                        T.C. Memo. 2002-173



                      UNITED STATES TAX COURT



            JEFFREY AND KAREN WINTER, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 5432-00.                  Filed July 22, 2002.


     Craig M. Hunt, for petitioners.

     Kathryn K. Vetter, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     RUWE, Judge:   Respondent determined a deficiency of $40,092

in petitioners’ joint 1994 Federal income tax.    The issue for

decision is whether petitioners may deduct or must capitalize

legal and consulting fees incurred in maintaining a lawsuit

against the seller of a hotel that they had previously purchased.
                                - 2 -

                          FINDINGS OF FACT

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

The stipulation of facts and the attached exhibits are

incorporated herein by this reference.    Petitioners resided in

Gold Run, California, at the time they filed their petition.

     In 1990, petitioners were interested in finding investment

property.    Petitioners saw a brochure advertising the Truckee

Hotel, located in Truckee, California, near Lake Tahoe, for the

price of $1.2 million.    The brochure included some financial and

room rental information regarding the hotel.    At that time, the

Truckee Hotel was owned by the Meglin Hotel Partnership (MHP).

Gerhard Meglin (Mr. Meglin) was the general partner of MHP and

owned an 82-percent interest in the partnership.

     On February 20, 1991, petitioners executed a “Commercial

Real Estate Contract and Receipt for Deposit” (real estate

contract) offering to purchase the Truckee Hotel for $1.2

million.    Mr. Meglin made a counteroffer, and the parties

ultimately agreed on the terms of the sale.1   The real estate

contract required Mr. Meglin to provide income and expense

statements for the hotel for 1989, 1990, and 1991.    The

statements were to be based on records maintained in the ordinary

course of business and used in the computation of Federal and

State income tax returns.    The statements were to be prepared


     1
      The purchase price remained at $1.2 million.
                               - 3 -

according to generally accepted accounting principles to provide

adequate, detailed information to the buyer and were to include

applicable tax returns.   During escrow, Mr. Meglin provided

petitioners with income and expenses statements for the Truckee

Hotel for 1988, 1989, and 1990.   He also provided MHP’s

partnership returns for 1988 and 1989 but not for 1990 because

that return had not yet been filed.    Petitioners did not hire an

appraiser to look at the property or anyone who was familiar with

the hotel industry to look at the books of the hotel during this

time.

     Petitioners noticed that there were inconsistencies between

the financial information contained in the advertising brochure

and the financial information provided by Mr. Meglin during

escrow.   For example, the advertising brochure overstated the

1988 and 1989 net income.   Additionally, although the income and

expense statements provided included no repair expenses, MHP had

claimed expenses for repairs on its partnership tax returns.

After corresponding with Mr. Meglin concerning the

inconsistencies, petitioners ultimately proceeded with the

purchase on the terms previously agreed to by the parties.     The

sale of the Truckee Hotel to petitioners closed on April 4, 1991.

Petitioners paid a portion of the purchase price in cash and

executed a promissory note for the balance of $870,000.
                               - 4 -

     Approximately 1 year after petitioners’ purchase of the

Truckee Hotel, the county hotel tax assessor asked petitioners

for a “Revenue Forecast” of their room revenues and room

occupancy taxes that the county could use for budgeting purposes.

Petitioners obtained copies of transient occupancy tax returns

that had previously been filed for the hotel.   Petitioners

discovered that the gross receipts listed on the returns were

less than those shown on the documents provided by Mr. Meglin

during escrow.   The actual gross receipts received by petitioners

from operating the hotel were less than they had anticipated.

     On May 10, 1993, petitioners filed a complaint for damages

in the Superior Court of the State of California against MHP and

Mr. Meglin alleging breach of contract, intentional

misrepresentation, and negligent misrepresentation.   Petitioners

alleged that Mr. Meglin breached the real estate contract by

providing petitioners with false, incorrect, or incomplete

financial statements showing that the income of the hotel was

greater than it was, which proximately resulted in petitioners’

suffering damages for the difference between the purchase price

and actual value of the hotel at the time of sale and the

difference between the reasonable projected profit of the hotel

and the actual income.   Petitioners further alleged that Mr.

