-held corporation and

does not pay dividends, Goldman wanted the stock only to the

extent it would provide compensation.   Correspondingly,

petitioner argues, petitioner would have been entitled to a

compensation deduction for any amounts paid to Goldman.

Petitioner characterizes Goldman in its brief as an employee

seeking lost compensation analogous to back pay.

     The flaw in this argument is its assumption that Goldman was

an employee of petitioner.   Petitioner stipulated that Goldman

was never employed by petitioner.   The record does not articulate

Goldman's intentions.   It seems a reasonable inference that

Goldman pursued the stock sale because the stock represented not

only future earnings, as petitioner alleges, but also control.

Had he been able to purchase the stock, Goldman would have owned

a significant minority of the corporation.   Such control,

arguably, may have been his goal.   Whatever his intentions, it is
                               - 11 -


clear that the stock, and not simply money, was what he desired

and pursued.    The cases petitioner relies on, which involve

amounts received upon cancellation of employment contracts, do

not apply to the current situation.

     Petitioner also contends that the outcome is controlled by

section 83.    Section 83(a) provides:

          (a) General Rule.--If, in connection with the
     performance of services, property is transferred to any
     person other than the person for whom such services are
     performed, the excess of--

               (1) the fair market value of such property * * *
          at the first time the rights of the person having the
          beneficial interest in such property are transferable
          or are not subject to a substantial risk of forfeiture,
          whichever occurs earlier, over

                 (2) the amount (if any) paid for such property,

     shall be included in the gross income of the person who
     performed such services * * *


Section 83(h) gives a corresponding deduction under section

162(a) "to the person for whom were performed the services in

connection with which such property was transferred".

     Section 83 is not applicable here.   First, section 1.83-

6(a)(4), Income Tax Regs.,    provides that the deduction under

section 83(h) does not apply to capital expenditures.    We held

above that the origin of the claim for which the settlement

amount was paid was capital in nature.    Thus, section 83(h) is

inapplicable.
                               - 12 -


     Second, section 83 does not apply to "the transfer of an

option without a readily ascertainable fair market value".    Sec.

83(e)(3).    Section 1.83-7(b), Income Tax Regs., provides that

where an option is not actively traded on an established market,

the option does not have a readily ascertainable fair market

value unless the taxpayer can demonstrate all of the following:

     (i) The option is transferable by the optionee;

     (ii) The option is exercisable immediately in full by the
     optionee;

     (iii) The option or the property subject to the option is
     not subject to any restriction or condition * * * which has
     a significant effect upon the fair market value of the
     option; and

     (iv) The fair market value of the option privilege is
     readily ascertainable in accordance with paragraph (b)(3) of
     this section.


The option in this case fails the first two conditions.    The

Option Agreement states that "The Options are not transferable

and are exercisable only by the Optionee, during his lifetime."

The option was also not exercisable immediately in full by

Goldman.    The Option Agreement provides that the Optionees can

exercise the options for 60 days, but only "after the date on

which Company has become a New York Tax Stamp Agent".    In view of

petitioner's obvious failure to satisfy the first two conditions,

we need not even consider whether the third or fourth conditions

have been met.
                              - 13 -


     Petitioner paid the settlement amount to protect or retain

title to its 24.5 percent of petitioner's stock.   That payment

was a capital expenditure.   The Commissioner's disallowance of

the business expense deduction claimed by petitioner is

sustained.

                                    Decision will be entered

                               under Rule 155.
