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for taxable year 1990 by $34,226, petitioner's distributive share
of the S Corporation's ordinary income.
OPINION
The first issue to be decided is whether petitioner's wholly
owned S Corporation was entitled to deduct on its 1988 tax return
the payment of $193,500 that it made to Color Q during 1988 in
settlement of Color Q's embezzlement suit against the S
Corporation (the Color Q payment).1 Petitioners contend that the
S Corporation was entitled to deduct the Color Q payment on its
1988 return as an ordinary and necessary business expense
pursuant to section 162. Respondent contends that, because the S
Corporation never included Mr. Jeffcott's embezzlement proceeds
in its income, the S Corporation is not entitled to a deduction.
Respondent relies on a line of cases holding that no deduction
may be taken for an expense that is associated with an income
item unless that income has been reported in the taxpayer's gross
income for the current year or some previous year. See, e.g.,
United States v. Skelly Oil Co., 394 U.S. 678 (1969).
1 The deduction of the Color Q payment resulted in a loss
reported by the S Corporation for 1988. Petitioners reported the
loss on their 1988 return as petitioner's distributive share of
the S Corporation's loss. As a result of their deduction of that
loss, petitioners reported on their 1988 return a net operating
loss which subsequently was carried forward to petitioners' 1990
return. It is the disallowance of the loss carryforward on
petitioners' 1990 tax return that requires an inquiry into the S
Corporation's 1988 tax return and the deductibility of the Color
Q payment by the S Corporation.
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