Case: 20-60004 Document: 00516013669 Page: 1 Date Filed: 09/14/2021
United States Court of Appeals
for the Fifth Circuit United States Court of Appeals
Fifth Circuit
FILED
September 14, 2021
No. 20-60004
Lyle W. Cayce
Clerk
Ames D. Ray,
Petitioner—Appellant,
versus
Commissioner of Internal Revenue,
Respondent—Appellee.
Appeal from the United States Tax Court
USTC No. 14052-16
Before Dennis, Higginson, and Willett, Circuit Judges.
Stephen A. Higginson, Circuit Judge:
Appellant Ames D. Ray claimed a deduction for certain legal expenses
on his 2014 federal income tax return. The Internal Revenue Service
disallowed this deduction and issued a notice of deficiency to Ray. The IRS
imposed an accuracy-related penalty in addition to the deficiency amount.
Ray filed a petition with the U.S. Tax Court challenging the deficiency
determination and the imposition of the accuracy-related penalty. Following
a one-day trial, the Tax Court issued a decision upholding in part the IRS’s
deficiency determination and imposition of the accuracy-related penalty. Ray
timely appealed the Tax Court’s decision. We affirm in part and reverse and
remand in part.
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No. 20-60004
I.
This case concerns deductions appellant Ames Ray claimed on his
2014 federal income tax return for legal expenses incurred in litigation against
his ex-wife, Christina Ray, and her attorneys. This litigation has been ongoing
for over twenty years, involves four separate lawsuits, and implicates facts
dating back several decades.
A.
Ames and Christina Ray met while they were undergraduate students
at Michigan State University, where both obtained advanced degrees in
physics. They married in 1972 and moved to New York City in 1976.
Christina developed a career in the finance industry, eventually serving as an
officer at multiple financial institutions. She developed mathematical models
for commodities trading and authored several books on risk management and
options trading. In 1990, she founded a consulting firm to advise finance
industry clients. Ames also worked for several financial institutions during
the early stages of his career, but was never a commodities trader. In 1979, he
developed a computer program that could analyze Securities and Exchange
Commission filings, search for company information, and print financial
statements, which he named “Firm Decisions.” Ames licensed this software
to Citibank and received income from Citibank for the software until 1986.
Ames and Christina divorced in 1977, though they continued to live
together off and on until 1992, when Ames moved to Florida. During the time
that they lived together after their divorce, the couple continued to maintain
joint banking and credit-card accounts and own shared assets. The Rays used
a ledger system to track their joint and separate expenses, as well as financial
transactions between them.
Over time, Christina incurred various debts to Ames, which the
couple formalized in several written documents. In 1981, Ames and Christina
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jointly purchased land in Sagaponack, New York with the intent of building
a vacation home on the land. Due to disagreements over construction, in 1984
Ames sold his share of the property to Christina for $350,000. Ames lent this
amount to Christina in exchange for her agreement to make regular payments
to him. The Rays memorialized this agreement in a written document, which
they notarized and accounted for in their ledger system.
A second real-estate transaction followed. The Rays lived in an
apartment on East 87th Street in Manhattan from the time they moved to New
York City in 1976. When that apartment was converted to a co-op around
1987, the Rays purchased shares in the co-op. In November 1991, Ames sold
his interest in the co-op shares to Christina, memorialized by a document
they each signed. Christina executed a note to Ames for $432,427, dated
November 25, 1991. According to Ames, this note covered the amounts
Christina owed him for both the Sagaponack property and the Manhattan
apartment.
Also in November 1991, Ames and Christina signed a document
stating that Christina was solely liable for six different credit-card accounts
in Ames’s name due to her charges to those accounts. The document further
stated that Christina would either close out or remove Ames’s name from
each account. Until Christina did so, the agreement would require her to
spend no more than $1,800 per month on living and non-reimbursed business
expenses.
In April 1993, Christina signed a $532,288.10 “judgment by
confession” in favor of Ames. The judgment by confession stated that it
represented amounts due from Christina to Ames for (1) Christina’s default
on the November 25, 1991 promissory note, (2) $99,860.43 in additional
credit-card debt that Ames had paid or would pay on Christina’s behalf,
(3) “legal and associated expenses incurred in connection with the
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enforcement of the note,” and (4) interest due on these amounts through
March 22, 1993. The judgment by confession was never entered in any court.
In September 1993, Christina signed a letter to Ames stating that she
would provide him with notarized financial statements on a semiannual basis
until the judgment-by-confession amount was paid in full. Christina would be
liable for a $50 penalty for each day she was late in providing her financial
statements to Ames.
On August 10, 1994, Christina signed another letter to Ames, this one
summarizing her debts to him, which then totaled $590,222.79. This amount
covered (1) the $532,288.10 represented by the judgment by confession,
(2) $18,774.24 for late financial statements plus interest, (3) additional
credit-card debt and related interest, and (4) a reduction for a rent
adjustment of $48,625.
