                          T.C. Summary Opinion 2017-51



                         UNITED STATES TAX COURT



    ARTHUR DULIK, JR. AND ELLEN B. KUGLER DULIK, Petitioners v.
        COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 16642-15S.                         Filed July 13, 2017.



      Arthur Dulik, Jr., and Ellen B. Kugler Dulik, pro sese.

      Brian E. Peterson, for respondent.


                              SUMMARY OPINION


      PANUTHOS, Chief Special Trial Judge: This case was heard pursuant to

the provisions of section 7463 of the Internal Revenue Code in effect when the

petition was filed.1 Pursuant to section 7463(b), the decision to be entered is not


      1
       Unless otherwise indicated, subsequent section references are to the
Internal Revenue Code (Code) in effect for the year in issue, and all Rule
                                                                       (continued...)
                                        -2-

reviewable by any other court, and this opinion shall not be treated as precedent

for any other case.

      In a notice of deficiency dated April 3, 2015, respondent determined a

deficiency of $7,758 in petitioners’ 2010 Federal income tax and a section 6662(a)

accuracy-related penalty of $1,552.

      After a concession,2 the issues for decision are (1) whether legal fees

petitioners paid in 2010 are properly deductible as an ordinary and necessary

business expense relating to petitioner Arthur Dulik’s activity as a sole

shareholder of an S corporation, or whether the legal fees are deductible by

petitioners as a miscellaneous itemized deduction as determined by respondent and

(2) whether petitioners are liable for the accuracy-related penalty under section

6662(a) for the year in issue.




      1
       (...continued)
references are to the Tax Court Rules of Practice and Procedure.
      2
       Petitioners conceded that the amount of the taxable dividend they received
in 2010 was $20,394, and not $18,657 as reported on the return; thus they failed to
report $1,737 ($20,394 ! $18,657 ' $1,737) in taxable dividend income.
                                        -3-

                                    Background

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

facts and the accompanying exhibits are incorporated herein by this reference.

      Petitioners resided in New York when the petition was timely filed. Mrs.

Dulik is a certified public accountant (C.P.A.) and a practicing attorney. Mr.

Dulik is also a C.P.A.

I.    Severance Agreement

      In 1980 Mr. Dulik was employed by Byk-Gulden, Inc. (Byk-Gulden), a

small domestic generic pharmaceutical company, as the “vice-president finance”.

In 1982 Mr. Dulik and Byk-Gulden signed an “Employee Secrecy Agreement”

(secrecy agreement). The secrecy agreement includes, among other things, a

noncompete covenant, which generally prevents Mr. Dulik from rendering

services, “directly or indirectly, to any Competitor within the United States or any

foreign country” for two years after terminating his employment, with limited

exceptions.

      Through a series of mergers and acquisitions Byk-Gulden became part of

Nycomed US, Inc. (Nycomed), which was petitioner’s employer from 2006 until

May 2010. As of May 2010 Mr. Dulik was senior vice president, chief financial

officer, chairman of the ERISA fiduciary committee, and a member of the board of
                                          -4-

directors of Nycomed. As an executive for Nycomed Mr. Dulik was a participant

in Nycomed’s Supplemental Executive Retirement Plan (SERP).

      On May 26, 2010, Nycomed terminated Mr. Dulik’s employment. On May

27, 2010, Nycomed provided Mr. Dulik a proposed “Confidential Separation

Agreement and General Release” (severance agreement), which provided terms for

the termination of his employment, including severance pay (equivalent to 52

weeks of salary), a prorated bonus for 2010, and continuing COBRA healthcare

coverage for 12 months after the date of termination. The severance agreement

also incorporated by reference the secrecy agreement Mr. Dulik had signed with

Byk-Gulden in 1982. In exchange for these benefits Mr. Dulik would agree to a

number of terms, including: (1) compliance with the secrecy agreement, (2) a

release of all claims against Nycomed arising out of his employment with the

company, and (3) a nondisparagement clause in which he agreed to not make

disparaging remarks about the company.

