The Tax Court in Brief – May 9th – May 13th, 2022
Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.
For a link to our podcast covering the Tax Court in Brief, download here or check out other episodes of The Freeman Law Project.
Tax Litigation: The Week of May 9th, 2022, through May 13th, 2022
- Lewis v. Commissioner, TC Memo. 2022-47| May 9, 2022 | Greaves, J. | Dkt. No. 10007-20W
- Rogerson v. Commissioner, TC Memo. 2022-49| May 12, 2022 | Toro, J. | Dkt. No. 5848-20
- Jackson v. Comm’r, T.C. Memo. 2022-50 | May 12, 2022 | Vasquez, J. | Dkt. No. 19634-18L
- Evert v. Comm’r, T.C. Memo. 2022-48| May 9, 2022 | Marshall, A | Dkt. No. 12901-19
Harrison v. Comm’r, T.C. Memo 2022-6 | May 12, 2022 | Panuthos, J | Dkt. No. 12170-19S
Summary: The IRS declared a deficiency, additional tax, and accuracy-related penalties on the 2015 income tax return of Nicole Harrison, an employee of Samsung Electronics and a consultant on the side. Harrison made several charitable contributions, mostly made through a PayPal account, and she regularly donated clothing, shoes, and jewelry to organizations such as Goodwill and Dress for Success. Harrison traveled in connection with Samsung and normally booked business class flights; however, when company policy changed so that she could only be reimbursed for the cost of coach, she continued to book business class. She began to deduct the difference on her Schedule A and substantiated the costs with bank statements of her corporate card. In connection with her sole proprietorship consulting, she paid a company to set up a website, networked, traveled for two clients, bought a laptop, and renovated her personal apartment to include a home-office. Lastly, she and a relative, purchased a rental property. She contributed to the mortgage by sending Venmo payments. She did not receive any income and claimed passive-activity losses for remediating a flooded basement, insurance, and other house-related expenses.
- Whether Harrison is entitled to deduct charitable contributions and unreimbursed employee expenses reported on Schedule A, Itemized Deductions?
- Whether Harrison is entitled to certain expense deductions relating to her consulting activity reported on Schedule C, Profit or Loss from Business?
- Whether Harrison is entitled to deduct real estate activity expenses reported on Schedule E, Supplemental Income and Loss?
- Whether Harrison is liable for an addition to tax for failure to timely file pursuant to § 6651(a)(1)?
- Yes and no. The Court limited charitable contributions for lack of evidence to properly substantiate the claimed deductions on both cash and noncash contributions. The record lacked approximate dates of acquisition, detailed descriptions, and the costs or other bases for the non-cash contributions, and Harrison did not provide sufficient substantiation for her claimed deduction on the cash contributions.
- Harrison did not meet the requirements of § 274(d) for reimbursement of flight expenses. She failed to provide records to demonstrate times, places, and business purpose.
- Harrison’s consulting activity did not rise to the level of carrying on a trade or business. Harrison was still in the exploratory stages of forming a business of which deductions under § 162(a) are not permitted.
- Harrison did not demonstrate she qualifies for the active participation exception of the rental endeavor. She only testified to co-signing the lease, she did not provide a copy of the lease, she did not provide receipts of the Venmo payments on the mortgage, and she did not receive any income from the activity. Therefore, she did not qualify for the exception under § 469(i). Accordingly, Harrison was not entitled to use § 162(a) for expenses associated with the real property.
- Harrison did not show her failure to timely file a return was due to reasonable cause. Thus, she was liable for the § 6651(a)(1) addition to tax.
Key Points of Law
- Burden of Proof. In general, the IRS’s determination set forth in a notice of deficiency is presumed correct, and the taxpayer bears the burden of proving that the determination is in error. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Under § 7491(a), the burden of proof can shift to the IRS if the taxpayer introduces credible evidence with respect to any factual issues relevant to ascertaining the taxpayer’s tax liability. If the burden remains on the taxpayer, then the taxpayer must prove he or she in entitled to a specific deduction in question. See Rule 142(a); Deputy v. du Pont, 308 U.S. 488, 493 (1940); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). If a taxpayer is able to establish that she paid or incurred a deductible expense but is unable to substantiate the precise amount, the Court may approximate the deductible amount, but only if the taxpayer presents sufficient evidence to establish a rational basis for making the estimate. See Cohan v. Comm’r, 39 F.2d 540, 543-44 (2d Cir. 1930).
- 170 Charitable Contributions. There is allowed a deduction for any charitable contribution payment, as defined by §170(c), and which is allowed under the regulations. § 170(a)(1); Treas. Reg. § 1.170A-13. The substantiation requirements depend on form of payment and the size of the contribution.
- Charitable Contributions of Property. If property other than money is donated, “the amount of the contribution is the fair market value (FMV) of the property at the time of the contribution.” Treas. Reg. § 1.170A-1(c)(1). FMV is defined as the price at which a willing buyer and seller would transact, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts. Treas. Reg. § 1.170A-1(c)(2)
- Substantiation Requirements of Money Donation. A charitable contribution of money must be substantiated by at least one of the following: (1) a canceled check; (2) a receipt from the donee charitable organization showing the name of the donee, the date of the contribution, and the amount of the contribution; or (3) in the absence of a canceled check or receipt from the donee charitable organization, other reliable written records showing the name of the donee, the date of the contribution, and the amount of the contribution. Treas. Reg. § 1.170A-13(a)(1). The reliability of the record is determined on the basis of all relevant facts. Treas. Reg. § 1.170A-13(a)(2)(i). If the donation is a small amount, any written or other evidence from the donee charitable organization acknowledging receipt is generally sufficient. Treas. Reg. § 1.170A-13(a)(2)(i)(C). However, donations in excess of $250 require donee written acknowledgement containing specified information. § 170(f)(8).
