                              T.C. Memo. 2019-40


                        UNITED STATES TAX COURT



       RICK B. FERGUSON AND DEANNA FERGUSON, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 10733-16.                        Filed April 23, 2019.



      Ashlea Brown, Walter M. Ebel III, and Joel F. Hoover, for petitioners.

      Ann L. Darnold and H. Elizabeth H. Downs, for respondent.



           MEMORANDUM FINDINGS OF FACT AND OPINION


      VASQUEZ, Judge: Respondent determined deficiencies in petitioners’

Federal income tax of $571,003 and $72,586 for 2011 and 2012, respectively.
                                         -2-

[*2] After concessions,1 the issues for decision are (i) whether petitioners may

deduct a settlement payment as a business expense on a Schedule C, Profit or Loss

From Business; (ii) if not, whether petitioners may deduct the settlement as a

passthrough loss on a Schedule E; and (iii) whether petitioners are entitled to

deduct an ordinary loss from the deemed sale of real property that was transferred

pursuant to the settlement.

      All section references are to the Internal Revenue Code (Code) in effect for

the years in issue, and all Rule references are to the Tax Court Rules of Practice

and Procedure, unless otherwise indicated.

                               FINDINGS OF FACT

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

the stipulation of facts and the attached exhibits by this reference. Petitioners are

husband and wife. When they timely filed their petition, they resided in Arkansas.

Background

      Petitioner Rick Ferguson has been in the custom home building and

construction business for over 30 years. Mr. Ferguson’s business is generally

      1
        Respondent concedes that there was an error in his calculation of the
adjustment from Schedule E, Supplemental Income and Loss, listed in the notice
of deficiency for 2011, necessitating a Rule 155 computation. As we explain infra
note 6, petitioners abandoned their claim of a passthrough deduction for legal fees
claimed by Mr. Ferguson’s S corporation.
                                        -3-

[*3] known in his community as “Rick Ferguson Custom Homes” and/or “Rick

Ferguson Homes” (collectively, Rick Ferguson Homes). However, Mr. Ferguson

operates his business through several different entities that engage in various

stages of home design and construction. Mr. Ferguson serves as a partner,

shareholder, and member in these entities that are organized as partnerships,

limited liability companies, and corporations. He has developed approximately

seven subdivisions and built between 150 and 200 homes in central Arkansas

through these entities.

      This case involves two of Mr. Ferguson’s entities. Rick Ferguson, Inc.

(RFI), is a C corporation of which Mr. Ferguson was the majority shareholder at

all relevant times. RFI is the corporation through which Mr. Ferguson operates as

a general contractor on custom home construction jobs. During the years in issue

Mr. Ferguson received a salary of $44,400 from RFI.

      The second entity, Pinnacle Precast Co. (Pinnacle), was an S corporation of

which Mr. Ferguson was also the majority shareholder.2 Pinnacle manufactured,

supplied, and installed cast stone.




      2
      Mr. Ferguson held a 96.24658% ownership interest in Pinnacle during
2011 and a 100% ownership interest in 2012.
                                        -4-

[*4] Lawsuit and Settlement

      In 2005 RFI contracted with a third party (homeowners) for the sale of three

lots in Little Rock, Arkansas, and the construction of a home on those lots. Mr.

Ferguson signed the construction contract on behalf of RFI, which agreed to

construct a large, single-family dwelling for the homeowners and to perform “all

work necessary to complete the dwelling”. RFI then subcontracted with 40

subcontractors to perform and supervise the work and to obtain appropriate

building permits. One of these subcontractors was Pinnacle, which was hired to

produce, supply, and install cast stone for use in the construction of the dwelling.

      After construction was completed, relations between Mr. Ferguson and the

homeowners became acrimonious. The construction of the dwelling involved the

installation of cast stone panels, balustrades, and columns. According to the

homeowners, the panels, balustrades, and columns threatened to fall or collapse

because of defects in the manufacture and installation of the cast stone.

