itemized deduction.1 Petitioner also contests respondent's determination that petitioner did not receive the punitive damages on account of a personal injury. We recently held that the punitive damages received by Mr. Whitley, petitioner's coplaintiff in the Academy lawsuit, were includable in Mr. Whitley's gross income. See Whitley v. Commissioner, T.C. Memo. 1999–124. We relied mainly on O'Gilvie v. United States, 519 U.S. 79 (1996), Commissioner v. Schleier, 515 U.S. 323 (1995), and United States v. Burke, 504 U.S. 229 (1992), concluding that punitive damages received under South Carolina law are not excludable from gross income under section 104(a)(2). We apply the reasoning in Whitley and hold the same here.

As to the primary issue, section 162(a) governs the deductibility of litigation costs as a business expense. Section 162(a) allows an individual to deduct all of the ordinary and necessary expenses of carrying on his or her trade or business. Section 212 governs the deductibility of litigation costs as an itemized deduction when the costs are incurred as a nonbusiness profit-seeking expense. Section 212 allows an individual to deduct all of the ordinary and necessary expenses paid or incurred in: (1) Producing income, (2) managing, conserving, or maintaining property held for the production of income, or (3) determining, collecting, or refunding a tax. Sections 162(a) and 212 are considered in pari materia, except for the fact that the income-producing activity of the former section is a trade or business whereas the income-producing activity of the latter section is a pursuit of investing or other profitmaking that lacks the regularity and continuity of a business. See Woodward v. Commissioner, 397 U.S. 572, 575 n.3 (1970); United States v. Gilmore, 372 U.S. 39, 44–45 (1963); Bingham's Trust v. Commissioner, 325 U.S. 365, 374-375 (1945).

A deduction of litigation costs under section 162(a) may be more desirable to an individual than is a deduction under section 212. The primary advantage to a deduction under section 162(a), vis-a-vis a deduction under section 212, rests on each deduction's effect on gross income and adjusted gross income. A deduction under section 162(a) is subtracted in full

1 Respondent concedes that the litigation costs attributable to the actual damages are deductible on Schedule C as a business expense.

from gross income to arrive at adjusted gross income. A deduction under section 212 is subtracted from adjusted gross income to arrive at taxable income and is subject to certain floor limitations in section 67(a). The benefit from a deduction of litigation costs under section 212 may also be limited by application of the alternative minimum tax. See sec. 56(b); see also Benci-Woodward v. Commissioner, T.C. Memo. 1998–395.

Whether an ordinary and necessary litigation expense is deductible under section 162(a) or section 212 depends on the origin and character of the claim for which the expense was incurred and whether the claim bears a sufficient nexus to the taxpayer's business. See Woodward v. Commissioner, supra; United States v. Gilmore, supra at 44-45; see also Peckham v. Commissioner, 327 F.2d 855, 856 (4th Cir. 1964), affg. 40 T.C. 315 (1963). Ordinary and necessary litigation costs are generally deductible under section 162(a) when the matter giving rise to the costs arises from, or is proximately related to, a business activity. See Woodward v. Commissioner, supra; Kornhauser v. United States, 276 U.S. 145, 153 (1928). Litigation costs must be "attributable to a trade or business carried on by the taxpayer" in order to be deductible as a business expense. Sec. 62(a)(1).

The ascertainment of a claim's origin and character is a factual determination that must be made on the basis of the facts and circumstances of the litigation. See United States v. Gilmore, supra at 47-49. The most important factor to consider is the circumstances out of which the litigation arose. See Boagni v. Commissioner, 59 T.C. 708 (1973). In passing on this factor, the fact finder must take into account, among other things, the allegations set forth in the complaint, the issues which arise from the pleadings, the litigation's background, nature, and purpose, and the facts surrounding the controversy. See id. at 713.

Petitioner's legal costs, which the parties agree are “ordinary" and "necessary" expenses, bear the required nexus to his sole-proprietor insurance business to meet the requirements for deductibility under section 162(a). As a matter of fact, petitioner's lawsuit against Academy arose entirely from his insurance business. Each cause of action petitioner alleged in the lawsuit was spawned entirely from the fact that, after Academy fired him, it failed to honor the terms of

their working agreement by not paying him the commissions to which he was entitled under their agreement. But for the agreement, and the fact that Academy breached the agreement by unilaterally terminating its obligation to pay commissions to petitioner, the instant lawsuit, as it was framed, would never have arisen, and petitioner would never have incurred (or paid) any of the legal costs.

Respondent devotes much time in his opening brief to his proffered method of apportioning petitioner's legal costs between his business and nonbusiness activities, spending little time arguing that apportionment of the legal costs is appropriate. As we understand respondent's argument on apportionment, petitioner must apportion his legal costs because, respondent asserts, petitioner has not proven that he incurred 100 percent of the costs in his insurance business. We disagree. After reviewing the record, which includes 19 stipulations and 9 exhibits, we are persuaded by more than a preponderance of the evidence that all of petitioner's legal costs were attributable to his insurance business and, more importantly, that all of the costs were connected to claims which arose in that business. Petitioner's complaint, for example, attests to the fact that each of his claims, and not simply his claim of conversion, arose from the soleproprietor insurance business.

