Summary: Kyle Simpson and Christen Simpson, husband and wife (the Simpsons), were equal shareholders in a wholly owned S corporation (S Corp). Through S Corp, Mr. Simpson developed open-source software. He was also employed by three different software development companies. In 2011, as S Corp grew, Mr. Simpson started phasing out his other work. S Corp maintained a corporate checking account, a corporate savings account, and two corporate credit cards. Mr. Simpson also participated in the formation of an LLC (LLC) business that rented communal office space. Mr. Simpson, acting as S Corp's agent, caused S Corp to join with two other entities to form LLC; each member contributed $2,500 in cash to LLC's business bank account at the LLC's outset in July 2011. S Corp served as LLC's operating manager and as LLC's registered agent. LLC ultimately failed.
The Simpsons timely filed a joint Form 1040 for their taxable year 2011. The return included Schedule E, Supplemental Income and Loss, with respect to their involvement in S Corp and LLC. The Simpsons reported losses from S Corp and income from LLC, for a total loss of $60,491. On its Form 1120–S, U.S. Income Tax Return for an S Corporation, for taxable year 2011, S Corp reported itemized expenses and "other deductions" that included auto, travel, gifts, supplies, home office rent, and other.
For tax year 2012, the Simpsons filed a joint Form 1040 on August 12, 2014. Similar to the returns filed for 2011, the Form 1040 included Schedule E with respect to S Corp, and S Corp's 2012 Form 1120–S included similar deductions. S Corp also reported an ordinary loss and a section 1231 loss, both of which were associated with S Corp's interest in LLC.
For tax year 2013, the Simpsons filed a joint Form 1040 on April 28, 2015. Similar to the returns filed for 2011 and 2012, the Form 1040 included Schedule E with respect to S Corp, and S Corp's 2012 Form 1120–S included similar deductions.
In 2012, the IRS began an investigation of Spectrum Financial (Spectrum), the provider of tax services that prepared S Corp's corporate returns and the Simpsons' personal returns. The IRS' investigation of Spectrum encompassed examinations of Spectrum's clients' returns, including those of S Corp and the Simpsons. The IRS issued to the Simpsons two notices of deficiency. The first notice of deficiency, regarding taxable years 2011 and 2012. The IRS also determined accuracy-related penalties under section 6662(a) for taxable years 2011 and 2012, as well as a failure-to-timely-file addition to tax under section 6651(a)(1) for taxable year 2012. The second notice of deficiency regarded taxable year 2013. The IRS also determined an accuracy-related penalty under section 6662(a) and a failure-to-timely-file addition to tax under section 6651(a)(1). The Simpsons challenged the determinations.
(1) Whether certain deductions claimed by the Simpsons wholly owned S corporation are properly deductible at the corporate level or, alternatively, as expenses incurred by Mr. Simpson as a Getify employee?
(2) Whether items underlying the Simpson's claimed deductions have been substantiated?
(3) Whether the Simpsons substantiated Getify's basis in South Austin Co-Working, LLC (Co-Working), so as to justify their purported loss deductions associated with that entity for taxable years 2011 and 2012?
(4) Whether the Simpsons are liable for accuracy-related penalties under section 6662(a) with respect to taxable years 2011, 2012, and 2013?
(5) Whether the Simpsons are liable for additions to tax associated with their failure to timely file tax returns under section 6651(a)(1) with respect to taxable years 2012 and 2013?
(1) The deductions are deductible by the Simpsons as unreimbursed employee expenses, and subject to the two-percent limitation of section 67(a). The expenses at issue were not incurred for the purpose of protecting Mr. Simpson's shareholder interest in S Corp. Instead, they were incurred to help Mr. Simpson in carrying on his trade or business as an employee of S Corp. Thus, all of the expenses should be properly characterized as ordinary and necessary employee expenses. And, the Simpsons failed to establish that S Corp had an accountable plan that meets the requirements of Treasury Regulation § 1.62-2(d)-(f), and as such, all the expenses incurred personally in connection with Mr. Simpson's employment with S Corp are considered unreimbursed employee expenses.
(2) With one exception, the Simpsons failed to substantiate the expenses underlying their claimed deductions beyond what the IRS allowed.
(3) The Simpsons did not substantiate their basis in LLC and are, therefore, limited to the loss deductions the IRS allowed.
(4) The Simpsons are liable for accuracy-related penalties under section 6662(a) for taxable years 2011, 2012, and 2013.
(5) The Simpsons are liable for additions to tax associated with their failure to timely file tax returns under section 6651(a)(1) with respect to taxable years 2012 and 2013. The Simpsons did not prove that the tardiness of their filing was due to reasonable cause.
Key Points of Law:
Burden of Proof. The determinations in a notice of deficiency bear a presumption of correctness, and the taxpayer generally bears the burden of proving them erroneous in proceedings in this Court. See Welch v. Helvering, 290 U.S. 111, 115 (1933); Rule 142(a)(1).