In early 1993, Christina approached Ames with a proposal to use a
trading method she had developed to “mak[e] money trading futures and
options.” On May 24, 1993, the Rays formalized the terms of their
arrangement in a written document (the “trading agreement”). The
document stipulated that Christina would manage the trading of Ames’s
commodities brokerage account in her “sole discretion.” Christina was to
provide monthly reports to Ames with the “analysis, rationale, and logic of
trades and positions.” Ames would pay Christina a 7 percent commission on
the increase in value of the account on a monthly basis. The trading
agreement further provided that “[Christina] and [Ames] may advertise the
accurate results of [Christina’s] trading [of Ames’s] account.” The trading
agreement stated that it would automatically terminate as of November 1993,
and that because Christina was to trade Ames’s account “for hire,” Ames
would be “permitted to terminate [the trading agreement] at any time.”
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Ames deposited $500,000 into his commodities brokerage account so that
Christina could trade his account pursuant to the trading agreement.
On June 14, 1993, Ames proposed an amendment to the trading
agreement that provided: “You’ll pay to me the amount of money that my
account falls below $350[,000] . . . . Otherwise, trade my account to liquidate
positions when my account’s value falls below $350[,000].” Christina signed
the amendment on September 4, 1993. However, by the time Christina signed
the amendment, the account’s value had already declined to $1,285, and she
had thus stopped trading on the account due to insufficient capital. In August
1994, Christina signed a letter to Ames confirming that she owed him
$384,388 for the losses to the commodities account plus interest.
Ames deducted his trading agreement losses as a Schedule C business
loss on his 1993 tax return. The Internal Revenue Service (IRS) disallowed
the deduction and sent Ames a notice of deficiency. Ames disputed the IRS’s
deficiency determination in the U.S. Tax Court, and he and the IRS
eventually reached a settlement, which was entered by the Tax Court on
December 16, 1997 as a stipulated decision “[p]ursuant to the agreement of
the parties.” Under the stipulated decision, Ames was charged a deficiency
of $88,926.42 for the 1993 tax year and was still allowed to deduct
$374,102.00 as a Schedule C business loss labeled “Futures Trader.”
Then came litigation. On September 9, 1998, Ames filed a lawsuit
against Christina in the New York Supreme Court for New York County (Ray
v. Ray, Index No. 604381/98) (“Ray I”). Ames alleged two causes of action
arising from (1) Christina’s failure to pay any part of the indebtedness
amount summarized by the August 10, 1994 letter (representing her debts
resulting from the two real estate purchase loans, the credit-card debt, and
the late financials) and (2) Ames’s losses under the trading agreement. The
New York Supreme Court dismissed the complaint on January 11, 2008.
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Ames appealed, and on April 7, 2009, the Appellate Division of the Supreme
Court of New York overturned the dismissal. As of June 2020, the case
remained pending. See Ray v. Ray, 149 N.E.3d 443 (N.Y. 2020). In 2014,
Ames incurred $77,724 in legal expenses for Ray I.
On October 20, 2010, Ames again sued Christina in the New York
Supreme Court for New York County (Ray v. Ray, Index No. 652314/2010)
(“Ray II”). Ames alleged that Christina owed him at least $970,000, and that
she had fraudulently conveyed property to avoid paying Ames. The New
York Supreme Court dismissed the complaint on July 12, 2011, and the
Appellate Division affirmed on July 9, 2013. Ames did not incur any legal
expenses for Ray II in 2014.
Ames filed another fraudulent conveyance lawsuit against Christina
and her business, Guarnerius Management, LLC, in the New York Supreme
Court on April 24, 2014 (Ray v. Ray et al., Index No. 153945/2014) (“Ray
III”). Ames alleged that Christina mortgaged the Manhattan co-op for
$500,000 and then fraudulently conveyed that amount—$80,000 to pay for
legal fees and the remaining $420,000 to Guarnerius. The New York
Supreme Court dismissed the complaint on December 22, 2014. Ames spent
$151,500 on legal expenses for Ray III in 2014.
On January 22, 2016, Ames sued Christina’s Ray I attorneys in the
United States District Court for the Southern District of New York, alleging
that they had made deceitful statements and representations to the trial and
appellate courts in Ray I in order to obtain an advantage in the litigation (Case
No. 1:15-cv-10176-JSR) (“Ray IV”). The district court dismissed the
complaint on April 26, 2016, and the United States Court of Appeals for the
Second Circuit affirmed the dismissal on April 14, 2017. Although Ames did
not file his complaint in Ray IV until 2016, he incurred $38,000 in legal
expenses for the case in 2014.
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That brings us to the tax deductions at issue on appeal. On his 2014
federal income tax return, Ames reported a negative amount of $238,937 as
“[o]ther income” with the label “legal fees, costs.” Ames did not file a
Schedule C (Profit or Loss from Business) with his 2014 tax return.
The IRS issued a notice of deficiency to Ames, informing him that the
IRS had disallowed the legal expense deduction and imposed a 20 percent
accuracy-related penalty pursuant to Internal Revenue Code § 6662(a).
B.
Ames filed a petition with the U.S. Tax Court challenging the
deficiency determination and the imposition of the accuracy-related penalty.