      Mr. Dulik did not wish to sign the severance agreement as proffered. He

retained the services of two law firms, the Wagner Law Group (Wagner Law) and

Farrell Fritz, P.C. (Farrell Fritz), to assist with negotiating the terms of this

agreement.
                                         -5-

        On June 18, 2010, Mr. Dulik spoke with the vice president of human

resources for Nycomed and requested a number of modifications to the severance

agreement, including the following: (1) remove the provision incorporating by

reference the secrecy agreement; (2) add a provision that he be able to disclose to

prospective employers that he was covered by a restrictive covenant; and (3) add a

provision that the nondisparagement clause be mutual. During this conversation

Mr. Dulik also disagreed with Nycomed’s position regarding the postemployment

benefits that he would receive under the SERP. On July 29, 2010, Wagner Law

sent a letter on behalf of Mr. Dulik to Nycomed’s ERISA Fiduciary Committee,

reasserting Mr. Dulik’s position regarding his benefits under Nycomed’s SERP

plan.

        On August 18, 2010, Nycomed sent a letter to Mr. Dulik’s attorney,

attaching the severance agreement and the secrecy agreement. The letter from

Nycomed provided Mr. Dulik with the following ultimatum:

        I am writing to advise you that the Company’s severance proposal
        only remains open until Wednesday, August 25, 2010 at 12:00 noon
        (EST), after which it will be withdrawn. Thus, if this office does not
        receive an original signature on the attached Agreement by that date
        and time, the company’s severance offer will be withdrawn, but Mr.
        Dulik will still be bound by all the terms and conditions of the
        agreement to which he is a party, as well as all obligations under the
        Company’s various policies and under statutory and common law.
        Please be advised that in making this severance offer the Company
                                        -6-

      specifically does not concede Mr. Dulik’s separation from Nycomed
      was for reasons other than “Cause,” as defined under the Nycomed
      US Inc Executive Severance Pay Plan or any other plan or program to
      which Mr. Dulik is subject, and expressly reserves all of its rights in
      that regard. Please note that the attached Agreement is substantially
      the same version you indicated that your client was prepared to sign
      weeks ago, when you stated that Mr. Dulik was prepared to agree to
      all the terms the Agreement, except for the release of the SERP claim.
      This version requires Mr. Dulik to release Nycomed from any and all
      claims, including but not limited to the SERP claim he has raised and
      any other pension-related claims.

After consulting with his attorneys, Mr. Dulik signed the severance agreement

attached to the letter and submitted it by the due date of August 25, 2010.

      On September 24, 2010, Mr. Dulik incorporated AED Associates II, Inc.

(AED), and caused it to elect treatment as an S corporation. Mr. Dulik was the

president and sole shareholder.

II.   Legal Fees

      Mr. Dulik paid Wagner Law a total of $16,229 for legal services performed

in 2010. According to Wagner Law’s billing reports, the following legal services

were performed for Mr. Dulik in June, July, and August of 2010: (1) research and

review section 409A regulations; (2) drafting argument for full benefits from

SERP plan; (3) consult with another attorney about the section 409A matter; (4)

telephone conference with Nycomed regarding the status of severance negotiations

and viability of section 409A argument; (5) review letter from Nycomed; (6) draft
                                        -7-

letter to Nycomed; (7) review pension calculations; and (8) review draft severance

agreement from Nycomed. The billing statements Wagner Law sent to Mr. Dulik

for services performed in June, July, and August of 2010 were, according to their

heading, regarding “Defined Benefit SERP Matters”.

       Mr. Dulik paid Farrell Fritz a total of $10,096 for legal services performed

in 2010. According to Farrell Fritz’s billing reports, the following legal services

were performed for Mr. Dulik during June and August 2010: (1) review of

severance agreement and related documents; (2) review of SERP documentation;

(3) telephone conferences and meetings to discuss severance agreement and SERP

documents with Mr. Dulik; (4) review proposed revisions to severance agreement;

(5) review final severance agreement offer from Nycomed; and (6) meet with Mr.

Dulik regarding final severance agreement. The billing statements Farrell Fritz

sent to Mr. Dulik for services performed in June and August of 2010 were,

according to their heading, regarding the “Severance Agreement”.

       During 2010 Mr. Dulik paid a total of $26,325 ($16,229 % $10,096 '

$26,325) to Wagner Law and Farrell Fritz out of his personal bank account.

III.   Tax Returns and Notice of Deficiency

       Mr. Dulik timely prepared and filed for AED a 2010 Form 1120S, U.S.