Deductions. Section 162(a) permits a deduction for ordinary and necessary expenses paid to carry on a trade or business during the taxable year. An "ordinary" expense is one that is common and acceptable in the particular business. Welch, 290 U.S. at 113–14. The main function of the word "ordinary" in section 162(a) is to clarify the distinction between currently deductible and capital expenses. Commissioner v. Tellier, 383 U.S. 687, 689–90 (1966). A "necessary" expense under section 162(a) is an expense that is appropriate and helpful in carrying on the trade or business. Heineman v. Commissioner, 82 T.C. 538, 543 (1984). Deductions are a matter of legislative grace, and the taxpayer bears the burden of clearly showing entitlement to any deduction claimed. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992).
Substantiation. The taxpayer must substantiate the amount and the purpose of the expense underlying the deduction. Higbee v. Commissioner, 116 T.C. 438, 440 (2001). A taxpayer must also maintain adequate records to demonstrate the propriety of any deduction claimed. Id.; see also 26 U.S.C. § 6001. Certain expenses otherwise deductible under section 162(a) are subject to heightened substantiation requirements under section 274(d); these include expenses for traveling and expenses with respect to any listed property under section 280F(d)(4). See 26 U.S.C. § 274(d)(1), (4).
The Cohan Rule No deduction is permitted for personal, living, or family expenses unless expressly permitted under the Code. See id. at § 262(a). If a taxpayer is unable to substantiate the amount of a deduction, the Tax Court may nonetheless allow it (or a portion thereof) if there is an evidentiary basis for doing so. See Cohan v. Commissioner, 39 F.2d 540, 543–44 (2d Cir. 1930); Vanicek v. Commissioner, 85 T.C. 731, 742–43 (1985). In estimating the amount of an allowable expense under the Cohan rule, the Court bears heavily against the taxpayer whose inexactitude is of his own making. Cohan, 39 F.2d at 544. The Cohan rule cannot be applied to deductions subject to the strict substantiation requirements of section 274(d). See Sanford v. Commissioner, 50 T.C. 823, 828 (1968), aff'd per curiam, 412 F.2d 201 (2d Cir. 1969); Temp. Treas. Reg. § 1.274-5T(a) (flush language).
Corporate Tax and Expenses. A corporation is treated as a separate entity from its shareholders for tax purposes. Moline Props., Inc. v. Commissioner, 319 U.S. 436, 438–39 (1943). While a shareholder may identify his or her interest and business with those of the corporation, they are legally distinct and, ordinarily, if he or she voluntarily pays or guarantees the corporation's obligations, the shareholder's expense may not be deducted on a personal return. Deputy v. du Pont, 308 U.S. 488, 494 (1940); Noland v. Commissioner, 269 F.2d 108, 111 (4th Cir. 1959), aff'g T.C. Memo. 1958-60. Such payments, absent any fixed obligation for repayment, are generally regarded as a contribution to the capital of a corporation and are deductible, if at all, by the corporation. Rink v. Commissioner, 51 T.C. 746, 751 (1969). However, a corporate resolution or policy requiring a corporate officer to assume certain expenses indicates that those expenses are the officer's rather than the corporation's. Noyce v. Commissioner, 97 T.C. 670, 683–84 (1991).
Trade or Business Expenses. Being an employee constitutes a trade or business. See Primuth v. Commissioner, 54 T.C. 374, 377 (1970). Shareholders of a corporation may be engaged in the trade or business of being an employee. See Winslow v. Commissioner, T.C. Memo. 1983-158, 45 T.C.M. (CCH) 1064, 1067. Expenses of employment, if incurred under a reimbursement arrangement, are deductible in computing the employee's gross income. See 26 U.S.C. § 62(a)(2)(A).
Reimbursement Arrangement. Employees that have unreimbursed expenses associated with their employment may deduct those expenses only as miscellaneous itemized deductions subject to the two-percent limitation of section 67(a). See 26 U.S.C. § 67(b). However, to the extent that any expenses are incurred to protect a shareholder-employee's equity interest, those expenses are to be capitalized and are not deductible to the taxpayer in the capacity as an employee. The character of such expenses depends on the facts and circumstances of a given case. See Deputy, 308 U.S. at 496. An expenditure must be capitalized when it (1) creates or enhances a separate and distinct asset, (2) produces a significant future benefit, or (3) is incurred "in connection with" the acquisition of a capital asset such that it is directly related to the acquisition. Lychuk v. Commissioner, 116 T.C. 374, 385–86 (2001).
Accountable Reimbursement Plan. Under section 62(a)(2)(A), an employee can deduct certain expenses incurred in connection with the performance of services for an employer under a reimbursement or other allowance arrangement. If these expenses are reimbursed by the employer pursuant to an "accountable plan," then the reimbursed amount is excluded from income and is not considered wages or compensation. Treas. Reg. § 1.62-2(c)(4). To qualify as an accountable plan, such a plan must meet the requirements of Treasury Regulation § 1.62-2(d)-(f).
Unqualified Reimbursement Plan. Section 62(c) provides that an arrangement will not be treated as a reimbursement or other expense allowance arrangement for purposes of section 62(a)(2)(A) if it (1) does not require the employee to substantiate the expenses covered by the arrangement to the person providing reimbursement or (2) provides the employee the right to retain any amount in excess of the substantiated expenses covered under the arrangement.