We consider it both ordinary and necessary from a business standpoint for petitioner to have filed the lawsuit against Academy and for him to have sought any and all damages to which he was entitled on account of Academy's breach of contract and related conversion. The mere fact that petitioner sought and was paid punitive damages to punish Academy for its "extraordinary misconduct, and to serve as a warning [to it and to other persons] not to engage in such conduct in the future" does not change the fact that petitioner's legal costs were all attributable to his business activity. Pursuant to South Carolina law, see Oxford Fin. Cos. v. Burgess, 402 S.E.2d 480, 482 (S.C. 1991); Rhode v. Ray Waits Motors, Inc., 74 S.E.2d 823, 825 (S.C. 1953); see also Sherrill White Constr., Inc. v. South Carolina Natl. Bank, 713 F.2d 1047, 1051–1052 (4th Cir. 1983), and the judge's instructions, the jury in the Academy lawsuit awarded petitioner both

actual and punitive damages on his conversion claim.2 The fact that petitioner received two different types of damages on his single claim of conversion does not mean, as respondent would have us hold, that the claim is bifurcated into two claims solely for purposes of applying the Federal income tax laws. Contrary to respondent's position in this case, the various types of damages which petitioner received on his conversion claim do not dictate whether his legal costs must be apportioned between his business and nonbusiness activities. An allocation of litigation costs, if and when applicable, rests on the origin of the claims relating to those expenses. See Woodward v. Commissioner, 397 U.S. at 577-578; United States v. Gilmore, 372 U.S. at 44-45; see also Peckham v. Commissioner, 327 F.2d at 856.

We recognize that, when appropriate, litigation costs must be apportioned between business and personal claims, and that business litigation costs are nondeductible to the extent that they constitute capital expenditures. See, e.g., Kurkjian v. Commissioner, 65 T.C. 862 (1976) (deduction disallowed for portion of attorney's fees attributable to personal matters); Buddy Schoellkopf Prods., Inc. v. Commissioner, 65 T.C. 640, 646-647 (1975) (deduction disallowed for portion of attorney's fees attributable to acquisition of intangible assets); Merians v. Commissioner, 60 T.C. 187 (1973) (deduction disallowed for portion of attorney's fees attributable to personal matters); see also Boagni v. Commissioner, supra (recognizing that litigation costs can be characterized as both deductible and nondeductible when the litigation is rooted in situations giving rise to both types of expenditures). This principle of allocation is inapposite to our decision herein for two main reasons. First, petitioner's legal costs were all attributable to claims which originated in his business activity, the primary claim being that of conversion. Second, in contrast to cases where each of the underlying claims could have resulted in an award of damages regardless of an award of damages on

2 We recognize that South Carolina law does not provide that punitive damages are awarded in every case in which a tortfeasor is held liable for an act of conversion. See Sherrill White Constr., Inc. v. South Carolina Natl. Bank, 713 F.2d 1047, 1051–1052 (4th Cir. 1983) ("in order to recover punitive damages [under South Carolina law] there must be more than mere conversion. There must be malice, ill will, a conscious indifference to the rights of others, or a reckless disregard thereof" (citations and quotation marks omitted)). The fact that the converter's degree of culpability enters into an award of punitive damages under South Carolina law, however, does not change the fact that the origin and character of a claim for punitive damage under that law is an act of conversion, which, in this case, stems from petitioner's business activity.

any other claim, petitioner's award of punitive damages could not have been made in isolation. As South Carolina's highest court has stated: "Punitive damages may be awarded [under South Carolina law] only upon a finding of actual damages." Dowling v. Home Buyers Warranty Corp., 428 S.E.2d 709, 711 (S.C. 1993); see also Gamble v. Stevenson, 406 S.E.2d 350 (S.C. 1991).

We hold that petitioner may deduct the legal costs under section 162(a).3 In reaching our holdings herein, we have considered all arguments by the parties, and, to the extent not addressed above, find them to be meritless or irrelevant. To reflect the foregoing,

Decision will be entered under Rule 155.

COMMON CAUSE, PETITIONER v. COMMISSIONER OF
INTERNAL REVENUE, RESPONDENT 1

Docket No. 13921-97.

Filed June 22, 1999.

P, an organization exempt from Federal income tax, receives payments from the rental of its mailing list. In each of P's list rental transactions, the mailer's rental payment compensates P for the mailer's use of P's list and, also, compensates a list broker, a list manager, and a computer house for their participation in the transaction. R determined that P's mailing list rental activities constitute an unrelated trade or business and that the list broker, the list manager, and the computer house are P's agents for the purpose of carrying on that business. R further determined that P's income from the rental of its mailing list is unrelated business taxable income pursuant to sec. 512(a)(1), I.R.C. P contends that it is not engaged in such a business and that, in any event, such payments are royalties that are excluded from unrelated business taxable income pursuant to sec. 512(b)(2), I.R.C. Held, excepting the portion of the list rental payment that compensates the list broker, or the list manager in its capacity as list broker, the mailer's list rental payment in each list rental transaction is a royalty that is excluded from unrelated business taxable income pursuant to sec. 512(b)(2), I.R.C. Held, further, the list brokerage activities are not royalty-related

3 The parties agree that our holding on this issue means that the punitive damage award is includable in petitioner's self-employment income and that it is subject to self-employment tax. See secs. 1401 and 1402.

1 This case was consolidated, for trial purposes only, with Planned Parenthood Fedn. of Am., Inc. v. Commissioner, T.C. Memo. 1999-206, in which an opinion is also being issued today.