He claimed that the IRS had erred in disallowing the deduction for his legal
expenses, arguing that they were “deductible either under [26 U.S.C.] § 162,
[26 U.S.C.] § 212 or as a capital loss in connection with a hedge fund of which
[Ames] was founder, and an officer and director.” The Tax Court held a one-day trial on May 3, 2017, and issued an opinion on April 15, 2019.
Applying the preponderance of the credible evidence standard, the
Tax Court found that none of Ames’s legal expenses was eligible for a
deduction as an expense of carrying on a trade or business under § 162(a) of
the Internal Revenue Code. The Tax Court next held that the portion of
Ames’s legal expenses related to the trading agreement losses (those legal
expenses attributable to the second cause of action in Ray I and part of Ray
III)—but not the portion of his legal expenses related to his efforts to recover
on his ex-wife’s indebtedness for the Sagaponack property purchase, the
Manhattan apartment purchase, the credit-card debt, and the late financial
statements (those legal expenses attributable to the first cause of action in
Ray I, part of Ray III, and all of Ray IV)—could be deducted under Internal
Revenue Code § 212. The Tax Court applied the “Cohan rule” (from Cohan
v. Commissioner, 39 F.2d 540 (2d Cir. 1930)), using the ratio of damages
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attributed to each Ray I cause of action, to determine that Ames could deduct
39.5 percent of the Ray I and Ray III legal expenses he paid in 2014 under
§ 212.
The Tax Court found Ames liable for an accuracy-related penalty
under Internal Revenue Code § 6662(a), (b)(1) and (2). The Tax Court
further found that Ames had failed to carry his burden of proof in establishing
an affirmative defense to the penalty.
Following the issuance of the Tax Court opinion, the Tax Court
entered its decision and adopted the IRS’s proposed deficiency computation.
The deficiency computation deducted from Ames’s taxable income 39.5
percent of Ames’s 2014 legal expenses from Ray I and Ray III (the expenses
related to his losses under the trading agreement), which the Tax Court had
determined Ames could deduct as expenses for the production of income
under § 212. The computation imposed a 20 percent penalty on Ames’s
underpayment. The penalty was not imposed on any underpayment
attributable to legal expenses concerning the trading agreement losses, which
Ames was allowed to deduct under § 212. But the penalty was imposed on
the underpayment attributable to (1) the difference in the amounts Ames
would be allowed to deduct for legal expenses for the trading agreement
losses if they were deductible under § 162(a) rather than § 212, and
(2) Ames’s deduction of his legal expenses relating to his litigation to recover
on his ex-wife’s indebtedness.
Ames timely appealed the Tax Court’s decision.
II.
This court applies the same standard of review to a decision of the
U.S. Tax Court as it would to a federal district court decision. We review
factual findings for clear error and legal determinations de novo. Estate of
Duncan v. Comm’r, 890 F.3d 192, 197 (5th Cir. 2018) (citing Terrell v.
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Comm’r, 625 F.3d 254, 254 (5th Cir. 2010)). “Clear error exists when this
[C]ourt is left with the definite and firm conviction that a mistake has been
made.” Terrell,
625 F.3d at 258 (alteration in original) (quoting Green v.
Comm’r,
507 F.3d 857, 866 (5th Cir. 2007)).
III.
We first consider whether the Tax Court erred in finding that Ames
Ray (hereinafter referred to as “Ray”) cannot deduct his legal expenses from
litigating to recoup his losses under the trading agreement as expenses of
carrying on a trade or business under § 162(a) of the Internal Revenue Code.
The Tax Court held that Ray could not deduct any of his 2014 legal fees as
expenses of carrying on a trade or business under § 162(a), finding that (1) the
claims underlying the litigation to recover on Christina Ray’s indebtedness
lacked any nexus to Ray’s purported computer programming business, and
(2) the claims underlying the litigation to recoup the trading agreement losses
lacked a sufficient nexus to a trade or business carried on by Ray because “the
purported business was in actuality Ms. Ray’s management of a hedge fund
and [] [Ray’s] involvement in her management of that fund extended no
further than his initial investment.”
On appeal, Ray argues that the Commissioner is collaterally estopped
from litigating the issue of whether the origin of the claims underlying Ray’s
2014 legal expenses relating to his trading agreement loss is a “business
investment” because the 1997 stipulated Tax Court decision determined that
his loss under the trading agreement was a deductible business loss. Ray
argues in the alternative that he is entitled to a § 162(a) deduction for his legal
expenses regarding the trading agreement losses because he and Christina
Ray were jointly engaged in a hedge fund business and collaborated to
develop a trading program, and the claims underlying the legal expenses were
related to this business.
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The Commissioner counters that Ray failed to preserve his collateral
estoppel argument in the Tax Court because he raised the issue for the first
time in his post-trial answering brief. Even so, the Commissioner further
maintains that collateral estoppel does not apply because the 1997 stipulated
Tax Court decision was entered pursuant to the agreement of the parties, and
thus the issue of whether the trading agreement loss was a deductible
business loss was not actually litigated. In response to Ray’s alternative
argument on the merits of § 162(a) deductibility, the Commissioner avers
that Ray did not carry on the trading venture as a trade or business and was
nothing more than an investor.