Travel Expense Substantiation. Travel expenses are subject to heightened substantiation requirements under section 274(d). Those requirements permit a deduction for traveling expenses only to the extent the taxpayer proves (1) the amount of each expenditure for traveling away from home, (2) the date of departure and return for each trip and the number of days spent on business, (3) the destination or locality of travel, and (4) the business reason for travel or the expected business benefit to be derived. See Temp. Treas. Reg. § 1.274-5T(b)(2). Each element of a traveling expense must be substantiated through "adequate records" or by "sufficient evidence corroborating the taxpayer's own statement." See 26 U.S.C. § 274(d) (flush language); see also Temp. Treas. Reg. § 1.274-5T(c)(1), (2), and (3).
Accounting Expenses. Accounting fees are not subject to the heightened substantiation requirements of section 274(d). Thus, the Tax Court may allow a deduction even if the taxpayer is unable to substantiate the expense, assuming there is a proper evidentiary basis for doing so. See Cohan v. Commissioner, 39 F.2d at 544.
Business Use of the Home. As a general rule, taxpayers are unable to claim deductions with respect to the business use of a dwelling unit that is used by the taxpayer as a residence during the taxable year. 26 U.S.C. § 280A(a). However, section 280A(c)(1)(A) provides an exception to the general rule to the extent that a taxpayer, on a regular basis, uses a portion of the dwelling unit exclusively as the principal place of business for any trade or business of the taxpayer. The term "dwelling unit" includes houses. 26 U.SC. § 280A(f)(1)(A).
Determining Taxpayer's Basis in an LLC. A limited liability company is treated as a partnership for federal tax purposes. See Treas. Reg. § 301.7701-3(b). Generally, a partner's distributive share of income, gain, loss, deduction, or credit shall be determined by the partnership agreement. 26 U.S.C. § 704(a). However, a partner's distributive share of partnership loss (including capital loss) is allowed only to the extent of the adjusted basis of the partner's interest in the partnership at the end of the year in which such loss occurred, and any excess of such loss over the partner's adjusted basis shall be allowed as a deduction at the end of the partnership year in which such excess is repaid to the partnership. Id. at § 704(d).
A partner's adjusted basis in a partnership is generally determined under section 705(a)(1), which provides that the partner's basis shall be the basis determined under section 722 or section 742 and shall be increased by the sum of the partner's distributive share of "(A) taxable income of the partnership as determined under section 703(a), (B) income of the partnership exempt from tax under this title, and (C) the excess of the deductions for depletion over the basis of the property subject to depletion." Moreover, the partner's adjusted basis shall be decreased by distributions by the partnership as well as the partner's distributive share for the taxable years and prior taxable years of "(A) losses of the partnership, and (B) expenditures of the partnership not deductible in computing its taxable income and not properly chargeable to capital account." 26 U.S.C. § 705(a)(2). A partner's adjusted basis is not determined solely by his initial contribution; subsequent contributions of property also increase a partner's adjusted basis.
Alternatively, section 742 provides that the "basis of an interest in a partnership acquired other than by contribution shall be determined under part II of subchapter O (sec. 1011 and following)." Under section 1015, the basis of property acquired by gift is the same in the hands of the donee as it would be in the hands of the donor, unless the donor's basis is "greater than the fair market value of the property at the time of the gift," in which case the donee's basis shall be the fair market value of the property for the purpose of determining loss. See 26 U.S.C. § 1015(a). Thus, if a partner receives a portion of his partnership interest via gift, he is a donee, and his adjusted basis with respect to that portion of his interest would be the same as the donor's basis, assuming the donor's basis did not exceed the fair market value of the interest at the time of the gift. The value of services performed is not included in basis unless and until the value of those services performed has been subjected to tax. See Hutcheson v. Commissioner, 17 T.C. 14, 19 (1951).
Books and Records. Under Texas law, all entities are required to keep books and records of accounts. Tex. Bus. Orgs. Code § 3.151. A member of an LLC or an assignee of a membership interest in an LLC, on written request and for a proper purpose, may examine and copy such records at any reasonable time. Id. at § 101.502. Where a party fails to introduce evidence within his or her possession which, if true, would be favorable to him or her, there arises a presumption that if the evidence was produced, it would be unfavorable. Wichita Terminal Elevator Co. v. Commissioner, 6 T.C. 1158 (1946).
Accuracy-Related Penalties. Under Section 6662(a), the IRS may determine accuracy-related penalties. This applies to the portion of any underpayment that is attributable to, among other things, any substantial understatement of income tax. 26 U.S.C. § 6662(b)(2). A substantial understatement of income tax exists if the amount of the understatement exceeds the greater of ten percent of the tax required to be shown on the return or $5,000. Id. at § 6662(d)(1)(A). For any substantial understatement of income tax, section 6662(a) provides for the imposition of an accuracy-related penalty in an amount equal to 20% of the portion of the underpayment of tax required to be shown on the return. The IRS bears the burden of production with respect to the liability of an individual for any penalty. Id. at § 7491(c); see Higbee, 116 T.C. at 446.
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