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Petitioner paid $300,000 to his lawyers upon the settlement
of claims against PepsiCo and increased the basis of his PMI
stock. Again, respondent, in her notice of deficiency, allowed
petitioner these fees as a miscellaneous itemized deduction. For
the reasons set out below, we hold that $219,000 of these fees is
a proper addition to the basis of petitioner's stock, $54,000 of
the fees is deductible as a miscellaneous itemized deduction, and
$27,000 of the fees is nondeductible. Section 265 precludes a
deduction for legal expenses attributable to a class of income
that is exempt from taxation. Section 1.265-1(c), Income Tax
Regs., provides as follows:
Expenses and amounts otherwise allowable which are
directly allocable to any class or classes of exempt
income shall be allocated thereto; and expenses and
amounts directly allocable to any class or classes of
nonexempt income shall be allocated thereto. If an
expense or amount otherwise allowable is indirectly
allocable to both a class of nonexempt income and a
class of exempt income, a reasonable proportion thereof
determined in the light of all the facts and circum-
stances in each case shall be allocated to each.
Ordinarily, we allocate the legal expenses in the same
proportion as the settlement payment. See Stocks v. Commis-
sioner, supra at 18; Metzger v. Commissioner, 88 T.C. 834, 860
(1987), affd. 845 F.2d 1013 (3d Cir. 1988); Church v. Commis-
sioner, supra at 1110-1111. But see Eisler v. Commissioner,
supra at 642. Based on the evidence, a proportionate allocation
is appropriate in this case. We have held that 73 percent of the
settlement payment was paid for petitioner's stock, 18 percent
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