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Courts Cast Cold Eyes on Questionable Business Deductions

(RIVERWOODS, ILL., January 2005) – Legitimate business or funny business? That’s the question the Tax Court has to decide dozens of times a year when the IRS contends that a taxpayer is using business deductions simply to reduce their ordinary income, according to CCH INCORPORATED (CCH), a leading provider of tax and accounting information, software and services (tax.cchgroup.com).

Amid the hundreds of cases reported by CCH last year for professional subscribers, these stand out for their creative interpretations of the tax laws.

Double-dipping Deductions

Chico, Calif., woman’s creative math drew the IRS to question her business deductions and ultimately led to a judgment against her in a small-claims Tax Court case.

The woman was employed but had entered into a sideline business distributing herbal-based products. She ended up with little to show for her efforts except deductions – but she showed them with a vengeance.

Over two years, she claimed "advertising" deductions of about $10,000. Some of this was accounted for by samples she gave away. That left about $7,500 of "advertising expenses" that were actually products that she used personally. What’s more, the amounts she deducted as advertising expenses were based upon the retail value of the items, not on the amount she had actually paid for the products as a distributor.

She also reported "costs of goods sold" of about $12,000 for the two years. But in figuring this, she entered the total amounts she paid for the products for each year, failing to subtract the cost of items "withdrawn for personal use," which made up the vast bulk of the amount deducted. Thus, she inflated the deduction for "cost of good sold," much of which duplicated the illegitimate deduction for "advertising expense."

Ingenious math, but the Court declined to go along with what it characterized as "the practical equivalent of double deduction."

TCS 2004-69, L. Blake, Tax Court: Summary Opinion

A Deductible Lifestyle

A couple in St. Charles, Ill., held jobs that brought them combined wages of over $96,000 in 1999 and nearly $99,000 in 2000, but their part-time business – a distributorship – offset their earnings by over $17,000 and $23,000 in those two years. The IRS denied the deductions.

In their 2004 Tax Court trial, it became clear that actually selling merchandise was only a small part of their business plan. Like the California herbal products distributor, they were their own best customers, with their own purchases accounting for about 75 percent of their total sales. As the wife told the judge: "I’m not going to …make Ms. Wal-Mart wealthy when I can buy it from myself. It’s my store. I wouldn't buy it from anywhere else."

Their major emphasis was on recruiting "downline" distributors and receiving an "override" on those distributors’ sales. But was the plan at all realistic, and did they have an "actual and honest" objective of making a profit? The IRS said no, and the Tax Court agreed. The Court noted that the couple didn’t seek independent advice before they started in the distributorship to figure out whether their business could succeed, and they failed to look for independent advice later on to turn around their years of losses.

They did not write a business plan and they never established a budget. Although they kept receipts and detailed records, the Court said this was "more for substantiation purposes than as a tool for analyzing and improving their business."

Over the four years of business records reviewed by the Court, they had never made a profit and racked up total losses of over $67,000. Many of their deductions were for travel expenses, including the purchase of a used Cadillac that they drove to sales conventions – often held on holidays such as New Year and the Fourth of July, the Court noted.

Although the couple claimed that on many of their trips they were prospecting for new downline distributors, the Court saw little that backed up their claims and was especially skeptical of "business trips" to the town where their daughter was enrolled in college and to Chattanooga, Tenn., on Thanksgiving – the city where the husband’s parents lived.

Bottom line? The Court concluded that although they may initially have had the "subjective intent" to make a profit, the couple ended up using their business as a way to lead "a deductible lifestyle." Their business deductions were denied.

TCS 2004-103, R.B. Ollett, Tax Court Summary Opinion

A Pyramid Without a Foundation

As a rule of thumb, business opportunities that sound too good to be true almost always are, but that did not stop a Gardena, Calif. service technician who took advantage of write-offs for participation in a pyramid sales scheme known as "The Tax People." With business deductions including advertising expenses, depreciation, repair services, charitable gifts, meals and even greens’ fees, he managed to knock more than $64,000 off his income on his 2000 tax return.

He did not fare so well when some real tax people – the kind with government ID cards – came calling. He ended up conceding that his pyramid had a shaky foundation at best and that the IRS was correct in denying all his business deductions.

He asked the Tax Court to spare him from a 20-percent accuracy-related penalty, though, on the ground that while the deductions ended up being disallowed, he still had a reasonable basis for taking them on his return.

But he had a great deal of difficulty explaining how the various deductions were part of any business activity. The Court noted that the man "did not know of any advertising expenses, that he had ‘absolutely no idea’ what the $24,944 reported as depreciation related to, that he did not know what the $8,707 in repair service expenses related to, and that he did not make any gifts to charities other than those listed on other parts of his tax return."