      The homeowners filed a lawsuit against RFI, Pinnacle, Valley Falls Estates,

Inc. (VFE),3 and Mr. Ferguson seeking a multimillion-dollar judgment on various

      3
        VFE was an S corporation owned by Mr. Ferguson that sold the
homeowners the lots on which the dwelling was constructed. Accordingly, the
homeowners named VFE as a defendant in their claims for restitution and
rescission of the construction contract. The homeowners did not allege that VFE
                                                                     (continued...)
                                         -5-

[*5] legal grounds. Over the course of the litigation, the homeowners filed

amended and second amended complaints. While the homeowners alleged various

problems with the construction of the dwelling, petitioners and respondent agree

that the primary grievance pertained to the cast stone.

      The homeowners alleged in their original complaint that Pinnacle

“improperly manufactured” the cast stone and, along with RFI, “improperly

installed the defective cast stone.” In their amended and second amended

complaints the homeowners alleged that: (i) Pinnacle manufactured the cast stone

“in such a manner as to render the product defective”, (ii) the improper

manufacturing of the cast stone, coupled with the improper installation, caused the

balustrades and columns of the home’s exterior to discolor and crack, and (iii) the

defective installation of the cast stone included Pinnacle’s failure to install

“expansion joints” and “weep holes”.

      With respect to RFI the homeowners alleged in the complaint, amended

complaint, and second amended complaint that: (i) RFI selected Pinnacle to

supply the cast stone for the construction project, (ii) RFI improperly affixed the


      3
       (...continued)
played any other role in the construction of the dwelling. Neither party in this case
contends that VFE was in any way responsible for the costs of the homeowners’
lawsuit.
                                         -6-

[*6] cast stone panels to the substrate walls, and (iii) RFI improperly installed the

cast stone balustrades on the home’s patio.

      The homeowners identified Mr. Ferguson in their pleadings as the “majority

stockholder and principal” of RFI and Pinnacle. The homeowners alleged that Mr.

Ferguson had misrepresented RFI’s and Pinnacle’s expertise in manufacturing and

installing cast stone. The homeowners also alleged that Mr. Ferguson, in concert

with Pinnacle and RFI, elected to use construction methods and materials that

reasonable persons would not have employed. On the basis of these allegations

the homeowners sought to hold Mr. Ferguson jointly and severally liable with RFI

and Pinnacle for counts of negligence, deceit, constructive fraud, and deceptive

trade practices.4

      In 2011 the lawsuit was settled. The homeowners, Mr. Ferguson, RFI,

Pinnacle, and VFE were parties to the settlement agreement, which Mr. Ferguson

signed in his individual capacity. As a part of the settlement, Mr. Ferguson




      4
        Other than stating that Mr. Ferguson had a relationship of trust with the
homeowners from prior business dealings, the homeowners’ pleadings do not
allege that Mr. Ferguson acted in any capacity other than as the principal and
majority shareholder of RFI and Pinnacle. On the basis of this and other evidence
in the record, we specifically find that all of Mr. Ferguson’s actions with respect to
the construction project at issue were on behalf of RFI and Pinnacle.
                                        -7-

[*7] transferred nine parcels of real estate to the homeowners.5 Mr. Ferguson also

gave the homeowners a check, which was drawn on his personal bank account. In

turn the homeowners agreed to release Mr. Ferguson, RFI, Pinnacle, and VFE

from their claims.

      Pinnacle recorded the aggregate value of the check payment and the fair

market value of the real estate transfer (collectively, settlement payment) on its

books for 2011 as a loan from Mr. Ferguson. No written loan documents were

prepared, and no interest was accrued on the loan. Mr. Ferguson believed he

could treat these amounts as a loan to Pinnacle because he believed that the

settlement was attributable to the defective cast stone. Pinnacle had no sales or

gross receipts in 2012, and Mr. Ferguson shut it down later that year; he assumed

Pinnacle’s liabilities regarding the recorded loan, essentially relieving Pinnacle of

the obligation to repay him.

Tax Returns

      On its 2011 tax return Pinnacle reported gross receipts of $94,987 and

claimed deductions for ordinary business expenses, which included: (i) $101,393

      5
        These properties were actually transferred to the homeowners by three
passthrough entities owned by Mr. Ferguson that were not parties to the lawsuit or
the settlement agreement. The notice of deficiency treated Mr. Ferguson as the
owner and transferor of the properties rather than the passthrough entities. We
will deem this a concession by respondent and do the same.
                                         -8-

[*8] in legal fees, (ii) the settlement payment, and (iii) an ordinary loss from the

deemed sales of three (of nine) parcels that were transferred to the homeowners.