Meglin intentionally misrepresented the income and expenses of

the hotel, which induced petitioners to purchase the hotel for a
                               - 5 -

price in excess of its worth and caused them to suffer damages

for this difference in value and the difference between the

represented income of the hotel and the actual income of the

hotel.   Finally, petitioners alleged that Mr. Meglin negligently

misrepresented that the Truckee Hotel had the income and expenses

for 1989, 1990, and 1991, as listed in the income and expense

statements, which proximately caused petitioners to purchase the

hotel for a price in excess of its worth and suffer damages for

the differences between the purchase price and actual value of

the hotel and the represented income and the actual income of the

hotel.

     The matter was referred to nonbinding arbitration, and a

hearing was held on April 14, 1994.    During arbitration,

petitioners sought the following damages:    (1) $612,000 for the

difference between the purchase price and the actual value of the

property at the time of sale; (2) $343,437.27 for lost profits

based on the financial information provided by Mr. Meglin; (3)

$338,000 for amounts reasonably expended in renovation of the

hotel based on Mr. Meglin’s representations; (4) attorney’s fees

and costs; and (5) punitive and exemplary damages.    The

arbitrator found that the income represented by Mr. Meglin in the

income and expense statements was accurate but that the

representations made regarding operating expenses were careless

at best and grossly negligent at worst.    The arbitrator found
                               - 6 -

that although petitioners reasonably relied on Mr. Meglin’s

representations, they failed to prove by a preponderance of the

evidence that they sustained damages as a direct result of the

breach of contract or misrepresentations.   The arbitrator

concluded that petitioners were not entitled to any damages for a

loss of value of the property because petitioners did not meet

their burden of showing that the alleged loss of value was a

proximate and direct result of Mr. Meglin’s misrepresentations.

     Petitioners decided to proceed with litigation, and a trial

was scheduled for July 1994.   In June 1994, petitioners hired

Arthur Gimmy International to prepare an appraisal report for the

Truckee Hotel.   The stated purpose of the appraisal was “to

estimate the fair market value of the whole property on the date

of the sale as well as the investment value of the estate sold

subject to pre-existing financing.”    The report stated that the

value of the property at the time of the sale was $800,000.

     In July 1994, the parties to the litigation entered into a

mutual release and settlement agreement.    Under the terms of the

agreement, Mr. Meglin agreed to pay petitioners the sum of

$271,473.95 by releasing them from $271,473.95 of the amount owed

under the terms of the promissory note executed in connection

with the sale of the hotel.

     Petitioners paid legal and consulting fees in connection

with the lawsuit against MHP and Mr. Meglin.   On the Schedule C,
                               - 7 -

Profit or Loss From Business, attached to their 1994 Form 1040,

U.S. Individual Income Tax Return, petitioners deducted $82,971

for legal and professional services and $17,712 for consulting.

These amounts included costs for legal counsel, accounting work,

and the appraisal.

     Respondent’s examination of petitioners’ 1994 return

commenced in January 1997.   On March 3, 2000, respondent issued

petitioners a notice of deficiency determining that petitioners’

deductions for legal and consulting fees were not deductible

because the fees were incurred in connection with the

establishment of the purchase price of the Truckee Hotel.

                              OPINION

     The issue for decision is whether legal and consulting fees

incurred in maintaining a lawsuit against a seller of property

are deductible as ordinary and necessary business expenses under

section 162.2   Respondent contends that the legal and consulting

fees must be capitalized pursuant to section 263(a) because they

arose out of, and were incurred in connection with, petitioners’

acquisition of the Truckee Hotel, a capital asset.3   Petitioners

argue that capitalization is not required because:    (1) The fees

were postacquisition expenditures not related to the purchase of


     2
      Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year in issue.
     3
      Petitioners do not dispute that the Truckee Hotel was a
capital asset.
                               - 8 -

the hotel; (2) the origin of the claim was not the purchase

agreement; and (3) acquisition costs are required to be

capitalized only when a new asset is acquired or the costs extend

the life or increase the value of the asset.