We consider, as a threshold matter, Ray’s argument that the
Commissioner is collaterally estopped from litigating the issue of whether the
origin of the claims underlying Ray’s trading agreement-related litigation is a
business loss entitling him to a § 162(a) deduction. Finding that collateral
estoppel does not bar the Commissioner from litigating this issue, we then
assess whether Ray is entitled to a § 162(a) business-expense deduction for
the portion of his 2014 legal expenses incurred in his efforts recoup his losses
under the trading agreement.
A.
An argument not raised before the trial court cannot be raised for the
first time on appeal. XL Specialty Ins. Co. v. Kiewit Offshore Servs., 513 F.3d
146, 153 (5th Cir. 2008) (citing Stokes v. Emerson Elec. Co.,
217 F.3d 353, 358
n.19 (5th Cir. 2000)). For an argument to be preserved, it “must be raised to
such a degree that the trial court may rule on it.”
Id. (quoting Butler Aviation
Int’l v. Whyte (In re Fairchild Aircraft Corp.),
6 F.3d 1119, 1128 (5th Cir. 1993),
abrogated on other grounds as recognized in Matter of Diaz,
972 F.3d 713, 720
n.6 (5th Cir. 2020)). Under the Tax Court Rules of Practice and Procedure,
Rule 39, an affirmative defense such as collateral estoppel must be set forth
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in a party’s pleading or else will be deemed abandoned. Tax Ct. R. 39;
Jefferson v. Comm’r, 50 T.C. 963, 966–67 (1968). The Tax Court does not
consider issues raised for the first time in an answering brief. Dutton v.
Comm’r,
122 T.C. 133, 142 (2004); accord Clay v. Comm’r,
152 T.C. 223, 236
(2019).
In his appellate briefing, Ray suggests that he first raised his asserted
collateral estoppel defense in his pre-trial submission. To the contrary, Ray’s
pre-trial submission merely mentioned the 1997 stipulated Tax Court
decision but did not assert collateral estoppel. Ray did not raise his asserted
collateral estoppel defense until his post-trial answering brief.
Because the Tax Court does not consider issues raised for the first
time in an answering brief, Ray did not raise the collateral estoppel defense
“to such a degree that the [Tax Court could] rule on it” in accordance with
this court’s preservation standard. See XL Specialty Ins. Co., 513 F.3d at 153
(quoting In re Fairchild Aircraft Corp.,
6 F.3d at 1128). We thus find that Ray
has failed to preserve his asserted collateral estoppel defense.
B.
We now turn to the merits of Ray’s argument that his 2014 legal
expenses incurred litigating to recover his trading agreement losses are
deductible as expenses of a trade or business under § 162(a). 1 The Tax Court
found that these legal fees are not deductible as expenses of a trade or
business under § 162(a), but did find that that Ray could deduct these legal
fees as expenses for the production of income under § 212. Neither party
1
Ray has abandoned by failing to brief any argument he might have against the Tax
Court’s finding that Ray’s 2014 legal expenses incurred litigating to recover on his ex-wife’s indebtedness are not deductible business expenses under § 162(a). See Coury v. Moss,
529 F.3d 579, 587 (5th Cir. 2008).
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disputes the Tax Court’s finding that these legal fees are deductible under
§ 212. This issue remains justiciable, however, because Ray would receive
greater tax-liability relief if he were able to deduct these expenses under
§ 162(a) rather than § 212. See Green, 507 F.3d at 870 n.7 (discussing the
comparative advantage of deducting an expense under Internal Revenue
Code § 162(a) versus § 212).
Section 162(a) of the Internal Revenue Code allows taxpayers to
deduct from their taxable income “all the ordinary and necessary expenses
paid or incurred during the taxable year in carrying on any trade or business.”
I.R.C. § 162(a). Because “an income tax deduction is a matter of legislative
grace,” a taxpayer claiming a business-expense deduction under § 162(a) has
the burden to prove that the expense is rooted in the taxpayer’s trade or
business. INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84 (1992) (quoting
Interstate Transit Lines v. Comm’r,
319 U.S. 590, 593 (1943)); see also Marcello
v. Comm’r,
380 F.2d 499, 504 (5th Cir. 1967); Brinkley v. Comm’r,
808 F.3d
657, 663 (5th Cir. 2015) (“As a general rule, the Commissioner’s
determination of a tax deficiency is presumed correct, and the taxpayer has
the burden of proving the determination to be erroneous.”).
The phrase “trade or business” in § 162(a) “connotes something
more than an act or course of activity engaged in for profit.” Stanton v.
Comm’r, 399 F.2d 326, 329 (5th Cir. 1968) (quoting McDowell v. Ribicoff,
292
F.2d 174, 178 (3d Cir. 1961)). A taxpayer can show that his activities
constitute a trade or business within the meaning of § 162(a) by
demonstrating that he engaged in “extensive activity over a substantial
period of time during which the [t]axpayer holds himself out as selling goods
or services.” Id. (quoting McDowell,
292 F.2d at 178); accord Louisiana Credit
Union League v. United States,
693 F.2d 525, 532 (5th Cir. 1982). “One
prearranged deal does not evidence the continuity and regularity found in
trades or businesses.” Harris v. Comm’r,
16 F.3d 75, 81 (5th Cir. 1994). The
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taxpayer’s management of his own investments is not a trade or business.
