Tax Court in Brief | Ismail v. Comm’r | Foreign LLC for U.S. tax purposes; Substantiation of Schedule C Expenses; Section 274

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The Tax Court in Brief – December 26th – December 30th, 2022

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Tax Litigation:  The Week of December 26th, 2022, through December 30th, 2022

Intan N. Ismail & Mohd Razu Abd Rahim v. Comm’r, T.C. Memo 2022-113 November 29, 2022| Paris, J. | Dkt. No. 16366-16, 13297-18

Short SummaryThe case discusses the tax classification of a foreign corporation for U.S. tax purposes and the substantiation of various business expenses such as vehicle, travel, and meals and entertainment expenses.

Mrs. Ismail and Mr. Rahim (petitioners) filed joint tax returns for the 2012-2015 period. Mr. Rahim was employed by RNR, a limited liability company organized according to the laws of Malaysia. RNR was founded by Mr. Rahim’s father and Mr. Nordin, and all the members of such company had limited liability. In 2013, petitioners became directors of RNR, but there was no documentation to support that petitioners became members of RNR. Also, there was no evidence to support that RNR filed form 8832, Entity Classification Election to be treated as a disregarded entity.

Petitioners claimed RNR business expenses on their Schedule C during 2012-2015 period. The IRS disallowed such expenses claiming that RNR constituted a foreign corporation and not a disregarded entity. The IRS issued a notice of deficiency for the 2012-2015 period disallowing the business expenses claimed. For 2015, the IRS partially disallowed only expenses related to vehicle, travel, and meals and entertainment expenses.

The Tax Court ruled in favor of the IRS by determining that RNR constituted a foreign corporation and not a disregarded entity for tax purposes. Consequently, the expenses of RNR could not be claimed on petitioners’ schedule C.

Key Issues: The proper classification of a Malaysian limited liability company for U.S. tax purposes and, the substantiation of vehicle, travel, and meals and entertainment expenses incurred by petitioners.

Primary Holdings: A Malaysian limited company – a Sendirian Berhad – is an eligible entity for U.S. tax purposes, and thus can elect is tax treatment. If no election is made and given that all the members of such entity have limited liability, such foreign entity is defaulted as a corporation.

Key Points of Law:

A business entity that is not “per se” a corporation, can elect its classification for federal tax purposes. Treas. Reg. § 301.7701-3(a). This entity is called an eligible entity. A foreign eligible entity in which all its members have limited liability is treated as an association, unless such entity makes an election Treas. Reg. § 301.7701-3(b)(2)(i)(B).

This is the “default” classification of a foreign eligible entity that does not make an election and whose members all have limited alibility. A foreign eligible entity that intends to make an election must file form 8832, Entity Classification Election.

In the case of RNR, that entity was organized as a Sendirian Berhad (a private limited liability company) under Malaysian law. Such entity is not a “per se” corporation, and thus can elect its tax treatment for U.S. purposes. Treas. Reg. § 301.7701-3(b)(8)(ii)(3). RNR did not file form 8832 for the years at issue. Given such circumstance, RNR default classification was applicable, thus, for U.S. tax purposes, RNR was treated as a corporation.

Because RNR was treated as a foreign corporation, none of its business expenses and losses flow through to its members. Accordingly, all business expenses claimed by the petitioners for the 2012-2014 period were disallowed.

For 2015, however, the IRS did not contend the tax classification of RNR, but rather, only contended the substantiation of the expenses claimed by the petitioners on their schedule C. Given such lack of contention, the Court focused its analysis on the substantiation of the various expenses disallowed which were vehicle, travel, and meals and entertainment expenses.

A business expense can be deductible if ordinary and necessary expenses. I.R.C. § 162(a). Taxpayers must prove that they are entitled to the deductions claimed. Rule 142(a). This requires substantiation expenses and producing records sufficient to enable the IRS to determine taxpayers’ correct tax liability. I.R.C. § 6001. See Hradesky v. Commissioner, 65 T.C. 87, 89–90 (1975), aff’d per curiam, 540 F.2d 821 (5th Cir. 1976).

If the taxpayer is unable to substantiate the expense, the Tax Court can estimate the amount of expense and allow a deduction to that extent. This is known as the “Cohan rule”. See Cohan v. Commissioner, 39 F.2d 540, 543–44 (2d Cir. 1930). To apply the Cohan rule, the Court must have a basis upon a which an estimate can be made. See Vanicek v. Commissioner, 85 T.C. 731, 742–43 (1985).

Section 274 denies a deduction for vehicle, travel, and meals and entertainment expenses unless such are substantiated. I.R.C. § 274(d). This means that the Cohan rule does not apply where section 274 imposes strict substantiation requirements. I.R.C. § 274(d). See Sanford v. Commissioner, 50 T.C. 823, 827–28 (1968), aff’d per curiam, 412 F.2d 201 (2d Cir. 1969).

In this case, petitioners tried to claim car and truck expenses, but failed to provide contemporaneous logs, and the Court considered that they were trying to deduct expenses related to the commute between their home to their work, which are not deductible. See Fausner v. Commissioner, 413 U.S. 838 (1973). Other expenses such as travel, meals and entertainment, were disallowed because petitioners failed to prove that the expense was allocable to petitioners’ trade or business. Rather such expenses were mostly personal in nature, and thus not deductible. I.R.C. § 274(c)(1); Treas. Reg. § 1.162-2(b)(1).

Insight: Tax classification of a business entity is always relevant, especially in the international context. Failure to properly elect the classification of a business entity can create a spiral of issues, such as the present case. In the case of foreign entities, is always important to review the limitation of liability to determine the correct default treatment, either a corporation or a partnership. And if required, filed form 8832 to change the default classification.