Pinnacle reported long-term capital gains from the deemed sales of the other six

parcels.

      On their 2011 income tax return petitioners reported a passthrough loss

from Pinnacle and carried it forward to their 2012 return. Petitioners’ 2011

income tax return includes two Schedules C for a commercial construction

business and a home remodeling business; the latter reported net profit of

$846,119. Mr. Ferguson also reported wage income from RFI on petitioners’ 2011

and 2012 returns.

Notice of Deficiency

      Respondent timely issued a notice of deficiency to petitioners for tax years

2011 and 2012 reporting deficiencies of $571,003 and $72,586, respectively. In

the notice respondent disallowed petitioners’ passthrough loss deduction from

Pinnacle in its entirety. Instead, respondent treated the settlement payment as an

unreimbursed employee business expense pertaining to Mr. Ferguson’s

employment with RFI and disallowed in full Pinnacle’s deduction of the legal fees

and ordinary loss. Respondent allowed petitioners to claim an itemized deduction
                                         -9-

[*9] for the settlement payment but did not make similar allowances for the legal

fees6 or the ordinary loss from the deemed sales of the parcels. Respondent’s

adjustments resulted in the disallowance of petitioners’ carryforward net operating

loss for 2012.7 Substantial portions of the deficiencies are attributable to the

application of the alternative minimum tax (AMT).8 Petitioners timely petitioned

this Court, and a trial was held in Little Rock, Arkansas.



      6
        Petitioners assigned error in their petition to respondent’s disallowance of
Pinnacle’s deduction for legal fees. However, they did not address the disallowed
legal fees at trial or on brief. Accordingly, we deem the issue abandoned. See
Thiessen v. Commissioner, 146 T.C. 100, 106 (2016) (“[I]ssues and arguments not
advanced on brief are considered to be abandoned.”).
      7
        Petitioners reported certain items on their 2012 return pertaining to their
interest in Generic Holdings, LLC (Generic), which is a partnership subject to the
unified audit and litigation procedures set forth in secs. 6221 through 6234
(TEFRA partnership procedures). For purposes of preparing the notice of
deficiency on which this case is based, respondent treated petitioners’ Generic-
related partnership items as if they were correctly reported on petitioners’ 2012 tax
return. However, the tax treatment of petitioners’ Generic-related partnership
items is the subject of an ongoing TEFRA examination by the Commissioner. The
parties have stipulated that the adjustments necessary to apply the results of the
TEFRA partnership proceeding to petitioners will be treated as computational
adjustments under sec. 6231(a)(6). The parties have also stipulated that, to the
extent any partnership adjustments result in a change to petitioners’ tax liability
attributable to nonpartnership items (which are at issue in this case), such change
may be treated as a computational adjustment under sec. 6231(a)(6) and assessed,
credited, or refunded accordingly.
      8
       This and other numerical adjustments will be addressed by the parties in
their Rule 155 computation.
                                         - 10 -

[*10]                                 OPINION

I.      Burden of Proof

        Generally, the Commissioner’s determination of a deficiency is presumed

correct, and the taxpayer has the burden of proving it incorrect. Rule 142(a);

Welch v. Helvering, 290 U.S. 111, 115 (1933). The burden of proof shifts to the

Commissioner, however, to the extent the taxpayer produces credible evidence

with respect to a factual issue relevant to the deficiency, the taxpayer complied

with the substantiation requirements, and the taxpayer cooperated with the

Commissioner with regard to all reasonable requests for information. Sec.

7491(a); see also Higbee v. Commissioner, 116 T.C. 438, 440-441 (2001).

        The parties stipulated that petitioners have maintained all records required

under the Code and have cooperated with respondent’s reasonable requests for

information. However, the parties disagree about whether petitioners have

produced the requisite credible evidence so that the burden of proof should be

shifted to respondent under section 7491(a).

