Tax bill includes 'Harvey Weinstein tax'

Celebrities often pay high legal fees. Harvey Weinstein, Kevin Spacey and others are probably paying some now. There may be legal expenses for contract discussions, expenses defending lawsuits, and even some legal settlements. In many cases, celebrities can probably find a way to deduct these expenses on their taxes.

In some cases, that can even be true with legal fees in criminal matters, and with payments of restitution. Many people are surprised to learn that even punitive damages are tax deductible for businesses, no matter how bad the conduct. In general, only fines and penalties paid to the government are not deductible.

In fact, even some of those can turn out to be by arguing they have a remedial rather than punitive purpose. Every time a big corporate wrongdoer pays punitive damages or settles a big regulatory mess, there are calls to change the tax rules. There have been several formal proposals to eliminate the tax deduction for punitive damages, but so far none of them has passed.

That some of these issues are again in the public eye is underscored by the latest tax bills. The House tax bill has passed, and the Senate bill is still being discussed. The Senate bill would include what some are calling a "Harvey Weinstein tax." It isn't a tax exactly, but it would deny tax deductions, which amounts to a tax.

The legal fees and legal settlements in sexual harassment cases often end up as deductible business expenses. The idea in the Senate bill is to deny tax deductions for settlement payments in sexual harassment or abuse cases, if there is a nondisclosure agreement. Notably, this "no deduction" rule would apply to the lawyers' fees, as well as the settlement payments.

In some ways, it is a far bigger deal to deny tax deductions for the attorney fees. Moreover, most legal settlement agreements of any type have some type of confidentiality or nondisclosure provision. So that limitation is not much of a qualifier.

Under current law, employers deduct legal fees and legal settlements relating to their trade or business. Business expenses are famously broad. They must be "ordinary and necessary." However, an expense can be "ordinary" even if it occurs once in a career.

And it is considered "necessary" if it is appropriate or helpful, even if it turns out not to be a good idea. Deductibility is controlled by nexus to a trade or business, or to income producing activity. In the case of celebrities, the connections between income and publicity seem symbiotic.

So, when celebrities pay whopping fees or even legal settlements, they may be deductible too. Legal expenses can be business expenses, or if they are paid or incurred pursuing investment activity, can be investment expenses. Trade or business expenses are worth more than investment expenses.

Notably, you get no deduction for personal legal expenses. That means the legal expenses of a divorce, a dispute over a fight at the local pub, or defending a rape or paternity charge, yield no tax deduction. Yet, what is personal and what is investment or business can be debated.

Both Harvey Weinstein and Kevin Spacey have faced massive economic harms from their conduct. Although those activities may seem to be purely personal, on the job harassment can be viewed in several ways. Virtually any settlement or judgment payment which arises out of a business should be deductible.

But, what "arises out of a business" can be debated. Many harassment cases arguably arise out of personal activity that could be considered outside the course and scope of employment. Thus, the line between deductible and nondeductible in this context can be a thin one.

Legal claims are often made against a company and its employees. If a company's delivery driver has a traffic accident, the company will be sued even if the driver was an independent contractor. The origin of the claim may be a bad driving record, but the basic activity is related to the conduct of business.

The same is true in sexual harassment litigation. If a supervisor harasses another employee, it is almost certain that the conduct is personal. It may well be outside the course and scope of the supervisor's employment, too.

Yet, it arises out of a working relationship, and often involves company property, business trips, and business activities. Under current law, that usually makes the payments tax deductible. Tax deductions can even be available in some criminal cases.

In Kelly v. Commissioner, T.C. Memo. 1999-69, a man deducted legal fees he paid defending a sexual assault charge as a business expense. The Tax Court found that the sexual harassment charges arose out of Kelly's personal activities, not out of any profit seeking activities, so were not deductible. Yet in Clark v. Commissioner, 30 T.C. 1330 (1958), a man succeeded with a similar tax deduction.

There, the taxpayer had been wrongfully accused of assault with intent to rape during the course of his employment. The court found the expenses deductible, because Clark had been working within the course and scope of his employment, and because he had not committed the rape.

Not every expense is deductible. In Cavanaugh v. Commissioner, T.C. Memo. 2012-324, James Cavanaugh was CEO and sole shareholder of Jani-King, a successful janitorial-services franchisor. He vacationed in St. Maarten one Thanksgiving with his girlfriend, Jani-King employee, Claire Robinson. It wasn't a business trip, but they were accompanied by Cavanaugh's bodyguard, and another Jani-King employee.

While on the trip, Robinson suffered fatal cardiac arrest after ingesting a large amount of cocaine. Her mother sued Cavanaugh and Jani-King. Jani-King's board worried that losing the case would trigger a backlash from franchisees, so settled for $2.3 million. Cavanaugh contributed $250,000, which Jani-King reimbursed. Jani-King deducted it all as a business expense.

The IRS challenged the deductions, but the Tax Court agreed with the IRS. The employees were on vacation, not on Jani-King business. And they were far from company property. For Cavanaugh, only the consequences of the suit -- not its origin -- were business-related.