Zink v. United States, 929 F.2d 1015, 1021 (5th Cir. 1991).
Legal expenses can be deductible as business expenses under § 162(a).
Estate of Meade v. Comm’r, 489 F.2d 161, 164–66 (5th Cir. 1974). In United
States v. Gilmore, the Supreme Court established the origin-of-the-claim test
to determine whether a legal expense is deductible.
372 U.S. 39, 48–49
(1963). The origin-of-the-claim test asks the court to consider “the origin and
character of the claim with respect to which [a legal] expense was incurred,
rather than its potential consequences upon the fortunes of the taxpayer,” to
determine whether the expense is a business or a personal expense, and thus
“whether it is deductible or not.” Gilmore,
372 U.S. at 49; see also Estate of
Meade,
489 F.2d at 165. In applying the origin-of-the-claim test to determine
whether a legal expense is deductible, courts should consider the issues,
nature, and objectives of the lawsuit, the defenses asserted, the purpose of
the expenses, and the background of the litigation. Morgan’s Estate v.
Comm’r,
332 F.2d 144, 151 (5th Cir. 1964).
We review the Tax Court’s factual finding as to whether the taxpayer
was carrying on a trade or business for clear error and its legal conclusions de
novo. See Green, 507 F.3d at 871 (“The determination of whether [the
taxpayer] was engaged in carrying on a trade or business is a determination of
fact that we review for clear error.”); Brinkley,
808 F.3d at 664.
In order to reverse the Tax Court on this issue, we would need to find
that the Tax Court clearly erred in finding that the origin of the claims
underlying Ray’s litigation to recoup his losses under the trading agreement
did not relate to his engagement in a trade or business within the meaning of
§ 162(a). This issue involves two distinct inquiries: (1) Did the Tax Court
clearly err in characterizing the trading agreement venture as “Ms. Ray’s
management of a hedge fund” rather than a computer programming
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business?; and (2) Did the Tax Court clearly err in finding that Ray was not
involved in the trading agreement venture as a trade or business, but rather
was merely an investor in the venture?
In the Tax Court, Ray argued that the trading agreement venture was
an extension of his earlier computer programming business because he took
part of his settlement from litigation involving his Firm Decisions software
and invested it in the trading agreement venture “to continue developing
programs for Wall Street.” The Tax Court rejected this argument, finding
that “the purported business was in actuality Ms. Ray’s management of a
hedge fund.” On appeal, Ray again attempts to characterize the trading
agreement venture as tied to his earlier computer programming business.
However, Ray does not point to any facts establishing a link between the
trading agreement venture and Ray’s earlier computer programming
business beyond the source of funding. In his testimony before the Tax
Court, in his post-trial brief, and again in his appellate brief, Ray states that
the purpose of the trading agreement venture was to test the trading
strategies that Christina Ray had developed. Although these trading
strategies involved computer programs, Ray cites no evidence establishing
that these computer programs were related to his earlier computer
programming business or were developed by Ray. The Tax Court thus did
not clearly err in characterizing the trading agreement venture as “Ms. Ray’s
management of a hedge fund.”
Ray further argues that he engaged in the trading agreement venture
as a trade or business within the meaning of § 162(a) because the venture was
a joint collaboration with his ex-wife “to profit from the track record they
sought to establish using Christina’s trading strategies.” To establish that he
was engaged in a trade or business under § 162(a), Ray must demonstrate that
he engaged in “extensive activity over a substantial period of time” with
respect to the purported business. Stanton, 399 F.2d at 329. A mere profit
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motive does not establish engagement in a trade or business, and the
management of one’s own investments is not a trade or business. Id.; Zink,
929 F.2d at 1021.
Nothing in the record establishes that Ray engaged in the trading
agreement venture with “continuity and regularity.” Comm’r v. Groetzinger,
480 U.S. 23, 35 (1987). Ray argues that “[c]onsistent with Groetzinger, Ray
was regularly and continuously engaged in writing and creating financial
software programs of a decision making and predictive nature from 1976
through the end of his collaboration with Christina.” Ray does not identify
evidence in the record, however, establishing that Ray developed the
computer programs that Christina Ray used in the trading agreement venture
or meaningfully contributed to Christina’s development of these programs.
As noted, Ray repeatedly characterized the purpose of the trading agreement
venture as testing the trading strategies that Christina had developed. Ray
also does not cite evidence showing that he participated in the trading aspect
of the purported business. In fact, in Ray I, Ray testified that he did not
“remember spending much time developing programs and models,” and that
trading was Christina’s profession rather than his. Under the terms of the
trading agreement, Ray disclaimed any right to be actively involved in the
trading aspect of the purported business, as the agreement gave Christina Ray
the authority to trade Ray’s commodities account in her sole discretion.
Ray argues that the trading agreement’s language providing that
either party could “advertise the accurate results” of Christina Ray’s trading
of Ray’s account shows that “[t]here was a clear purpose and intent to
commercially exploit what both believed would be a profitable program.”