        With respect to the deductibility of the settlement payment, we need not

resolve this dispute because our conclusions are based on a preponderance of the

evidence, and thus the allocation of the burden of proof is immaterial. See

Blodgett v. Commissioner, 394 F.3d 1030, 1039 (8th Cir. 2005), aff’g T.C. Memo.
                                          - 11 -

[*11] 2003-212; Knudsen v. Commissioner, 131 T.C. 185, 189 (2008),

supplementing T.C. Memo. 2007-340; Martin Ice Cream Co. v. Commissioner,

110 T.C. 189, 210 n.16 (1998).

      As for the ordinary loss claimed by Pinnacle for the deemed sales of three

transferred parcels, we find that petitioners failed to produce credible evidence to

support their return position that Pinnacle is entitled to an ordinary loss deduction.

See infra part III. Accordingly, section 7491(a) does not apply, and the burden of

proof on this issue remains with petitioners.

II.   The Settlement Payment

      A.     Contentions of the Parties

      Petitioners argue that Pinnacle properly deducted the settlement payment

and that they are entitled to their pro rata share of the deduction. According to

petitioners, the homeowners’ lawsuit is attributable to Pinnacle, and the payment

of the settlement by Mr. Ferguson should be treated as a loan or capital

contribution to the S corporation.9 In the alternative petitioners contend that the

      9
        If a business meets the requirements of sec. 1361, it may elect to be treated
as an S corporation and generally avoid corporate tax. Secs. 1362(a), 1363(a). An
S corporation, like a partnership, is a flowthrough entity; its income and losses
flowthrough to its shareholders, who then pay income tax. See sec. 1363(b). Sec.
1366(a)(1) provides that an S corporation shareholder determines his or her tax
liability by taking into account his or her pro rata share of the S corporation’s
                                                                         (continued...)
                                       - 12 -

[*12] settlement payment should be deducted on a Schedule C10 as an ordinary and

necessary expense of a business activity other than employment.

      Respondent counters that Pinnacle cannot deduct any of the costs pertaining

to the lawsuit because it did not pay or incur them. Respondent further contends

that the costs of the lawsuit were the responsibility of RFI. Accordingly,

petitioners may deduct the settlement payment only as an unreimbursed employee

business expense.

      B.      Schedule C Deduction

      We first address petitioners’ argument that they are entitled to deduct the

settlement payment as an ordinary and necessary business expense on a

Schedule C.

      Deductions are a matter of legislative grace, and the taxpayer generally

bears the burden of proving entitlement to any deduction claimed. Rule 142(a);

INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co.


      9
        (...continued)
income, losses, deductions, and credits for the S corporation’s taxable year ending
with or in the shareholder’s taxable year. We have jurisdiction in this deficiency
case to redetermine the income and expense items of Pinnacle. See Winter v.
Commissioner, 135 T.C. 238 (2010); Berry v. Commissioner, T.C. Memo. 2018-
143, at *6; Alli v. Commissioner, T.C. Memo. 2014-15, at *17 n.11.
      10
        It is commonly known that a Schedule C is the form a sole proprietor uses
to report income and deductions attributable to the sole proprietorship.
                                       - 13 -

[*13] v. Helvering, 292 U.S. 435, 440 (1934). Section 162(a) permits a taxpayer

to deduct ordinary and necessary expenses paid or incurred in carrying on a trade

or business. See Commissioner v. Lincoln Sav. & Loan Ass’n, 403 U.S. 345, 352

(1971). Section 62(a)(1) allows deductions for those expenses to be made from

gross income in computing adjusted gross income (AGI) except for those expenses

incurred by a taxpayer as an employee.

      The parties agree that petitioners are entitled to deduct the settlement

payment as a trade or business expense under section 162. However, they disagree

as to whether the settlement payment should be deducted from gross income in

computing petitioners’ AGI.11

      Respondent asserts that the settlement payment was RFI’s expense because

RFI was responsible for the work that gave rise to the homeowners’ lawsuit.