     Deductions are a matter of legislative grace, and the

taxpayer bears the burden of proving the entitlement to any

deduction claimed.4   INDOPCO, Inc. v. Commissioner, 503 U.S. 79,

84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440

(1934).   Section 162(a) allows a deduction for ordinary and

necessary business expenses paid or incurred during the taxable

year in connection with the carrying on of a trade or business.

Commissioner v. Lincoln Sav. & Loan Association, 403 U.S. 345,

352 (1971).   Expenses incurred in defending a business and its

policies from attack are generally deductible as ordinary and

necessary business expenses.   E.g., Commissioner v. Tellier, 383

U.S. 687 (1966); Commissioner v. Heininger, 320 U.S. 467 (1943);

Am. Stores Co. & Subs. v. Commissioner, 114 T.C. 458 (2000).      On

the other hand, no current deduction is allowed for capital



     4
      In certain circumstances, if the taxpayer introduces
credible evidence with respect to any factual issue relevant to
ascertaining the proper tax liability, sec. 7491 places the
burden of proof on the Secretary. Sec. 7491(a). Sec. 7491 is
effective with respect to court proceedings arising in connection
with examinations commencing after July 22, 1998. Internal
Revenue Service Restructuring and Reform Act of 1998, Pub. L.
105-206, sec. 3001(c), 112 Stat. 727. The examination in this
case commenced in January 1997; thus, sec. 7491 is not
applicable.
                                - 9 -

expenditures.    Sec. 263(a); INDOPCO, Inc. v. Commissioner, supra

at 83.

       “A particular cost, no matter what its type, may be

deductible in one context but may be required to be capitalized

in another context.”    Am. Stores Co. & Subs. v. Commissioner,

supra at 469.    An expense that might otherwise qualify as

currently deductible must be capitalized when it:    (1) Creates or

enhances a separate and distinct asset; (2) produces a

significant future benefit; or (3) is incurred in connection with

the acquisition of a capital asset.     Lychuk v. Commissioner, 116

T.C. 374, 385-386 (2001) (and cases cited therein).

       Capital expenditures are not limited to the actual price

that the buyer pays to the seller for the asset but include the

payment of legal, brokerage, accounting, appraisal, and other

ancillary expenses related to the asset’s acquisition.       Id. at

389.    Whether legal costs are incurred in connection with the

acquisition of a capital asset depends on whether the origin of

the claim litigated is the process of the acquisition itself.

Woodward v. Commissioner, 397 U.S. 572, 577-578 (1970); Berry

Petroleum Co. & Subs. v. Commissioner, 104 T.C. 584, 618-619

(1995), affd. without published opinion 142 F.3d 442 (9th Cir.

1998).    Under the origin of the claim test, the nature of the

transaction out of which the expenditure in controversy arose

governs whether the item is a deductible expense or a capital
                              - 10 -

expenditure, regardless of the payor’s motives in making the

payment.   Woodward v. Commissioner, supra at 578; Am. Stores Co.

& Subs. v. Commissioner, supra at 470.

     Petitioners contend that the legal and consulting fees were

not incurred in connection with the acquisition of the Truckee

Hotel and should be allowable as a current deduction.

Petitioners emphasize that the lawsuit did not begin until 2

years after they purchased the hotel, and the settlement was not

reached until 3 years after the purchase.   Petitioners claim that

Mr. Meglin did not have any cash resources, and their only

recourse available was the reduction of the purchase price.

Petitioners maintain that the adjustment of the purchase price is

not determinative because all facts and circumstances must be

considered.