The existence of an intent to commercially exploit the trading program does
not show that Ray engaged in extensive activity over a substantial period of
time with respect to the purported trading business. Moreover, the existence
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of a profit motive does not establish a trade or business within the meaning
of § 162(a). Stanton, 399 F.2d at 329.
Ray has not carried his burden of proof to show that the origin of the
claims underlying his litigation to recoup his trading agreement losses—the
trading agreement venture—was related to his engagement in a trade or
business within the meaning of § 162(a). Accordingly, the Tax Court did not
clearly err in finding that Ray is not entitled to deduct his 2014 legal expenses
under § 162(a).
IV.
We next consider whether the Tax Court erred in finding that Ray
cannot deduct his legal expenses incurred litigating to recover on his ex-wife’s indebtedness as expenses for the production of income under § 212(1)
of the Internal Revenue Code.
The Tax Court found that Ray’s legal expenses relating to the first
cause of action in Ray I, i.e., those incurred litigating to recover on Christina
Ray’s debts to Ray for (1) the Sagaponack property purchase, (2) the
Manhattan apartment purchase, (3) the charges to Ray’s credit-card
accounts, and (4) the late financial statements, are not deductible as expenses
for the production of income under § 212(1). On appeal, Ray argues that the
Tax Court erred in finding against deductibility because each of the relevant
debt instruments was an interest-bearing, income-producing asset to Ray.
The Commissioner counters that none of the claims underlying the first
cause of action in Ray I was a claim for the production or collection of income
because “all of the debts were personal debts unrelated to the production of
income.”
Section 212(1) of the Internal Revenue Code allows taxpayers to
deduct “all the ordinary and necessary expenses paid or incurred . . . for the
production or collection of income.” I.R.C. § 212(1). Once again, the
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Commissioner’s deficiency determination is “presumptively correct,” and
the taxpayer bears the burden of demonstrating their entitlement to a
deduction. Payne v. Comm’r, 224 F.3d 415, 420 (5th Cir. 2000); INDOPCO,
503 U.S. at 84.
The key inquiry for determining deductibility under § 212(1) is
“whether the expenditures were made primarily in furtherance of a bona fide
profit objective.” Westbrook v. Comm’r, 68 F.3d 868, 875 (5th Cir. 1995)
(internal quotation marks omitted) (quoting Agro Sci. Co. v. Comm’r,
934
F.2d 573, 576 (5th Cir. 1991)). “A deduction claimed under § 212(1) must
meet the same requirements applicable to trade or business expenses under
§ 162, except that the person claiming the deduction need not be in the trade
or business.” Green,
507 F.3d at 870 (internal quotation marks omitted)
(quoting Simon v. Comm’r,
830 F.2d 499, 501 (3d Cir. 1987)).
The origin-of-the-claim test applies to determine the deductibility of
legal expenses under § 212(1) just as it applies to the deductibility of such
expenses under § 162(a). Applying the origin-of-the-claim test, legal fees are
considered personal expenses and thus not deductible under § 212(1) if the
claims underlying the lawsuit are personal in nature. See Colvin v. Comm’r,
122 F. App’x 788, 790 (5th Cir. 2005).
In considering the Tax Court’s conclusion as to whether legal fees are
deductible as expenses incurred for the production of income, we review the
Tax Court’s factual finding regarding profit motive for clear error and its
legal conclusions do novo. See Westbrook, 68 F.3d at 876; Colvin,
122 F.
App’x at 790.
We must decide whether the Tax Court clearly erred in finding that
the origins of the claims underlying Ray’s litigation to recover on Christina
Ray’s indebtedness were not related to the production or collection of
income within the meaning of § 212(1). In determining whether Ray’s legal
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expenses incurred litigating to recover on the principal of Christina Ray’s
indebtedness are deductible under § 212(1), the key question is whether Ray
entered into each of the following transactions “in furtherance of a bona fide
profit objective,” Westbrook, 68 F.3d at 875: (1) Ray’s ownership and sale of
the Sagaponack property; (2) Ray’s ownership and sale of the Manhattan
apartment; (3) Ray’s arrangement with Christina Ray regarding the charges
she incurred on his credit-card accounts; and (4) Ray’s agreement with
Christina Ray for her to provide him with regular financial statements. We
address each of these transactions in turn.
Tax Court caselaw addressing the § 212 deductibility of expenses
incurred in the maintenance and sale of properties distinguishes between
personal residences and investment properties. See, e.g., Murphy v. Comm’r,
66 T.C.M. (CCH) 32, *2 (1993) (stating that, in determining the § 212
deductibility of property-related expenses, “if property has been acquired or
used as the taxpayer’s personal residence, it must be converted to a use
related to the production of income in order for the taxpayer to become
entitled to deduct such losses and/or expenses”); Thomas v. Comm’r,
42
T.C.M. (CCH) 496 (1981) (providing that the deductibility of property-related costs incurred prior to sale “depends upon whether the taxpayer has
shown that a conversion of the property for the production of income has
occurred”). A taxpayer can show that his property was converted from
personal residential use to profit-producing use by demonstrating that he
rented the property out to third parties or that, after converting the property
from residential to investment use, he held the property and attempted to
realize a profit from the appreciation in market value. Murphy, 66 T.C.M.