Respondent argues that as a statutory employee of RFI under section 3121(d)(1),12


      11
         If the settlement payment is treated as an unreimbursed employee business
expense as respondent determined, certain consequences follow: (1) the deduction
would be limited by sec. 67(a) and (2) petitioners might be subject to AMT
liability because miscellaneous itemized deductions are not taken into account in
the determination of taxpayers’ AMT income. See sec. 56(b)(1)(A); Johnson v.
Commissioner, T.C. Memo. 1993-530.
      12
        Sec. 3121(d)(1), (3), and (4) describes individuals who are considered
employees regardless of their status under the common law. Individuals described
in those paragraphs are commonly referred to as “statutory” employees. Joseph
                                                                      (continued...)
                                       - 14 -

[*14] Mr. Ferguson may deduct the settlement payment only as an unreimbursed

employee business expense. Petitioners counter that RFI was not Mr. Ferguson’s

only trade or business. According to petitioners, they may deduct the settlement

payment on a Schedule C because Mr. Ferguson paid it to protect his business

reputation and, by extension, his other businesses.

      The deductibility of legal fees depends on the origin and character of the

claim for which the expenses were incurred and whether the claim bears a

sufficient nexus to the taxpayer’s business or income-producing activities. See

United States v. Gilmore, 372 U.S. 39 (1963); Helgerson v. United States, 426

F.2d 1293, 1297 (8th Cir. 1970).13 Legal expenses paid as ordinary and necessary



      12
        (...continued)
M. Grey Pub. Accountant, P.C. v. Commissioner, 119 T.C. 121, 126 (2002), aff’d,
93 F. App’x 473 (3d Cir. 2004). Sec. 3121(d)(1) defines a statutory employee as
“any officer of a corporation”. Petitioners do not contend that statutory employees
under sec. 3121(d)(1) may deduct business expenses on Schedules C. See Cole v.
Commissioner, T.C. Memo. 2006-44; Rev. Rul. 90-93, 1990-2 C.B. 33; cf. Rosato
v. Commissioner, T.C. Memo. 2010-39 (holding that a statutory employee under
sec. 3121(d)(3) is not an employee for purposes of sec. 62 and may deduct
business expenses on Schedule C).
      13
         The same criterion has been applied to determine whether a payment made
in settlement of litigation constitutes such a business expense. Redwood Empire
Sav. & Loan Ass’n v. Commissioner, 628 F.2d 516, 520 (9th Cir. 1980), aff’g 68
T.C. 960, 977 (1977); Anchor Coupling Co. v. United States, 427 F.2d 429 (7th
Cir. 1970); Entwicklungs & Finanzierungs A.G. v. Commissioner, 68 T.C. 749,
759 (1977).
                                        - 15 -

[*15] expenses may be deductible on Schedule C when the matter generating the

expense arises from, or is proximately related to, a business activity other than

employment. Colvin v. Commissioner, T.C. Memo. 2007-157, slip op. at 36-37,

aff’d, 285 F. App’x 157 (5th Cir. 2008); Test v. Commissioner, T.C. Memo. 2000-

362, slip op. at 12-13, aff’d, 49 F. App’x 96 (9th Cir. 2002); see Bagley v.

Commissioner, 8 T.C. 130, 134 (1947). A taxpayer generally must report on

Schedule A, Itemized Deductions, legal expenses attributable to the taxpayer’s

service as an employee. See sec. 62(a)(1); McKay v. Commissioner, 102 T.C.

465, 493 (1994), vacated on other grounds 84 F.3d 433 (5th Cir. 1996); O’Malley

v. Commissioner, 91 T.C. 352, 363-364 (1988); Test v. Commissioner, T.C.

Memo. 2000-362.

      Petitioners do not dispute that Mr. Ferguson was a shareholder and

employee of RFI. The question therefore becomes whether and to what extent the

homeowners’ lawsuit arose from, or is proximately related to, a business activity

of Mr. Ferguson other than his employment with RFI.

      The record establishes that the origin of the homeowners’ lawsuit stems

from work performed by RFI and Pinnacle rather than a separate trade or business

of Mr. Ferguson. While the homeowners’ complaint, amended complaint, and

second amended complaint alleged various problems with the construction of the
                                       - 16 -

[*16] dwelling, the parties agree that the claims regarding the cast stone were the

homeowners’ primary grievance. The cast stone work was performed and/or

supervised by RFI and Pinnacle. RFI was the general contractor for the

construction project and agreed to perform “all work necessary to complete the

dwelling”. Pinnacle was subcontracted to produce, supply, and install cast stone

for use in the construction.

