77 T.C. 608">*608 Respondent determined a $ 9,878 deficiency in petitioners' 1976 income tax. In an amended answer, respondent increased the deficiency to $ 10,392. The sole issue is whether petitioners are entitled to deduct a payment made 1981 U.S. Tax Ct. LEXIS 61">*63 in 77 T.C. 608">*609 settlement of a judgment rendered against petitioner C. A. Ostrom for alleged fraudulent misrepresentations.

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly.

C. A. (petitioner) and Mollie J. Ostrom, ¹ husband and wife, resided in Palm Beach County, Fla., when they filed their petition.

In 1968, petitioner and two others formed Pan American Plumbing, Inc. (the company). Petitioner owned 10 percent of the company's stock and was its sole employee at the time of incorporation. During the entire life of the company, petitioner was its president and general manager. From 1968 through 1971, the company prospered. ² During this time, the company's two other shareholders purchased some ranch property and an airplane and had the bills for these purchases sent to the company. By the end of 1971, as a result of these purchases and other obligations, the company was faced with1981 U.S. Tax Ct. LEXIS 61">*64 a serious cash flow problem. Arrangements were made whereby a new investor, Carl Reagan, made two investments in the company ³ totaling $ 35,000. By virtue of these investments, Reagan acquired 75 percent of the company's stock by the end of 1972, and petitioner increased his ownership to 25 percent of the company.

Petitioner understood that $ 25,000 of the $ 35,000 invested by Reagan would be used to complete certain work in progress which would produce sufficient cash to keep the company in business. The company apparently completed some of the work, but that work failed to produce the expected cash flow. In March 1973, petitioner decided to terminate the business operations of the company. At that time, the company had approximately $ 140,000 to $ 150,0001981 U.S. Tax Ct. LEXIS 61">*65 in uncollectible receivables for completed work. The company also owed $ 52,000 in 77 T.C. 608">*610 back payroll taxes and owed significant amounts to various creditors. The company did not institute either Federal bankruptcy or State insolvency proceedings. Instead, both petitioners assumed and paid (over a period of time) all of the company's outstanding debts and taxes. ⁴

In April 1973, petitioner delivered to Reagan's attorney most ⁵ of the company's financial records. On July 24, 1973, Reagan sued petitioner and one of the other former shareholders for fraudulent misrepresentation of the financial status of the company, on which Reagan allegedly relied to his detriment. In his complaint for damages, Reagan requested compensatory damages of $ 100,000.

1981 U.S. Tax Ct. LEXIS 61">*66 On March 19, 1976, a Palm Beach County jury returned a verdict for Reagan and assessed damages of $ 25,000 against petitioner. On April 12, 1976, the Palm Beach County Circuit Court entered judgment against petitioner in that amount. Sometime in 1976, petitioner satisfied this judgment by assigning to Reagan a second mortgage worth $ 24,700.

On their 1976 joint return, petitioners deducted $ 24,700 as a "Real Estate Bankruptcy Business Bad Debt." In his notice of deficiency, respondent determined a $ 9,878 deficiency in petitioner's tax, based, inter alia, on a determination that petitioner's $ 24,700 business bad debt deduction was really a nonbusiness bad debt. In an amended answer, respondent increased the deficiency to $ 10,392 on the ground that the $ 24,700 was neither a business nor a nonbusiness bad debt.

OPINION

The issue for decision is whether petitioner is entitled to deduct the $ 24,700 paid in satisfaction of the judgment awarded Reagan. Petitioner asserts that he is entitled to a deduction on the ground that the payment represented a business bad debt, a business loss, or a loss in a transaction entered into for profit. Respondent, on the other hand, 77 T.C. 608">*611 1981 U.S. Tax Ct. LEXIS 61">*67 contends that petitioner is not entitled to a deduction under section 166 ⁶ for a bad debt because the payment did not stem from a bad debt, and that petitioner is not entitled to a business loss under section 166 or a loss under section 165 or 212 on a transaction entered into for profit. We hold for petitioner on the ground that he is entitled to a deduction in the amount of $ 24,700 under section 162(a). ⁷

Section 162(a) allows a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in 1981 U.S. Tax Ct. LEXIS 61">*68 carrying on any trade or business. We must determine whether an amount paid in settlement of a civil judgment based on fraud may ever be an ordinary and necessary expense of a trade or business. In a recent decision, this Court stated:

Generally, payments in settlement of a suit arising from allegedly fraudulent activities are deductible as ordinary and necessary business expenses where the activities giving rise to the suit were ordinary business activities. See James E. Caldwell & Co. v. Commissioner, 234 F.2d 660">234 F.2d 660 (6th Cir. 1956), revg. 24 T.C. 597">24 T.C. 597 (1955); Helvering v. Hampton, 79 F.2d 358">79 F.2d 358 (9th Cir. 1935). [Bradford v. Commissioner, 70 T.C. 584">70 T.C. 584, 70 T.C. 584">590 (1978).]