     The fact that legal costs are incurred after a capital asset

is acquired does not necessarily mean that the costs were not

incurred in connection with the acquisition of the asset.    In

United States v. Hilton Hotels Corp., 397 U.S. 580, 584 (1970),

the Supreme Court noted that the prior passage of title in the

underlying stock acquisition was “a distinction without a

difference” in deciding whether costs of litigation arose out of

the process of acquisition.   This Court reached a similar result

in Am. Stores Co. & Subs. v. Commissioner, supra (legal fees

incurred in defending against antitrust suit filed after stock
                             - 11 -

purchase were capital expenditures because they arose out of, and

were incurred in connection with, acquisition of stock).   See

also Berry Petroleum Co. & Subs. v. Commissioner, supra (costs

incurred in defending lawsuit filed after merger were capital

expenditures because lawsuit had its origins in the process of

acquisition culminating in the merger); Wagner v. Commissioner,

78 T.C. 910 (1982) (legal fees incurred by seller of stock to

defend against lawsuit by purchaser were capital expenditures

because the origin of the claim was the sale); Redwood Empire

Sav. & Loan Association v. Commissioner, 68 T.C. 960 (1977)

(amount paid to settle lawsuit brought by former owners of

property, and legal fees incurred in connection therewith, were

capital expenditures), affd. 628 F.2d 516 (9th Cir. 1980).

     In the instant case, petitioners sought damages from MHP and

Mr. Meglin related to the purchase of the Truckee Hotel.   During

arbitration, petitioners sought specific damage amounts for the

difference between the purchase price and the actual value of the

hotel, lost profits, and renovation costs.   During the course of

litigation, petitioners had an appraisal done to determine the

fair market value of the property as of the date of purchase.

The appraisal indicated that petitioners paid a price

substantially in excess of the fair market value.   As part of the

release and settlement agreement, Mr. Meglin agreed to reduce the

amount owed on the promissory note for the hotel by $271,473.95;
                              - 12 -

thus, the lawsuit essentially resulted in a redetermined purchase

price for the hotel.   Overall, the evidence reflects that the

legal and consulting fees were incurred in connection with the

acquisition of the hotel and were directly related to the

purchase price.

     Petitioners argue that the legal and consulting fees

originated from the misrepresentations made by Mr. Meglin as to

the expected average annual income of the hotel and were not

related to the purchase of the hotel.   Petitioners represented

during their lawsuit against MHP and Mr. Meglin that they were

seeking damages to recover the difference between the purchase

price and the fair value of the hotel, as well as lost profits.

Petitioners ultimately settled their lawsuit in exchange for the

discharge of a portion of the amount owed under the purchase

agreement.   The evidence indicates that the legal and consulting

fees incurred were a result of petitioners’ ultimate desire to

recover the amount they felt they had overpaid to purchase the

hotel.   Thus, the origin of the claim in this case was the

purchase of the hotel.5


     5
      If petitioners had sought and recovered damages solely on
the basis of lost profits incurred in reliance on Mr. Meglin’s
misrepresentations, then it appears that such damages might
constitute ordinary income and the legal fees incurred in
recovering the damages might not be directly related to the
acquisition of a capital asset. However, petitioners’ own
representations in the lawsuit against MHP and Mr. Meglin, as
well as their representations in this proceeding, indicate that
                                                   (continued...)
                               - 13 -

     Petitioners’ reliance on Freeland v. Commissioner, T.C.

Memo. 1986-10, is misplaced.   In that case, the taxpayers

incurred litigation expenses in a wrongful foreclosure action

resulting from the taxpayers’ declaration of default on a

promissory note, their exercise of an option to accelerate

installments, and their initiation of foreclosure proceedings.

Neither party to the litigation was seeking to adjust the

purchase price of the sales agreement; rather, the purpose of the

foreclosure action was to move title to the property from one

party to another.   We found that the kind of transaction out of

which the litigation arose was the foreclosure action, not the

original acquisition of the property.   However, because the

taxpayers ultimately were the successful bidders at the

foreclosure sale, we held that all of their litigation expenses

were attributable to the reacquisition of title and were not

currently deductible.   The instant case is distinguishable

because petitioners incurred legal fees maintaining a lawsuit to

recover damages from Mr. Meglin for misrepresentations which

caused petitioners to pay an inflated price for the hotel.



