Back to Basics
As we mark the “end” of the tax season (it never really ends), it may be helpful to remind folks that not every expense incurred by a business may be claimed as a deduction in determining the taxable income of the business.
While that may seem obvious, tax practitioners are forever encountering closely-held businesses that appear to be (willfully?) ignorant of the rule. In many cases, the non-business expense is reported on the “other deductions” line of the relevant tax return, and the required attached statement (intended to identify the specific expense) describes the expense simply as “miscellaneous.”
By claiming the expense as a business deduction, the taxpayer is, of course, reducing the taxable income of the business and, perhaps, of the owners. In those situations, the disallowance of the deduction by the IRS will create a tax deficiency, and may also result in the imposition of penalties.
What is the expenditure, really?
In cases of more accurate reporting, the business may report the expenditures as distributions made to one or more of its owners, or as compensation paid to such persons. In those situations, the business is not claiming that the expenditures, in and of themselves, are ordinary and necessary business expenses. Rather, it is recognizing that they are of a different nature, that they are being paid on behalf of the owners and, so, that they represent something else as to the owners – a constructive distribution or payment—that may still be deductible (e.g., reasonable compensation).
Unfortunately, the latter situation occurs relatively infrequently. Moreover, even that treatment may not be available if the business cannot substantiate the actual payment.
The Corporation’s Business
In 1992, Taxpayer started a company called SLS, which elected S corporation status. Taxpayer operated this business out of his home. An outside contractor, SLS offered services to various clients chiefly by conducting training seminars at the client’s place of business. SLS was engaged by a principal client through 2003, but that client stopped using SLS in 2004. SLS had one or two other clients, but their work also began to dry up; by 2006, the SLS business had diminished to the point where it involved little more than ad hoc consulting that Taxpayer personally performed. SLS had no other employees.
The IRS Asks for Proof
After SLS filed its 2007 return, the IRS requested additional information with respect to certain claimed deductions. Taxpayer provided the IRS with documentation for a portion of the allegedly SLS business-related expenses incurred in 2007.
The IRS allowed some of the deductions for the expenses substantiated, chiefly those for office supplies and computer-related items.
The remaining balance of the substantiated expenses, however, were attributable to (among other things) a camcorder, a treadmill, a wireless router, music CDs, luggage, museum membership fees, a cell phone charger kit, candles, and a Microsoft Office software package. The IRS disallowed the deduction for these expenses on the ground that they were not “ordinary and necessary” expenses of SLS’ trade or business. The IRS accordingly reduced the allowable Schedule E loss claimed by the Taxpayer.
The Code, of course, allows the deduction of “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” A necessary expense is one that is “appropriate and helpful” to the taxpayer’s business, whereas an ordinary expense is one that is common or frequent in the type of business in which the taxpayer is engaged. Personal, living, and family expenses are generally not deductible.
The Taxpayer Fails
The Tax Court reminds us, first, that “deductions are a matter of legislative grace, and the taxpayer bears the burden of proving that claimed expenses are ordinary and necessary.” The Court reminds us further that “[the] taxpayer also bears the burden of substantiating claimed deductions by keeping and producing records sufficient to enable the IRS to determine the correct tax liability. The failure to keep and present such records counts heavily against a taxpayer’s attempted proof.”
According to the Court, the IRS did not dispute that SLS was engaged in a “trade or business” during 2007. But, the Court noted, the scale of its business had declined considerably since 2004 and was extremely limited during 2007 and the immediately preceding years. In fact, its gross receipts during 2007 were minimal and were derived from ad hoc consulting that Taxpayer personally performed. According to the Court, an assessment of what expenses were “ordinary” and “necessary” for this business had to take into account “its relatively moribund state.”
Many of the disallowed expense deductions were for obviously personal items. Taxpayer did not carry its burden of proving that these represented “ordinary and necessary” expenses of the SLS business as opposed to “personal, living, or family expenses” that are not deductible under the Code.
In sum, the Court concluded that the IRS had properly disallowed the Taxpayer’s claimed deductions for lack of substantiation or as “personal, living, or family expenses.”
We have all advised business clients that they should not pay the personal expenses of their owners from the accounts of the business (e.g., to avoid “piercing the veil” arguments). We have told them that they should not deduct such expenditures against their business income for tax purposes unless they are willing to treat the expenditures as compensation or as distributions.
Notwithstanding our directives, many clients have chosen to view them as well-intentioned “guidance,” rather than as “commandments.” They are basically willing to accept the audit risk.
Given this predisposition on the part of so many clients, it is imperative that each client understand the impact of its decision on the outcome of any future audit. Not only will the taxpayer lose the benefit of the deduction at issue, it will also give the auditor an unfavorable impression of both themselves – as someone who may not be trusted – and of the tax professional defending them (oftentimes, the return preparer). This, in turn, will make it more difficult for the taxpayer to successfully carry defensible positions that are not necessarily on all-fours with the general position of the IRS. It will also make the imposition of penalties more likely.
The bottom-line: the foregoing consequences must be discussed with clients in detail before the client makes the decision to “gamble.”