He’d put down the deductions for meals and greens fees on the advice of his tax preparer, but the Court questioned whether she was the best source for advice in this case. It was she, in fact, who had recruited him into "The Tax People" scheme, and then advised him that she was under investigation and that he should not recruit any additional participants until she’d been cleared. She did not appear at his trial to testify on his behalf.

In the end, the Court complimented him for his candor, but for little else. He knew that at least some of the deductions "were too good to be true," and he failed to investigate whether others were appropriate after he learned his tax preparer was under investigation. On top of the extra taxes owed for the deductions that were disallowed, the Court imposed the accuracy-related penalty.

TCM, Dec. 55,535(M), P.R. Peete

There’s No Business Like Show Business

A professor of literature at Wayne State University in Detroit moved a Tax Court judge to creative heights in a case that centered on business deductions connected with writing plays. Was his playwriting activity a business at all? The IRS had its doubts. And even if the professor did have a genuine profit motive behind his literary venture, were the deductions he claimed fact or fiction?

In a break with the usual Tax Court style, Judge Mark V. Holmes answered the questions involved in an opinion with headings titled Prologue, Act I, Act II and Epilogue. The copious footnotes contained more citations to literary works – from the Epic of Gilgamesh to The Producers – than to the Internal Revenue Code.

The professor had not made a profit through playwriting over the course of several years, while claiming substantial deductions. Immediate profitability is not a requirement for a legitimate business deduction, however. Some businesses – like oil-well wildcatting and playwriting – may prove profitable only after years of losses.

But the judge noted that the professor had also made "businesslike" efforts to market his plays. One of them won a prize that led to a production at Humboldt State University, a $1,000 royalty and a two-week residency, including travel expenses. In addition, the professor’s creative endeavors had paid off in the "here and now" in the form of sabbaticals and research grants directly related to his playwriting.

But granting that entrepreneurs, "even playwrights," were entitled to legitimate deductions, Judge Holmes then turned to the actual items claimed on the return and concluded that the professor went overboard, succumbing to "deduction fever."

For example, at his trial, the professor produced a mileage log that showed he made trips to libraries for research every Tuesday and Thursday, practically without fail. The judge found that this pattern "strongly suggests that petitioner merely ascribed mileage deductions to his nonteaching days, without regard to actual events." In fact, the professor claimed a mileage deduction for July 4th and Memorial Day, "days when many libraries are closed and most people do not work," the judge added. Furthermore, the professor had testified that he took part in two intense rehearsal periods during the year, when he said he put in seven-day weeks of 14 hours a day. But his travel log showed no corresponding breaks in trips to the libraries.

On other items, the professor engaged in a rather creative interpretation of the rules for allowable deductions. For example, he said that every time he listened to a CD or watched a movie it was part of his playwriting business, not recreation.

"This suggests a less than candid assessment of his business expenses," the judge observed.

Judge Holmes also noted that even if the professor was believable, these deductions would still be precluded by regulations which require that the taxpayer must have more than a "general expectation" of deriving income for an entertainment expense to be deductible. For example, if he was having a specific problem with his play he might be able to justify going to another play that he had selected because he thought it contained the solution to his difficulty. "Merely broadening one’s horizons is not enough," the judge ruled.

In the end, Judge Holmes allowed a fraction of the deductions claimed, relying on a rule named after another playwright, George M. Cohan, to estimate what portions of certain deductions were legitimate.

Finally, in his Epilogue, the judge provided his own bit of literature, alluding to the Tax Court rule regarding computation of deficiencies with the lines:

Dramatists used to finish with some rhymes,
Mostly iambs with a pinch of dactyly,
But in these more prosaic times
Works usually end more matter-of-factily.
In our Court, though, the oldest ways seem somehow to survive -
A decision will be entered under Rule 155.

TCS 2004-94, N.J. Calarco, Tax Court Summary Opinion

About CCH INCORPORATED

CCH INCORPORATED (tax.cchgroup.com), based in Riverwoods, Ill., is a leading provider of tax and accounting information, software and services. CCH has served tax, accounting and business professionals and their clients since 1913, providing them with the most authoritative, timely and comprehensive tax resources. CCH is a Wolters Kluwer company (www.wolterskluwer.com).

Wolters Kluwer is a leading multinational publisher and information services company. The company’s core markets are spread across the health, tax, accounting, corporate, financial services, legal and regulatory, and education sectors. Wolters Kluwer has annual revenues (2003) of €3.4 billion, employs approximately 18,750 people worldwide and maintains operations across Europe, North America and Asia Pacific. Wolters Kluwer is headquartered in Amsterdam, the Netherlands. Its depositary receipts of shares are quoted on the Euronext Amsterdam (WKL) and are included in the AEX and Euronext 100 indices.

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