      While the homeowners also sued Mr. Ferguson in his individual capacity,

he was not a party to the construction contract with the homeowners.

Furthermore, the homeowners did not allege that Mr. Ferguson took any action in

the construction of the dwelling other than as the face and controlling shareholder

of RFI and Pinnacle.14

      We recognize that Mr. Ferguson had a separate home remodeling business

that generated substantial Schedule C income for 2011, and we do not doubt that

he was indeed concerned about the consequences of an unfavorable judgment on

this and other business ventures. However, we are bound by the rule established

      14
        Petitioners suggest that Mr. Ferguson was operating Rick Ferguson Homes
as a sole proprietorship and that this entity was separate from RFI. However,
petitioners’ returns for the years in issue do not include Schedules C for Rick
Ferguson Homes. Moreover, Mr. Ferguson testified that RFI has done business as
Rick Ferguson Homes. Given these facts, we decline to find that Rick Ferguson
Homes and RFI were separate entities during the construction of the homeowners’
dwelling.
                                        - 17 -

[*17] by Gilmore, 372 U.S. at 48, to look at the origin of the underlying claim and

not the consequences. In this case the origin of the claims is the work performed

by RFI and Pinnacle, both of which filed corporate returns for 2011. Accordingly,

petitioners cannot deduct the settlement payment on a Schedule C.

      C.     Loan to Pinnacle

      We next address petitioners’ primary argument that Pinnacle should be

treated as having paid the settlement. They contend that Mr. Ferguson intended

the settlement payment to be a loan to Pinnacle because it was responsible for the

work that gave rise to the homeowners’ claims.

      Whether a particular transaction constitutes a loan is a question of fact to be

determined by considering all of the pertinent facts in the case, Fisher v.

Commissioner, 54 T.C. 905, 909 (1970), and we look for both objective and

subjective evidence of the parties’ intent, see United States v. Uneco, Inc. (In re

Uneco, Inc.), 532 F.2d 1204, 1209 (8th Cir. 1976). The Court of Appeals for the

Eighth Circuit, to which an appeal would lie absent a stipulation to the contrary,

lists a number of factors to determine whether a bona fide loan exists, such as

whether: (1) the corporation was so grossly undercapitalized that the loans were in

fact needed for capital purposes and were actually intended to be risked capital

rather than a loan, (2) the purported loans were made in proportion to equity
                                        - 18 -

[*18] holdings, (3) the repayment of the loan was predicated on the success of the

venture, (4) there was a fixed date for payment of the note and a reasonable

expectation of payment by that date, (5) the note was subordinated to other

corporate debts, (6) third parties would have made the loan under the same

conditions, (7) the claimed loan was secured by a mortgage or otherwise, (8) a

provision was made for a sinking fund to retire the loan, (9) the person making the

purported loan participated in the management of the corporation, and (10) the

corporation had a large proportion of debt to equity. J.S. Biritz Constr. Co. v.

Commissioner, 387 F.2d 451, 457 (8th Cir. 1967), rev’g T.C. Memo. 1966-227;

see also Uneco, Inc., 532 F.2d at 1208. The factors are not equally significant, and

no one factor is determinative. Dixie Dairies Corp. v. Commissioner, 74 T.C. 476,

493 (1980). Nor are all the factors relevant to every case. J.S. Biritz Constr. Co.

v. Commissioner, 387 F.2d at 456-457.

      Petitioners’ argument that Mr. Ferguson’s payment of the settlement was

actually a loan to Pinnacle is not supported by the record. Petitioners cite

Pinnacle’s treating the settlement payment as a loan on its books as evidence of a

bona fide loan. However, no loan documents were prepared, and the record is

devoid of any evidence of a fixed repayment date or repayment schedule. No

interest or principal was paid or accrued on the purported loan, which Mr.
                                         - 19 -

[*19] Ferguson effectively canceled when he ended Pinnacle’s operations in 2012.

Furthermore, Mr. Ferguson testified that Pinnacle had little chance of obtaining

third-party financing on its own when he paid the settlement. This view was

shared by Mr. Ferguson’s accountant, who acknowledged at trial that Pinnacle’s

poor cash position made repayment unlikely.