Income Tax Return for an S Corporation, signed and dated April 10, 2011. AED
                                        -8-

did not report any gross receipts or sales and claimed a total of $31,125 in

deductions for expenses, including a deduction of $26,781 for “legal and

professional” expenses, resulting in a loss of $31,125. Petitioners timely filed a

joint 2010 Form 1040, U.S. Individual Income Tax Return, reporting the $31,125

loss from AED on their Schedule E, Supplemental Income and Loss. Petitioners

reported total tax of $233,631.

      Respondent disallowed the $26,781 deduction for legal fees claimed as

ordinary and necessary business expenses relating to AED, determining that the

attorney’s fees related to Mr. Dulik’s employment and should properly have been

deducted on petitioners’ Schedule A, Itemized Deductions. Petitioners timely

filed a petition asserting that the legal fees represented business expenses for AED

because Mr. Dulik retained the services of the attorneys so that he could “continue

to conduct his business and earn income consulting in the pharmaceutical

industry”.

                                     Discussion

I.    Burden of Proof

      In general, the Commissioner’s determination set forth in a notice of

deficiency is presumed correct, and the taxpayer bears the burden of proving that

the determination is in error. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115
                                        -9-

(1933). Pursuant to section 7491(a), the burden of proof as to factual matters

shifts to the Commissioner under certain circumstances. Petitioners did not allege

or otherwise show that section 7491(a) applies. See sec. 7491(a)(2)(A) and (B).

Therefore, petitioners bear the burden of proof. See Rule 142(a).

II.   Legal Fees

      Petitioners assert that their legal fees are deductible as ordinary and

necessary business expenses relating to the activities of AED. Section 162(a)

provides the general rule that a deduction is allowed for “all the ordinary and

necessary expenses paid or incurred during the taxable year in carrying on any

trade or business”. Generally expenses not incurred in carrying on a trade or

business activity but in the production or collection of income are deductible only

as miscellaneous itemized deductions on Schedule A. Secs. 67(a) and (b), 211,

212(1). Miscellaneous itemized deductions are deductible only to the extent that

the total of such deductions exceeds 2% of the individual’s adjusted gross income.

Secs. 67(a) and (b), 211, 212(1). Itemized deductions may be limited under the

overall limitations on itemized deductions under section 68 and may have an

alternative minimum tax implication under section 56(b)(1)(A)(i).

      Generally, legal fees are deductible as an ordinary and necessary business

expense only if the matter with respect to which fees were incurred originated in
                                        - 10 -

the taxpayer’s trade or business and only if the claim is sufficiently connected to

that trade or business; the treatment does not depend on the consequences that

might result from a win or loss of a legal claim. See United States v. Gilmore, 372

U.S. 39 (1963); Kenton v. Commissioner, T.C. Memo. 2006-13, 2006 WL

237112; Test v. Commissioner, T.C. Memo. 2000-362, 2000 WL 1738858, aff’d,

49 F. App’x 96 (9th Cir. 2002).

      In Test v. Commissioner, 2000 WL 1738858, the taxpayer pursued legal

claims related to her employment with the University of California, San Francisco

(UCSF) as director of the Center of Prehospital Research and Training, in part

because she feared harm to her reputation which, in turn, would harm a business,

Save-a-Life Systems (SLS), that she operated independent of her position at

UCSF. While she was launching SLS, the taxpayer’s UCSF department became

the subject of a State audit. Before a draft of the audit report was released

publicly, the San Francisco Examiner published several stories about the audit.

During this time the taxpayer retained counsel to respond to the negative publicity

and attempted to prevent the public release of the draft of the audit report, among

other things.

      The taxpayer claimed that she hired counsel primarily to maintain her

professional reputation, which was important to the success of SLS. Relying on
                                        - 11 -

prior caselaw,3 we held that we look to the origin of the claim rather than the

consequences of the legal action. Id., 2000 WL 1738858, at *5. Because the

claim originated with her employment at UCSF, not with her operation of SLS, the

legal fees could not be claimed as business deductions on Schedule C but rather

were properly claimed as miscellaneous itemized deductions on Schedule A. Id.

at *6.

         Petitioners assert that after Nycomed terminated Mr. Dulik’s employment he

was “pursuing his business” and seeking to work as an independent contractor

consulting for the pharmaceutical industry; but because of the noncompete

covenant of the secrecy agreement, no one would hire him. Mr. Dulik testified

that he signed the severance agreement because he would have had to forgo his

severance pay if he had not signed it. Mr. Dulik also testified that he did not

incorporate AED until September 2010 because “[o]riginally when I started the

business it was going to be a Schedule C proprietorship * * * later in 2010 I

formed a subchapter S corporation fearing * * * legal issues could arise out of

some of my activities.”