(CCH) at *2 & n.7 (citing Newcombe v. Comm’r,
54 T.C. 1298, 1302 (1970)).
The record shows that both the Sagaponack property and the
Manhattan apartment were used by Ames and Christina Ray for residential
purposes for the entire period prior to Ames’s sale of his interest in the
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properties to Christina. Ames and Christina Ray jointly purchased the
Sagaponack property for the purpose of building a vacation home on the land.
Construction of this vacation home was ongoing at the time that Ray sold his
interest in the land to his ex-wife. The record does not support clear error on
the ground that Ames and Christina Ray rented the property or were holding
the land for an investment rather than a residential purpose. Likewise, Ames
and Christina Ray owned the Manhattan co-op shares for personal residential
use for the full time period prior to Christina’s purchase of Ray’s interest in
the shares. The record does not support clear error on the ground that Ray
and Christina Ray rented the Manhattan apartment to third parties or ceased
their residential use and held the property for investment purposes.
The record also does not support clear error on the ground that Ray
entered into the agreements with Christina regarding her personal charges to
his credit-card accounts or the penalty for late financial statements with the
primary motive of profiting from these arrangements. In a deposition in Ray
I, Ray testified that he entered into the arrangement with respect to
Christina’s credit-card charges because he and his ex-wife had identified
charges that were solely Christina’s responsibility and they intended to
further separate their finances. Ray also suggested in deposition testimony
that he entered into the agreement for Christina Ray to provide him financial
statements in order to obtain better assurance that she could repay him for
her debts. All of these debt arrangements were thus personal rather than
profit-motivated. None of the origins of the claims underlying Ray’s litigation
to recover the principal amount of Christina Ray’s indebtedness is related to
the production or collection of income.
In his brief, Ray relies on Green, 507 F.3d at 870–71, where this court
found that a taxpayer could deduct under § 212 expenses incurred attempting
to recover on a judgment he was awarded in a wrongful termination lawsuit.
Green is inapposite. In Green, the judgment stemmed from the taxpayer’s
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wrongful termination and was primarily intended to compensate the taxpayer
for his lost employment income. Green, 507 F.3d at 867–68. Here, as
established, the transactions underlying Christina Ray’s indebtedness to
Ames Ray were not profit-motivated or income-generating in nature.
We next consider whether Ray’s legal expenses incurred litigating to
recover the interest accrued on Christina Ray’s indebtedness are deductible
under § 212(1). Ray cites Kelly v. Commissioner, 23 T.C. 682, 688 (1955),
aff’d,
228 F.2d 512 (7th Cir. 1956), in which the Tax Court held that the
portion of expenses attributable to the recovery of interest on a personal loan
may be deducted as expenses incurred for the collection of income. Kelly, 23
T.C. at 688–90; accord Young v. Comm’r,
113 T.C. 152, 157 (1999), aff’d,
240
F.3d 369 (4th Cir. 2001). The Commissioner does not dispute this caselaw
but argues that Ray has forfeited this argument because he did not raise it in
the Tax Court.
As previously discussed, an argument not raised before the trial court
cannot be raised for the first time on appeal. XL Specialty Ins. Co., 513 F.3d at
153 (citing Stokes,
217 F.3d at 358 n.19). For an argument to be preserved, it
“must be raised to such a degree that the trial court may rule on it.”
Id.
(quoting In re Fairchild Aircraft Corp.,
6 F.3d at 1128).
Ray did not raise his Kelly argument before the Tax Court, and barely
argued for the § 212 deductibility of his legal expenses in his pre-trial and
post-trial briefing. This argument, then, was not raised to such a degree that
the Tax Court could have ruled on it. Ray has thus failed to preserve any
argument he might have that the portion of his legal fees attributable to his
efforts to recover the interest on his ex-wife’s indebtedness is deductible
under § 212(1).
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V.
The Tax Court found Ray liable for an accuracy-related penalty under
Internal Revenue Code § 6662, which imposes a 20 percent penalty on tax
underpayments attributable to the taxpayer’s “[n]egligence or disregard of
rules or regulations” or “substantial understatement of income tax.” I.R.C.
§§ 6662(a), (b)(1), (b)(2). 2 Because the Tax Court found that Ray could
deduct his trading agreement loss-related legal expenses under § 212, the
computation adopted by the Tax Court did not impose a penalty on any
underpayment attributable to legal expenses concerning the trading
agreement losses, which Ray was allowed to deduct under § 212. But the Tax
Court did impose a penalty on Ray’s underpayment attributable to (1) the
difference in the amounts Ray would be allowed to deduct for legal expenses
for the trading agreement losses if they were deductible under § 162(a) rather
than § 212, and (2) Ray’s deduction of his legal expenses relating to his
litigation to recover on his ex-wife’s indebtedness.
On appeal, Ray argues that the Tax Court erred in finding him liable
for an accuracy-related penalty because he is entitled to both a “reasonable
cause and good faith” defense and a “substantial authority” defense to the
imposition of the penalty. The Commissioner responds that Ray has failed to
meet his burden of proving these defenses. We address Ray’s entitlement to
each of these asserted defenses in turn.
A.
