Rev. Rul. 78-210

Advice has been requested whether amounts paid by a professional medical association for malpractice claims or judgments, and related legal fees and court costs, under the circumstances described below, are deductible as ordinary and necessary business expenses pursuant to section 162 of the Internal Revenue Code of 1954.

X is a professional medical association taxable as a corporation that uses the cash receipts and disbursements method of accounting. X is engaged in the business of providing medical services to its patients. X performs its activities through its employees, some of whom are medical doctors. Under local law X is jointly and severally liable for negligent acts of its employees committed within the scope of their employment. Under the employment contract between X and its doctor-employees, X waived its right of contribution and agreed to indemnify, save, and hold harmless the employees from any claim of negligence, whether valid or not, arising out of the employees' duties as employees of X. X further agreed to furnish, at no cost to the employees, the cost of defense of any claims, including court costs and attorney's fees. X is self-insured with respect to these claims.

Section 162 of the Code provides that there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.

Section 1.162-1(a) of the Income Tax Regulations provides, in part, that business expenses deductible from gross income include the ordinary and necessary expenditures directly connected with or pertaining to the taxpayer's trade or business.

In Kornhauser v. United States, 276 U.S. 145, (T.D. 4222) VII-2 C.B. 267 (1928), the Supreme Court of the United States concluded that when a suit or action against a taxpayer is directly connected with or proximately resulted from the taxpayer's business, the expense incurred for attorney's fees is a deductible business expense.

Losses caused by one's professional negligence have been allowed as ordinary and necessary business deductions. See Cochrane v. Commissioner, 23 B.T.A. 202 (1931), acq. X-2 C.B. 14 (1931). In Mulgrew Blacktop, Inc. v. United States, 311 F. Supp. 570 (S. D. Iowa 1969), a corporation was entitled to deduct, as a business expense, the amount of a judgment it paid which arose from a suit brought by a person injured by an automobile owned by the corporation and driven by an employee in the scope of his employment.

Rev. Rul. 69-491, 1962-2 C.B. 22, holds that premiums paid by a bank on an insurance policy that indemnifies the officers and directors of the bank for their expenses arising from wrongful acts committed or alleged to have been committed in their capacity as officers and directors, are deductible business expenses under section 162 of the Code and not includible in income of the officers anad directors. In so holding, the Revenue Ruling states that the premiums paid are paid by the taxpayer to protect its business by limiting its liability for wrongful acts of its officers and directors and to assure the taxpayer that its officers and directors can make necessary corporate decisions without fear of legal entanglement. Thus, the costs are incurred for the benefit of the taxpayer rather than for the benefit of the officers.

In the instant situation, X is engaged in the business of providing medical services. In carrying on such a business, it is normal to expect that malpractice claims and judgments, along with legal expenses and court costs will be incurred by X. Furthermore, any malpractice claims or judgments that X is required to pay arise directly out of and are proximately related to the carrying on of the business of X. See Kornhauser v. United States.

Accordingly, amounts paid by X for malpractice claims or judgments, and related legal fees and court costs, under the circumstances described above are deductible as ordinary and necessary business expenses under section 162 of the Code.