         3
     See United States v. Gilmore, 372 U.S. 39, 49 (1963); Ahadpour v.
Commissioner, T.C. Memo. 2000-68, aff’d, 32 F. App’x 319 (9th Cir. 2002).
                                        - 12 -

      Petitioners do not assert that the claim against Nycomed was rooted in Mr.

Dulik’s consulting business; instead they contend that the origin of the claim is

Nycomed’s restriction on Mr. Dulik’s ability to work. Petitioners assert that Mr.

Dulik hired counsel solely to renegotiate the terms of the severance agreement, so

that he could operate a business as a consultant in the pharmaceutical industry.4

Mr. Dulik testified that but for his desire to work in the pharmaceutical industry he

would have not hired counsel; for example, if he had wanted to work as a C.P.A.

for an accounting firm, he would not have tried to negotiate the terms of the

severance agreement.

      Although the terms of the severance agreement may have prevented Mr.

Dulik from operating a consulting business in the pharmaceutical industry, we

look to the origin of the claim, not to the potential consequences of a win or loss in

negotiating the terms of the severance agreement. Mr. Dulik’s claim arose from

his status as a former employee of Nycomed, not from his consulting business. He

hired attorneys because he was trying to negotiate the terms of the severance


      4
        Petitioners assert that the noncompete covenant of the secrecy agreement
was overly broad and in violation of New York State law. In response to the
question of why his counsel was also working on renegotiating his SERP benefits,
Mr. Dulik testified that the attorneys had devised a strategy to offer to exchange
the full SERP benefit (which the attorneys were asserting that he was entitled to)
for the removal of the secrecy agreement.
                                       - 13 -

agreement proffered in connection with the termination of his employment at

Nycomed. See Gilmore, 372 U.S. at 49; Kenton v. Commissioner, 2006 WL

237112, at *2-*3; Test v. Commissioner, 2000 WL 1738858, at *4. We conclude

that petitioners are not permitted to deduct the legal fees as ordinary and necessary

business expenses of Mr. Dulik’s consulting business as a flowthrough from

AED.5 However, petitioners are entitled to $26,3256 as a miscellaneous itemized

deduction on Schedule A, subject to the limitations set forth supra. See secs.

56(b)(1)(A)(i), 67(a) and (b), 68, 211, 212(1).




      5
         We further note that it would appear that Mr. Dulik was not “carrying on” a
trade or business when the legal expenditures were made, as required by sec. 162.
Carrying on a trade or business requires more than preparatory work such as initial
research or solicitation of potential customers; it requires that the business have
actually commenced. Ordinarily, expenses paid after a decision has been made to
start a business, but before the business commences, are not deductible as ordinary
and necessary business expenses. These preparatory expenses are capital. See
secs. 162, 195; Frank v. Commissioner, 20 T.C. 511, 513-514 (1953); Christian v.
Commissioner, T.C. Memo. 1995-12, 1995 WL 9151, at *5. There is nothing in
the record indicating that Mr. Dulik commenced any business activity as a sole
proprietor, nor is it clear to what extent, if any, AED conducted business activity
after its incorporation.
      6
       Petitioners provided substantiation for legal fees totaling $26,325, and did
not provide an explanation for the discrepancy of $456 ($26,781 ! $26,325 '
$456).
                                       - 14 -

III.   Accuracy-Related Penalty

       Section 6662(a) and (b)(1) imposes an accuracy-related penalty on any

portion of an underpayment of Federal income tax that is attributable to the

taxpayer’s “negligence or disregard of rules or regulations”.7 The term

“negligence” in section 6662(b)(1) includes any failure to make a reasonable

attempt to comply with the Code and any failure to keep adequate books and

records or to substantiate items properly. Sec. 6662(c); sec. 1.6662-3(b)(1),

Income Tax Regs. Negligence has also been defined as the failure to exercise due

care or the failure to do what a reasonable person would do under the

circumstances. See Allen v. Commissioner, 92 T.C. 1, 12 (1989), aff’d, 925 F.2d

348, 353 (9th Cir. 1991); see also Neely v. Commissioner, 85 T.C. 934, 947

(1985). The term “disregard” includes any careless, reckless, or intentional

disregard. Sec. 6662(c).