An accuracy-related penalty does not apply to any portion of a
taxpayer’s underpayment for which the taxpayer had “reasonable cause”
2
An understatement of income tax is substantial if the amount of understatement
exceeds the greater of 10 percent of the taxpayer’s total tax liability or $5,000. I.R.C.
§ 6662(d)(1)(A).
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and acted in good faith. I.R.C. § 6664(c)(1). The taxpayer bears the burden
of proving entitlement to the reasonable cause and good faith defense.
Klamath Strategic Inv. Fund v. United States, 568 F.3d 537, 548 (5th Cir.
2009); accord Brinkley,
808 F.3d at 668. The assessment of whether the
taxpayer has met this burden is “made on a case-by-case basis, taking into
account all pertinent facts and circumstances.”
Treas. Reg. § 1.6664-4(b)(1);
Brinkley,
808 F.3d at 669. “Circumstances that may indicate reasonable
cause and good faith include an honest misunderstanding of fact or law that
is reasonable in light of all of the facts and circumstances, including the
experience, knowledge, and education of the taxpayer.”
Treas. Reg. §
1.6664-4(b)(1). “The most important factor[,]” however, “is the extent of
the taxpayer’s effort to assess his proper liability in light of all the
circumstances.” Klamath,
568 F.3d at 548. The Tax Court’s determinations
regarding the taxpayer’s eligibility for a reasonable cause and good faith
defense are factual findings reviewed for clear error. Sun v. Comm’r,
880 F.3d
173, 181 (5th Cir. 2018).
The Tax Court found that Ray failed to carry his burden of proving his
entitlement to the reasonable cause and good faith defense because (1) Ray’s
reliance on the 1997 stipulated Tax Court decision was unreasonable, as the
stipulated decision “does not state or give rise to an inference that petitioner
was involved in a computer programming business as he claims here”; and
(2) Ray’s argument that he made a mistake of law as to the applicability of
§ 162(a) versus § 212 was meritless because Ray never conceded in the Tax
Court proceedings that “he was not engaged in a trade or business or even
argue[d] in the alternative that he may only be entitled to a section 212
deduction.”
On appeal, Ray again contends that he reasonably relied on the
stipulated Tax Court decision in deducting his legal expenses under § 162(a).
The Commissioner argues that Ray could not have reasonably relied on the
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stipulated decision because he was aware of the circumstances surrounding
its adoption by the Tax Court and that it was the result of a settlement, he
did not present evidence showing that he took any steps to confirm its
applicability to his 2014 taxes, and the loss claimed in the prior Tax Court
proceeding related solely to the trading agreement losses and not to Christina
Ray’s indebtedness.
The Commissioner is correct that the stipulated Tax Court decision
related solely to Ray’s trading agreement losses and not to Christina Ray’s
indebtedness. As discussed, Ray has failed to show that the claims underlying
his first cause of action in Ray I are related to the trading agreement venture.
However, the 1997 stipulated Tax Court decision is related to the
characterization of the trading agreement losses, which implicates the
portion of the accuracy-related penalty that was imposed on the difference in
the amounts Ray would be allowed to deduct for the relevant legal expenses
if they were deductible under § 162(a) rather than § 212. Given the IRS’s
prior position regarding Ray’s trading agreement venture, and considering
the particular facts and circumstances of this case, it was reasonable for Ray
to have relied upon the stipulated decision in assessing whether his legal
expenses could be deducted under § 162(a) as a Schedule C business loss. We
conclude that Ray is entitled to a reasonable cause and good faith defense for
his understatement attributable to deducting his trading agreement legal fees
under § 162(a) rather than § 212. 3
VI.
For the foregoing reasons, we AFFIRM the Tax Court’s decision,
with the exception of the penalty attributable to the difference in the amounts
3
In light of this ruling, we do not reach the issue of whether Ray is entitled to a
substantial authority defense.
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Ray would be allowed to deduct for legal expenses for the trading agreement
losses under § 162(a) rather than § 212. As to this exception, we VACATE
and REMAND for entry of judgment consistent with this opinion.
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James L. Dennis, Circuit Judge, dissenting in part:
I concur in Parts I through IV of the majority opinion. However, I
respectfully dissent from Part V because, in my view, the Tax Court did not
clearly err in finding that Ray was not entitled to the reasonable cause and
good faith defense. The Tax Court’s determinations that Ray lacked
reasonable cause and was not acting in good faith are factual findings subject
to clear error review. Green v. Comm’r, 507 F.3d 857, 871 (5th Cir. 2007).
“Clear error exists when this court is left with the definite and firm
conviction that a mistake has been made.”
Id. at 866. Whether a taxpayer
has proven his or her entitlement to the reasonable cause and good faith
defense is a fact-intensive inquiry that is “made on a case-by-case basis,
taking into account all pertinent facts and circumstances.”
Treas. Reg.
§ 1.6664-4(b)(1). Reviewing the record in light of the applicable law and our
deferential standard of review, I am not “left with the definite and firm
conviction that a mistake has been made.” See Green,
507 F.3d at 866.
Because I would affirm fully the Tax Court’s decision, I dissent from Part V
of the majority opinion.
25
