Upon close inspection, you will notice a familiar theme throughout many of these cases: If you can’t substantiate a deduction, you lose it!
Alimony and separate maintenance payments
Not a divorce or separation agreement: Taxpayer and ex-spouse signed an agreement just between them to modify their divorce agreement. The Tax Court concluded that the taxpayers’ agreement was not a divorce or separation instrument, so the payments made under the agreement were not alimony because they were not mandated by a divorce or separation agreement.
Oral modification doesn’t constitute a divorce or separation agreement: In another related case, the taxpayer and his ex-wife agreed orally to modify their separation agreement. Under the modification the taxpayer paid his ex-wife $5,000 per month instead of the $2,000 amount ordered by the court. The tax court found that the oral modification of the separation agreement did not meet the requirements of a divorce or separation agreement, and, therefore, the amounts the taxpayer paid to his ex-wife more than the amount required by the separation agreement were not deductible as alimony.
Trade or business expenses
Travel: In a business expense case, the IRS denied the taxpayer’s deduction for business-related travel expenses to Washington DC because it determined that DC was his tax home. However, the tax court held in favor of the taxpayer. Because the taxpayer performed a substantial portion of his work in Nevada, the taxpayer’s travel to Washington for just a few sporadic weeks did not support the position of the IRS that the taxpayer’s tax home was in Washington. The taxpayer still took a beating because the court disallowed many of the expenses for lack of substantiation.
Substantiation: In another case involving substantiation, the IRS disallowed many of the deductions claimed by the taxpayers on their Schedule C. The taxpayers failed to provide documentation to support their claims for deductions and credits associated with several of the husband’s business endeavors. These claims included home office expenses, depreciation for a home computer, medical expenses, home mortgage interest, casualty losses, and charitable contributions. The husband provided limited documentation, and the court disallowed most of them. The court found the husband’s credibility lacking.
Business purpose: In a tax court case, a taxpayer was denied deductions for unreimbursed employee expenses and home office expenses. All unsupported expenses were disallowed. The taxpayer presented records of the travel but failed to prove its business purpose, so the court held that those expenses were nondeductible.
Legislation enacted on Sept. 29, 2017, provides benefits for victims of hurricanes Harvey, Irma, and Maria. For qualified disaster-related personal casualty losses from those hurricanes, the act removes the requirement that personal casualty losses must exceed 10% of the taxpayer’s AGI to be deductible and allows nonitemizers to increase their standard deduction by the amount of their net disaster loss.
In this case the taxpayer was denied a business bad debt deduction. The taxpayer advanced more than $80 million to a company. Promissory notes were executed for and interest was paid on the advances. In a subsequent year, the taxpayer decided to take a bad debt loss deduction for a portion of his advances to the company.
The court denied the deduction, determining that the advances were equity investments rather than bona fide debt. (Note: this should open the opportunity for a worthless security deduction – D.M.S., CPA). The court further found that even if the advances were considered debt, they would be nonbusiness debt and therefore nondeductible because the taxpayer was not in the business of lending money.
Charitable contributions and gifts
Real estate: A partnership was denied a $33 million noncash charitable deduction for a contribution of an interest in real estate because the Form 8283, Noncash Charitable Contributions, attached to its tax return failed to include the original cost of the real estate interest.
Facade easement: A partnership was allowed a $7 million noncash charitable deduction for a facade easement. Although the written acknowledgment issued by the recipient charity did not indicate that “no goods or services were provided”, the deed stated that the charity supplied no goods or services in exchange for the gift of the easement, and that the deed reflected the entire agreement of the parties.
Contemporaneous written acknowledgment: In a similar case, the IRS denied a partnership a noncash charitable deduction of a $26.7 million facade easement because no separate contemporaneous written acknowledgment was received from the charity. However, the Tax Court further found that the deed satisfied the requirement and held that the taxpayer was therefore entitled to the deduction.
In perpetuity: In a tax court case, a partnership’s noncash charitable deduction for a facade easement was denied because the easement was subject to a mortgage and therefore not protected in perpetuity. The taxpayer argued that a clause in the easement deed would retroactively amend the deed to cure the defect. However, the Tax Court found that the requirement must be satisfied at the time of the gift.
Valuation: An avid hunter’s noncash charitable deduction for donations of big-game specimens to an ecological foundation was reduced from $1,425,900 to $163,045. The Tax Court noted that the taxpayer’s donated specimens were neither world-class trophies nor of museum quality, and there was an active market in specimens like the taxpayer’s. The court concluded, therefore, that they should be valued at FMV rather than replacement cost. The court upheld the IRS’s valuation.
Substantiation: The Tax Court reduced a married couple’s noncash deduction for 20,000 items given to Goodwill Industries valued at a total of $145,250 to $250. The receipts from Goodwill did not describe any of the items or indicate how many items were donated or their condition, so the court found that the taxpayers’ records were not adequate to support their claimed deductions. The court further found that certain items would have required qualified appraisals since the taxpayer valued them at more than $5,000 each.
Activities not engaged in for profit
Gambling activity: FACTS: The taxpayer worked full time which generated almost all his annual earnings. The taxpayer claimed net losses on Schedule C of $89,116 and $85,783 from his activity as a professional gambler. Most of the expenses he claimed were for auto expenses, travel, and meals and entertainment incurred while on gambling trips. The Tax Court determined that the taxpayer failed to prove that his gambling activity was a for-profit business activity, and he could not deduct any expenses for his gambling activities on Schedule C.
Businesslike manner: In a tax court case, a taxpayer who had over 20 years of experience in car racing deducted losses from a car-racing activity. The Tax Court found that the taxpayer’s experience in the industry, the substantial time he spent on the activity, and the fact that it was his only significant source of income weighed in his favor. However, it found that these factors were heavily outweighed by his not running the activity in a businesslike manner, his lack of expertise in running a car-racing business (as opposed to racing cars), the prior failure of his previous similar car-racing business (which had caused the taxpayer to file for bankruptcy), and the personal pleasure he derived from the activity.
Real estate professional’s expenses: In another case, the IRS challenged numerous items within the individual taxpayer’s tax return. The crucial determination was whether the individual qualified as a real estate professional, which would allow her to offset her otherwise passive rental losses against her other ordinary income. The court found that she met the requirements. The court further found that she materially participated in the rental activities, so the activities were not passive activities and she could deduct the losses. However, the court sustained the IRS’s disallowance of most of the taxpayer’s claimed unreimbursed employee expenses for lack of substantiation.
Adjusted basis for determining gain or loss
The taxpayer and his parents had purchased a home with the taxpayer paying $234,312 and the parents paying $40,000. Later, the parents gave their interest in the home to the taxpayer. The taxpayer sold the house to his parents. The parents did not give the taxpayer any cash in the sale but paid off two outstanding mortgages on the property (in aggregate, $664,048).
The court held that the taxpayer had to report the sale and that the taxpayer’s basis in the property was the amount paid by the taxpayer when the home was purchased ($234,312), plus the basis of the parents’ interest in the property ($40,000), for a total of $274,312. The court did not allow any increase in basis for improvements claimed by the taxpayer, because the taxpayer was unable to provide adequate substantiation. The court also found that the amount realized was the amount of the two mortgages discharged by the parents (less settlement costs) and not the FMV of the property ($975,000). The court stated that the IRS failed to understand that the taxpayer’s sale to his parents was a transfer of property that was in part a sale and in part a gift. The IRS had previously conceded that the taxpayer could exclude $250,000 of the gain under Sec. 121.