- Substantiation Requirements of Property Donation. A charitable contribution of property must be substantiated by a receipt showing (1) the name of the donee; (2) the date and location of the contribution; and (3) a description of the property in detail reasonably sufficient under the circumstances. Treas. Reg. § 1.170A-13(b)(1). A receipt is not required if the contribution is made in circumstances where it is impractical to obtain a receipt. See id. The reliability of the records is determined on the basis of all of the relevant facts and circumstances. Treas. Reg. 1.170A-13(b)(2). If the deduction on the contribution of property exceeds $500, then the taxpayer must maintain written records establishing (1) the item’s manner of acquisition as well as either the item’s approximate date of acquisition or date the property was substantially completed and (2) the cost or other basis, adjusted as provided by section 1016, of property donated by the taxpayer during the taxable year. See 170(f)(11)(A)(i), (B); Treas. Reg. § 1.170A-13(b)(3)(i).
- 162 Trade or Business Expense. § 162 generally allows for the deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Boyd v. Comm’r, 122 T.C. 305, 313 (2004). The taxpayer bears the burden of proving that expenses were of a business nature rather than personal and that they were ordinary and necessary. Rule 142(a); Welch v. Helvering, 290 U.S. at 115. Performing services as an employee constitutes a trade or business. See O’Malley v. Commissioner, 91 T.C. 352, 363–64 (1988); Primuth v. Commissioner, 54 T.C. 374, 377–78 (1970).
- 274 Disallowance of Certain Travel Expenses. Travel expenses require strict substantiation through adequate records or by sufficient evidence corroborating the taxpayer’s own statement as to the amount, time, place, and business purpose of these expenditures. § 274(d). Substantiation by adequate records requires the taxpayer to maintain an account book, a diary, a log, a statement of expense, trip sheets, or a similar record prepared contemporaneously with the expenditure and documentary evidence (e.g., receipts or bills) of certain expenditures. Treas. Reg. § 1.274-5(c)(2)(iii); Temp. Treas. Reg. § 1.274-5T(c)(2). Substantiation by other sufficient evidence requires the production of corroborative evidence in support of the taxpayer’s statement specifically detailing the required element. Temp. Treas. Reg. § 1.274- 5T(c)(3).
- 162 vs § 195. § 162(a) does not provide the operative rule for deducting start-up costs. The Code section that does provide the mechanical rule is § 195. A preliminary search for a potential business opportunity does not qualify the taxpayer for deductions under §§ 162, 165, or 212. Dean v. Comm’r., 56 T.C. 895, 902 (1971). Carrying on a trade or business requires more than initial research into business potential and the solicitation of potential customers. Christian v Comm’r., T.C. Memo. 1995-12.
- 469 Passive Activity Loss. § 469(a) generally disallows any “passive activity loss” for the taxable year. A passive activity loss is defined as the excess of the aggregate losses from all passive activities for that year over the aggregate income from all passive activities for such year. § 469(d)(1).
- Passive Activity Defined. A passive activity is any trade or business in which the taxpayer does not materially participate. § 469(c)(1). Rental activity is generally treated as per se passive regardless of whether the taxpayer materially participates. § 469(c)(2). There are two exceptions to the general rule that rental real estate activities are per se passive activities: (1) passive activity losses up to $25,000 under section 469(i) and (2) certain taxpayers in real property trades or businesses (real estate professionals) under section 469(c)(7). Moss v. Comm’r., 135 T.C. 365, 368 (2010).
- 469(i) Exception to Passive Activity Definition. a Section 469(i) allows taxpayers who “actively participated” in rental real estate activities during any taxable year to deduct up to $25,000 of the passive activity losses attributable to those activities in that year. § 469(i)(1) and (2). This Court has determined that the active participation standard is met if a taxpayer participates in a significant and bona fide sense in making management decisions or arranging for others to provide services such as repairs. Madler v. Comm’r., T.C. Memo. 1998-112.
- 6651(a)(1) Failure to Timely File. A Section 6651(a)(1) imposes an addition to tax for failure to file a return on the date prescribed (including extensions) unless the taxpayer can establish that the failure is due to reasonable cause and not due to willful neglect. Respondent bears the burden of production with respect to petitioner’s liability for the addition to tax under section 6651(a)(1). See § 7491(c); Higbee v. Comm’r., 116 T.C. 438, 446–47 (2001). Once the burden is met, the taxpayer bears the burden of proving that her failure to file a timely return was due to reasonable cause rather than willful neglect. Higbee, 116 T.C. at 446.
Insights. This case demonstrates the taxpayer’s burden of production once the IRS has declared a deficiency due to improper deductions. The case highlights the factual circumstances a court will inquire into for certain claimed deductions. As such, taxpayers will need to keep detailed records for cash and noncash charitable contributions. Moreover, taxpayers should note that pre-business expenses are not deductible under § 162. Instead, the deduction for start-up costs is allowable under §§ 195 and 709. Travel expenditures should be accompanied with times, places, and documentation of the business purpose. Lastly, this case shows the complicated passive activity loss disallowance rules. Specifically, those related to real estate owned by individuals.
For additional information on the subject of passive versus nonpassive, see Freeman Law’s Tax Court in Brief: Tax Court in Brief | Rogerson v. Commissioner | Passive Income, Rent of Yachts, and Reliance on Competent Tax Counsel – Freeman Law (May 12, 2022).
For additional information on the tax treatment of charitable contributions, see Freeman Law’s blog on Joint Committee on Taxation Report on Tax Treatment of Charitable Contributions – Freeman Law (March 22, 2022).