       Under section 7491(c), the Commissioner bears the burden of production

with regard to penalties. See Higbee v. Commissioner, 116 T.C. 438, 446 (2001).

       7
        The notice of deficiency reflected an increase in tax of $7,758. Petitioners’
return as filed reported total tax of $233,631. Petitioners’ understatement of
$7,758 does not exceed $24,139, which is the greater of 10% of the tax required to
be shown on the return for the taxable year ($233,631 reported on return % $7,758
increase in tax ' $241,389 tax required) or $5,000. Therefore, the understatement
is not substantial. See sec. 6662(b)(2), (d)(1)(A), (2)(A). Respondent asserts the
penalty only on the basis of negligence.
                                         - 15 -

To meet that burden the Commissioner must produce sufficient evidence to show

that it is appropriate to impose the accuracy-related penalty.8 See id. Petitioners

kept adequate records, providing bills from Mr. Dulik’s legal counsel, bank

statements, and other records which substantiated most of the amount claimed as a

deduction for legal fees. See sec. 6662(c); sec. 1.6662-3(b)(1), Income Tax Regs.

Respondent asserts that the accuracy-related penalty is appropriate because

petitioners are both C.P.A.s. We do not find that it is appropriate to impose the

accuracy-related penalty to the extent that it is attributable to petitioners’

deduction for legal fees, for the reasons set forth infra.

      Application of the accuracy-related penalty may be avoided with respect to

any portion of an underpayment if it is shown that there was reasonable cause for

such portion and the taxpayer acted in good faith with respect to such portion.

Sec. 6664(c)(1). The determination of whether the taxpayer had reasonable cause




      8
        Petitioners did not allege, in their petition or at trial, that the accuracy-
related penalty at issue was not “personally approved (in writing) by the
immediate supervisor of the individual making * * * [the penalty] determination.”
Sec. 6751(b)(1). That issue is therefore deemed conceded. See Rule 34(b)(4)
(“Any issue not raised in the assignments of error shall be deemed to be
conceded.”); cf. Lloyd v. Commissioner, T.C. Memo. 2017-60, at *7 n.3 (deeming
similarly conceded any sec. 6751(b)(1) challenge to assessable penalties in a sec.
6330 levy case).
                                         - 16 -

and acted in good faith depends upon the pertinent facts and circumstances of a

particular case. Sec. 1.6664-4(b)(1), Income Tax Regs.

      As previously discussed, petitioners kept adequate records to substantiate

the legal fees. Further, respondent determined and we conclude that petitioners

are entitled to deduct their legal fees as an itemized deduction (subject to

applicable limitations). Thus, the underpayment in this case is primarily

attributable to the characterization of the claimed deduction for legal fees, rather

than disallowance of the deduction. Mr. Dulik testified about his understanding of

the facts and law; but for his consulting business, he would not have hired counsel

to negotiate the Nycomed severance agreement, and for that reason he believed

that the legal fees could be deducted by the corporation and the deduction passed

through to him. The origin of the claim doctrine, regarding treatment of this

particular type of expense for legal fees, is a technical area of law, is fact

intensive, and required a reference to and analysis of caselaw as more fully

discussed in this opinion. Under the circumstances of this case, we conclude that

petitioners had reasonable cause and good faith in their treatment of the deduction

for legal fees. See sec. 6664(c)(1); sec. 1.6664-4(b)(1), Income Tax Regs.

      Petitioners conceded that they failed to report taxable dividend income of

$1,737. Petitioners did not provide an explanation for this failure or assert that
                                       - 17 -

they tried to determine the proper tax liability. We conclude that petitioners were

negligent in their failure to report this taxable dividend income and did not

establish that they had reasonable cause and acted in good faith under section

6664(c). See sec. 6662(c); Allen v. Commissioner, 92 T.C. at 12; Neely v.

Commissioner, 85 T.C. at 947; sec. 1.6662-3(b)(1), Income Tax Regs.

      We have considered all of the parties’ arguments, and, to the extent not

addressed herein, we conclude that they are moot, irrelevant, or without merit.

      To reflect the foregoing,


                                                Decision will be entered

                                       under Rule 155.