      On the basis of these facts, we find that Mr. Ferguson knew that Pinnacle

would be unable to repay him when he funded the settlement. Accordingly, Mr.

Ferguson did not intend to establish a creditor-debtor relationship with Pinnacle,

and his payment of the settlement was not a loan to the S corporation.

      D.     Deemed Capital Contribution to Pinnacle

      Petitioners argue that, even if Mr. Ferguson’s payment of the settlement was

not a loan, the payment was nevertheless attributable to Pinnacle’s trade or

business and deductible by Pinnacle as an ordinary and necessary business

expense. According to petitioners, Mr. Ferguson’s payment of the settlement is a

contribution to the capital of Pinnacle if it is not a loan. See Rink v.

Commissioner, 51 T.C. 746, 751 (1969) (stating that payment of corporate

expenses by shareholder generally constitutes “either a loan or a contribution to

the capital of the corporation and * * * [is] deductible, if at all, by the

corporation”); Koree v. Commissioner, 40 T.C. 961, 966 (1963) (holding that
                                         - 20 -

[*20] payments in furtherance of a venture calculated to enrich corporation are

capital in nature); see also Gantner v. Commissioner, 905 F.2d 241 (8th Cir.

1990), aff’g 91 T.C. 713 (1988) and 92 T.C. 192 (1988).

      Respondent acknowledges that a shareholder’s payment of corporate

expenses may be deemed a capital contribution in appropriate circumstances.15

However, respondent asserts that “[a]ny conclusion that a capital contribution [to

Pinnacle] was deemed to have been made prior to the payment of the settlement

costs would still require a finding that the settlement costs were, in fact, the

expenses of Pinnacle * * * despite their payment by Rick Ferguson.” According

to respondent, the Court can make no such finding because the settlement costs

were solely attributable to RFI.

      In support of his argument respondent contends that (i) RFI was the general

contractor on and bore the ultimate responsibility for the construction project that

gave rise to the homeowners’ lawsuit, (ii) Pinnacle was not a party to RFI and the

homeowners’ contract, and (iii) the allegations in the homeowners’ lawsuit

address RFI’s decisions to use defective materials and RFI’s inadequate

installation of the materials. Citing these factors, respondent argues that the costs


      15
       Respondent does not contend that this principle is inapplicable to S
corporations.
                                         - 21 -

[*21] and obligations arising from the ill-fated construction project were the

responsibility of RFI.

      We believe respondent ignores the realities of Pinnacle’s role in the

construction project. As mentioned previously, the homeowners’ primary

grievance pertained to the cast stone. In the complaint the homeowners alleged

that Pinnacle “improperly manufactured” the cast stone. In the amended and

second amended complaints the homeowners alleged that Pinnacle manufactured

the cast stone “in such a manner as to render the product defective.” The amended

and second amended complaints further alleged that the improper manufacturing

of the cast stone, coupled with the improper installation, caused the balustrades

and columns of the dwelling’s exterior to discolor and crack.

      While respondent avers that Pinnacle played no role in the installation of the

cast stone, the record indicates otherwise. The parties stipulated that Pinnacle

subcontracted with RFI to “produce, supply, and install cast stone” for use in the

construction of the homeowners’ home. The homeowners’ original complaint

alleges that Pinnacle, along with RFI, “improperly installed the defective cast

stone.” In the amended and second amended complaints the homeowners allege

that the defective installation of the cast stone included Pinnacle’s failure to install

“expansion joints” and “weep holes”.
                                       - 22 -

[*22] Furthermore, Pinnacle’s interests were accounted for in the settlement

agreement. Pinnacle was a party thereto and was therefore released by the

homeowners from all claims pertaining to the construction project at issue. In the

light of these facts, we disagree with respondent that the homeowners’ lawsuit was

solely attributable to RFI.

      That is not to say, however, that we agree with petitioners’ contention that

the lawsuit was solely attributable to Pinnacle. RFI was also a party to the

settlement agreement. As respondent notes, the complaint, amended complaint,

and second amended complaint allege that RFI selected Pinnacle to supply the cast

stone for the construction project. All three pleadings also contain allegations that

RFI improperly installed the cast stone. Furthermore, pursuant to its contract with

the homeowners, RFI was responsible for “performing all work necessary to

complete the dwelling for the Contract price”. At trial Mr. Ferguson confirmed

that the general contractor--RFI, in this case--was “ultimately responsible” for the

construction of the dwelling.