     5
      (...continued)
they sought and recovered damages to compensate them for the
difference between the purchase price of the hotel and the fair
market value of the hotel at the time of sale. Petitioners have
made no attempt in the instant case to allocate the $271,473.95
reduction in the amount owed under the promissory note among the
difference between purchase price and actual value of the hotel,
lost profits, and renovation costs.
                               - 14 -

Unlike the taxpayers in Freeland, the kind of transaction out of

which the litigation arose was petitioners’ original acquisition

of the hotel, and the litigation essentially resulted in a

reduced purchase price for the hotel.

     Finally, petitioners claim that acquisition costs are only

required to be capitalized when a new asset is acquired or the

costs extend the life or increase the value of the asset.

Petitioners contend that because the Truckee Hotel was

substantially overvalued at the time of purchase and its

capitalized value remained substantially in excess of its fair

market value after the settlement agreement, there was no

increase in the life or value of the hotel as a result of the

litigation.

     We recently rejected the argument that acquisition costs are

capitalizable only if they create or add value to a capital

asset.    In Lychuk v. Commissioner, 116 T.C. at 413-414, we

stated:

     we disagree with * * * [the taxpayers] that acquisition
     costs are capitalizable under section 263(a) only if
     they create or add value to a capital asset. In Dustin
     v. Commissioner, 467 F.2d 47, 49-50 (9th Cir. 1972),
     affg. 53 T.C. 491 (1969), the taxpayer was a
     shareholder of an S corporation (Capitol) that agreed
     to acquire the stock of a company that owned and
     operated radio station KGMS. In 1961, Capitol incurred
     $12,460 of legal, engineering, and accounting fees in
     connection with the transfer to Capitol of control of
     station KGMS’ radio-broadcasting license. The taxpayer
     deducted his proportionate share of these expenses, and
     the Commissioner disallowed the deduction asserting
     that the expenses were capital expenditures. The
                                - 15 -

     taxpayer argued in this Court that he could deduct
     $10,960 of the expenses because they were attributable
     to a hearing held by the Federal Communications
     Commission on this matter and did not add any value to
     the acquired stock. We disagreed with the taxpayer
     that any of these amounts were currently deductible.
     On appeal, so did the Court of Appeals for the Ninth
     Circuit. According to that court: “The expenditures
     connected with the acquisition of the broadcast license
     were no less capital in character because they did not
     themselves contribute additional and specific financial
     value to the license being sought. The important fact
     is that the expenditures were made for the purpose of
     acquiring a capital asset.” * * * [Fn. ref. omitted.]

We noted that the test for capitalization does not hinge on the

amount of value added to property but looks at the nature of the

expense itself.   Id. at 414.   We concluded that “When the nature

of an expenditure bears a direct relation to the acquisition of a

capital asset * * * the expenditure must be capitalized.”      Id.

     Petitioners acquired a capital asset.   Petitioners

subsequently discovered that they paid more for the asset than it

was worth.   Petitioners initiated a lawsuit against MHP and Mr.

Meglin and sought to recover damages on the grounds that

misrepresentations by Mr. Meglin had caused them to pay more than

the hotel was worth.   Petitioners and Mr. Meglin eventually

entered into a release and settlement agreement whereby

petitioners’ obligation under the promissory note executed for
                              - 16 -

the purchase of the hotel was decreased by $271,473.95.6   On the

basis of the evidence in the record, we find that the legal and

consulting fees arose out of, were incurred in connection with,

and were directly related to, the acquisition of the Truckee

Hotel, a capital asset.   Accordingly, we hold that the fees at

issue must be capitalized.


                                    Decision will be entered

                               for respondent.




     6
      The settlement agreement essentially resulted in a reduced
purchase price for the Truckee Hotel. It appears that the
reduction in the purchase price would decrease petitioners’ basis
in the hotel.
