Rosso v. Commissioner

The $28,000 Deduction: When Legal Fees Become Personal Losses

Joanne G. Rosso found herself in Tax Court contesting a $5,388 deficiency, the result of deducting $28,485 in legal expenses on her 2012 tax return. The core issue: whether these legal fees were legitimate deductions for expenses incurred for the "production or collection of income" under Section 212, or non-deductible personal expenses. Ultimately, Judge Foley sided with the IRS, disallowing the deduction. Thus, Ms. Rosso was not allowed to deduct her legal expenses. At the heart of the dispute lay the distinction between expenses related to producing income and those that are inherently personal, a distinction that hinges on the nature of the lawsuits Ms. Rosso filed against her own lawyers.

A Web of Litigation: The Malpractice Saga

The legal fees in question stemmed from a protracted series of lawsuits initiated by Ms. Rosso against her former legal representatives. In 2012, the tax year under scrutiny, Ms. Rosso was actively engaged in multiple legal battles arising from an earlier real estate partition suit. She had initially hired attorneys Diane Deckard and Fenn Horton III to represent her in the partition suit against Robert Bruce Pittman. Dissatisfied with their services, Ms. Rosso then retained J. Byron Fleck to pursue a malpractice claim against Mr. Horton.

On July 1, 2008, Ms. Rosso filed a complaint against Mr. Horton in California, alleging breach of contract. After a trial, the court entered a final judgment in favor of Mr. Horton on April 27, 2010. Undeterred, Ms. Rosso appealed this decision to the California Court of Appeals for the Sixth District on June 8, 2010, continuing to argue professional negligence, breach of contract, and breach of fiduciary duty. The appellate court affirmed the lower court's ruling on January 13, 2012. Ms. Rosso then filed a petition for rehearing on January 30, 2012, which was denied, and subsequently appealed to the California Supreme Court on February 22, 2012; that court denied her appeal on March 28, 2012.

Meanwhile, Ms. Rosso also pursued legal action against Ms. Deckard, filing suit on November 12, 2010, alleging professional negligence and breach of contract. This case was ordered to arbitration on June 5, 2012, with the arbitrator ruling in favor of Ms. Deckard on October 9, 2012.

Simultaneously, Ms. Rosso's relationship with Mr. Fleck, the attorney who had represented her in the suit against Mr. Horton, deteriorated. On October 8, 2010, she filed a complaint against him for breach of contract. A jury trial resulted in a verdict for Mr. Fleck on December 3, 2012. Ms. Rosso's motion for a new trial, filed on December 19, 2012, was denied.

The Origin of the Claim: Why Personal Torts Aren't Deductible

Following the denial of her motion for a new trial in the breach of contract suit against Mr. Fleck, Ms. Rosso attempted to deduct $28,485 in legal costs on Schedule A of her tax return. The IRS disallowed this deduction, first, because Ms. Rosso failed to adequately substantiate $2,194 of those expenses. Internal Revenue Code Section 6001 states that taxpayers must keep records sufficient to establish the amount of gross income, deductions, credits, or other matters required to be shown by such person in any return of such tax. Treasury Regulations Section 1.6001-1(a) further specifies that any person required to file a return of income shall keep such permanent books of account or records, including inventories, as are sufficient to establish the amount of gross income and the deductions, credits, or other matters required to be shown by such person in any return of such tax or information.

More importantly, the IRS argued that the remaining $26,291 in litigation expenses stemmed from a personal matter and were therefore not deductible. The Tax Court agreed, citing Sections 212(1) and 262(a) of the Internal Revenue Code. Section 212(1) allows individuals to deduct expenses incurred for the production or collection of income. Even if § 212(1) were available, Section 262(a) generally disallows deductions for "personal, living, or family expenses."

The court then applied the "origin of the claim" test established in United States v. Gilmore, 372 U.S. 39 (1963). In Gilmore, the Supreme Court determined that the deductibility of legal expenses hinges on the origin and character of the claim, not its potential consequences. The question is, "Did the expenses originate from income-producing activity, or a personal matter?". In Ms. Rosso's case, the lawsuit against her former attorney, Mr. Fleck, arose from a dispute over his representation of her in a prior, underlying personal injury lawsuit against Mr. Horton. Because the malpractice claim stemmed from representation in a personal injury case, the legal fees incurred in suing Mr. Fleck were deemed personal expenses under Section 262, regardless of Ms. Rosso's intent. The Tax Court thus sustained the IRS's disallowance of the deduction.

This case highlights the critical importance of establishing a direct connection between legal expenses and income-producing activities. Taxpayers attempting to deduct legal fees must demonstrate that the origin of the claim lies in a business or investment pursuit, not a personal matter. Given the limitations on deducting personal legal expenses, careful consideration and substantiation are crucial when claiming such deductions.