      This Court has examined lawsuit allegations to determine who, among

associated businesses and individuals, may deduct legal fees incurred as joint

defendants in a lawsuit. See Hauge v. Commissioner, T.C. Memo. 2005-276, slip

op. at 13, 16-18; Graphic Bus. Sys., Inc. v. Commissioner, T.C. Memo. 1982-167,
                                         - 23 -

[*23] 1982 Tax Ct. Memo LEXIS 583, at *14-*17. We have also allocated

deductible and nondeductible litigation expenses where appropriate. See, e.g.,

Bledsoe v. Commissioner, T.C. Memo. 1995-521, slip op. at 12 (allocating

business and personal expenses).

      We believe an allocation of the deduction for the settlement payment is

appropriate in this case. It is clear from the record that the lawsuit that gave rise to

the settlement was partially attributable to RFI and partially attributable to

Pinnacle. Furthermore, the settlement was paid by Mr. Ferguson, the controlling

shareholder of both corporations. Accordingly, after a thorough review of the

record, including the lawsuit pleadings and the settlement agreement, we allocate

50% of the settlement payment to RFI and 50% to Pinnacle.16

      Because Mr. Ferguson personally funded the settlement payment, 50% of

which was an expense of Pinnacle, we will deem 50% of the payment a capital

contribution to Pinnacle. See Rink v. Commissioner, 51 T.C. at 751-752; Koree v.

Commissioner, 40 T.C. at 966. Accordingly, Pinnacle may deduct 50% of the




      16
        Because all of Mr. Ferguson’s actions with respect to the construction
project at issue were on behalf of RFI and Pinnacle, see supra note 4, we allocate
0% of the settlement payment to Mr. Ferguson individually. We also allocate 0%
to VFE because neither party has argued that VFE bore any responsibility for the
costs of the lawsuit.
                                        - 24 -

[*24] settlement payment for 2011, and petitioners are entitled to their pro rata

share of any loss this deduction produces.

       Because the remaining 50% was an expense of RFI, we would normally

hold that this portion of the payment is not a deductible expense to petitioners but

rather a capital contribution to the C corporation. See Rink v. Commissioner, 51

T.C. at 751-752; Koree v. Commissioner, 40 T.C. at 966. However, respondent

has conceded that petitioners can deduct amounts paid on behalf of RFI as

unreimbursed employee business expenses. On the basis of this concession,

petitioners may deduct the remaining 50% of the settlement payment as an

unreimbursed employee business expense.

III.   Loss From Deemed Sale of Real Property

       Respondent disallowed an ordinary loss deduction claimed by Pinnacle on

its 2011 return for the deemed sale of three parcels that were transferred to the

homeowners as part of the settlement. Petitioners argue that either Mr. Ferguson

or Pinnacle is entitled to deduct the loss. In his answering brief respondent

concedes that petitioners should be allowed a capital loss deduction to reflect that

in the deemed sales, the parcels were relinquished for less than their bases. It is

unclear from petitioners’ briefs whether they still maintain that the deemed sales

should produce an ordinary loss rather than a capital one.
                                        - 25 -

[*25] Section 1221(a) provides that a capital asset is “property held by the

taxpayer (whether or not connected with his trade or business)”. Congress has

provided in section 1221 eight specific types of property excepted from the

definition of a capital asset. See sec. 1221(a).

      Petitioners have not directed the Court to any of the exceptions listed in

section 1221. There is scant evidence in the record pertaining to the three parcels

at issue, and it is unclear why these properties differed from the other six parcels,

for which capital gains were reported on their deemed sales. Accordingly,

petitioners have not met their burden to prove that they are entitled to an ordinary

loss deduction for the deemed sales of the three parcels. We therefore accept

respondent’s concession and hold that petitioners are entitled to a capital loss

deduction with respect to these properties.

      We have considered all of the arguments made by the parties and, to the

extent they are not addressed herein, we find them to be moot, irrelevant, or

without merit.

      To reflect the foregoing,


                                                 Decision will be entered under

                                        Rule 155.
