Moore and Feinberg, Circuit Judges, and McLean, District Judge.*fn*
Samuel and Marian Galewitz filed a joint income tax return for the calendar year 1961 in which they took a deduction for legal fees in the amount of $11,568.95 which Samuel Galewitz paid in that year to attorneys who had represented him in successfully defending an action brought against him and others in the Supreme Court, New York County, by his step-mother, Hannah Galewitz. The Commissioner disallowed the deduction on the ground that the fees constituted "expenses paid * * * in defending * * * title to property" within the meaning of Section 1.212-1(k) of the Treasury Regulations on Income Tax (1954 Code), 26 C.F.R. § 1.212-1(k), and hence constituted part of the cost of the property and not a deductible expense.*fn1 Accordingly, the Commissioner notified the taxpayers that determination of their income tax liability disclosed a deficiency in taxes of $7,466.70. The taxpayers thereupon petitioned the Tax Court for redetermination. The Tax Court held that the legal fees were properly deductible under Section 212(2) of the Internal Revenue Code of 1954, 26 U.S.C. § 212(2) as ordinary and necessary expenses paid "for the management, conservation, or maintenance of property held for the production of income."*fn2 Accordingly, the Tax Court decided that there was no deficiency in tax.
Upon the facts disclosed by the record, we conclude that the tax treatment accorded this item by the Commissioner, rather than that adopted by the Tax Court, was correct. We therefore reverse the decision of the Tax Court.
The relevant facts are undisputed. They are embodied in a stipulation entered into by the parties in the Tax Court and in the findings of fact set forth in the opinion of the Supreme Court, New York County, which dismissed Hannah Galewitz' action after trial. They may be summarized as follows.
Jacob Galewitz, Samuel's father, married Hannah on November 30, 1931. It was a second marriage for each of them. Jacob had four children by his first wife, including Samuel and his sister Elsie, now Elsie Galewitz Schreiber. Jacob controlled Clinton Paper Corporation (Clinton). At about the time of his marriage to Hannah, Jacob organized Walter Peek Paper Corporation (Peek) to act as a sales agent for Clinton. The New York court found that Jacob had done this in order to provide income for Hannah, certain of her friends, and her first husband. Apparently the stock of Peek was originally issued to them.
By 1933 Peek was in serious financial difficulty. Its affairs were then liquidated. The New York court found that all of Peek's "outstanding shares were turned in by the stockholders," and that "full control was turned over" to Jacob. Peek ceased to do business and by July 1935 it had no assets. By 1938, however, it had taken a new lease on life as a real estate holding corporation. It has since prospered in that field and now has substantial assets.
On February 25, 1938, Peek issued ten shares of stock, which constituted all the stock which Peek then had or now has outstanding. One share was issued to Jacob, five to Samuel and four to Elsie. The parties stipulated that Samuel and Elsie paid full value for the shares issued to them. Samuel and Elsie were elected directors. Samuel was made chairman. He became active in the operation of the business. The business grew and dividends were paid on the stock.
Jacob died in 1950. His will was admitted to probate in the Surrogate's Court of New York County. It bequeathed to Hannah $2,500 and the income for life from one-third of his estate. Hannah was dissatisfied with the provision made for her. She embarked upon a course of litigation which continued for some years thereafter in the New York courts.
First she attempted to assert a widow's right of election under Section 18 of the New York Decedent Estate Law to take her intestate share of her husband's estate despite his will. The Surrogate, however, held that the will was sufficient to defeat a right of election. His decision was affirmed by the Appellate Division and in turn by the Court of Appeals. Matter of Galewitz' Estate, 3 Misc.2d 197, 148 N.Y.S.2d 823 (1955), affirmed, 3 A.D.2d 736, 163 N.Y.S.2d 937 (1st Dept.1957), affirmed, 5 N.Y.2d 725, 177 N.Y.S.2d 710, 152 N.E.2d 668 (1958).
While this proceeding was making its way up through the courts, Hannah began another action, this time in the Supreme Court, New York County. She eventually lost it. This is the action which gave rise to the legal fees with which we are concerned here.
In that action Hannah named as defendants Peek, the executors of Jacob's estate, and Samuel and Elsie individually. She based her claim upon the principle laid down in Newman v. Dore, 275 N.Y. 371, 9 N.E.2d 966, 112 A.L.R. 643 (1937). She claimed that the nine shares of Peek stock always belonged to Jacob, that the purported issuance of that stock to Samuel and Elsie was a transfer in form only, not in substance, and was "illusory," and that consequently, the stock formed part of Jacob's estate after his death and had to be taken into account in computing the one-third of his estate from which, under Jacob's will, Hannah was to enjoy the income. Her complaint alleged that Samuel and Elsie had "improperly, falsely and fraudulently claimed" to be the owners of the nine shares, and that the executors had "acquiesced" in their claims. She asked for a judgment setting aside the alleged transfer of the stock to Samuel and Elsie as void.
Samuel and Elsie attempted to secure a dismissal of the action without a trial, but their attempt was unsuccessful. The court held that the complaint stated a cause of action and that the statute of limitations was not a bar. Defendants' motion for summary judgment was denied. Galewitz v. Walter Peek Paper Corporation, 145 N.Y.S.2d 402 (N.Y. Co. 1955), affirmed, 3 A.D.2d 741, 161 N.Y.S.2d 566 (1st Dept.1957), leave to appeal denied, 3 A.D.2d 897, 163 N.Y.S.2d 363 (1957).
The action then went to trial on the merits. The trial court held that the issuance of the stock to Samuel and Elsie was not "illusory." In the course of its opinion, the court made some uncomplimentary remarks about Hannah, characterizing her testimony as "utterly incredible," and referring to her claim as "wholly without credible support in the record." The judgment for defendants entered upon the trial court's decision was affirmed on appeal. Galewitz v. Walter Peek ...