In Helvering v. Hampton, 79 F.2d 358">79 F.2d 358 (9th Cir. 1935), ⁸ affg. a Memorandum Opinion of the Board of Tax Appeals, the taxpayer made a payment in settlement of a judgment based in part on his fraudulent activities in connection with his business of buying, selling, and leasing real properties. The Ninth Circuit held that the taxpayer was entitled to an ordinary and necessary 1981 U.S. Tax Ct. LEXIS 61">*69 business expense because the fraudulent activities arose out of the taxpayer's business activities. Relying in part on language from Solicitor's Memorandum 4078, V-1 C.B. 226 (1926), declared obsolete in Rev. Rul. 69-31, 1969-1 C.B. 307, the Ninth Circuit distinguished civil fraud damages from fines or penalties imposed under State or 77 T.C. 608">*612 Federal law. The court reasoned that civil damages arise from the ordinary and necessary operation of a business, while expenses in connection with criminal actions do not. Accordingly, the taxpayer was allowed a deduction.

In James E. Caldwell & Co. v. Commissioner, 234 F.2d 660">234 F.2d 660 (6th Cir. 1956),1981 U.S. Tax Ct. LEXIS 61">*70 revg. 24 T.C. 597">24 T.C. 597 (1955), the Sixth Circuit, in reversing the majority opinion of this Court and adopting Judge Bruce's dissenting opinion, held that an amount paid in settlement of a judgment rendered against the corporate taxpayer for fraud was deductible as an ordinary and necessary business expense. Judge Bruce reasoned that the taxpayer was in the business of making investments of the type from which the fraudulent activity arose, and thus, the payment was an ordinary expense. Furthermore, the payment was necessary to avoid execution of levy against the taxpayer's property.

Finally, in Rev. Rul. 80-211, 1980-2 C.B. 57, the Internal Revenue Service basically adopted the holdings in 79 F.2d 358">Helvering v. Hampton, supra, and 234 F.2d 660">James E. Caldwell & Co. v. Commissioner, supra. There, the taxpayer was sued for fraudulent acts and contractual violations perpetrated in the ordinary conduct of its business. A judgment rendered against the taxpayer included an amount for punitive damages. The Service held that the amounts paid by the taxpayer as punitive damages were1981 U.S. Tax Ct. LEXIS 61">*71 deductible as ordinary and necessary business expenses under section 162(a). ⁹

1981 U.S. Tax Ct. LEXIS 61">*72 Thus, payment of an amount in settlement of a judgment based upon a taxpayer's fraud arising from the ordinary conduct of the taxpayer's business may be deductible as an 77 T.C. 608">*613 ordinary and necessary business expense. See Spitz v. United States, 432 F. Supp. 148">432 F. Supp. 148 (E.D. Wis. 1977).

We now must decide whether petitioner's payment of $ 24,700 in settlement of the judgment based on his fraudulent misrepresentations arose in the ordinary course of his trade or business. It is well established that, for purposes of section 162, a taxpayer may be in the trade or business of being an employee such as a corporate president or general manager. Primuth v. Commissioner, 54 T.C. 374">54 T.C. 374, 54 T.C. 374">376 (1970). Petitioner was in the trade or business of being the president and general manager of Pan American Plumbing, Inc. (the company). ¹⁰

1981 U.S. Tax Ct. LEXIS 61">*73 Moreover, petitioner's payment was an ordinary and necessary expense. In United States v. Gilmore, 372 U.S. 39">372 U.S. 39 (1963), the Supreme Court ruled that the origin and character of the claim with respect to which an expense was incurred control whether the expense was a business expense. Reagan's claim against petitioner arose directly from petitioner's misrepresentations of the company's financial status made while petitioner was performing his duties as president and general manager of the company. We find that the payment to Reagan is an ordinary and necessary expense of petitioner's business of being an employee. The fact that petitioner made the payment 3 years after the company ceased operations does not bar petitioner's deduction. Dowd v. Commissioner, 68 T.C. 294">68 T.C. 294, 68 T.C. 294">301-302 (1977). The expense relates directly to his activities as an employee, and petitioner, a cash basis taxpayer, is only entitled to a deduction in the year payment is made ( sec. 1.461-1(a)(1), Income Tax Regs.), regardless of the fact that in that year he no longer acted as an employee of the company.

Decision will be entered under Rule 155.