Tax Court in Brief | Luna v. Comm’r | Disallowance of Itemized Business Deductions and Lack of Substantiation

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Tax Litigation:  The Week of August 29th, 2022, through September 2nd, 2022

Luna v. Comm’r, T.C. Summ. Op. 2022-18| September 1, 2022 | Carluzzo, Chief SJT | Dkt. No. 17748-18S

Opinion

Short SummaryGeorge Luna (Luna) served as the executive director of a non-profit organization, the Center for Health Justice, Inc. (CHJ).  In addition, he served as a board member of E.S.S.E. Mundo Digital (EMD), a Brazilian organization. During 2015, he traveled to various cities in connection with his role as executive director of CHJ.  Also during 2015, he traveled to Brazil to meet with other board members of EMD.  Luna claimed miscellaneous itemized deductions on his 2015 return related to his travel for CHJ and EMD.  He also claimed a deduction for $225 of tax preparation fees.  The IRS disallowed all of these miscellaneous itemized deductions in full.  Aggrieved, Luna filed a petition with the Tax Court for review of the IRS’s determinations.

Key IssuesWhether Luna is entitled to claim miscellaneous itemized deductions for unreimbursed employee business expenses and for tax preparation fees.

Primary Holdings

  • Luna is not entitled to claim miscellaneous itemized deductions for unreimbursed employee business expenses because: (1) he failed to show the connection between the trips and the trade or business (e., his employment); and (2) he failed to show how the trips were “helpful” to his employment position.  Moreover, with respect to many of the claimed expenses, he has failed to properly substantiate the same under section 274(d).
  • Luna is not entitled to claim miscellaneous itemized deductions for his tax preparation fees because, even if the amount he claimed were allowed, the amount would not exceed 2% of his adjusted gross income, which in itself would result in no permitted deduction.

Key Points of Law

  • Generally, the IRS’s determination of a taxpayer’s federal income tax liability in a notice of deficiency is presumed correct, and the taxpayer bears the burden of proving that the determination is erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).
  • Deductions are a matter of legislative grace; accordingly, the taxpayer bears the burden of proving entitlement to any claimed deduction. Rule 142(a); INDOPCO,  v. Comm’r, 503 U.S. 79, 84 (1992).  This burden requires the taxpayer to substantiate expenses underlying claimed deductions by keeping and producing adequate records that enable the IRS to determine the taxpayer’s correct tax liability.  See I.R.C. § 6001; Hradesky v. Comm’r, 65 T.C. 87, 89-90 (1975), aff’d per curiam, 540 F.2d 821 (5th Cir. 1976).
  • A taxpayer claiming a deduction on a federal income tax return must demonstrate that the deduction is allowable pursuant to some statutory provision and must further substantiate that the expense to which the deduction relates has been paid or incurred. See R.C. § 6001; Hradesky, 65 T.C. at 89-90; Treas. Reg. § 1.6001-1(a).
  • Taxpayers may deduct ordinary and necessary expenses paid in connection with operating a trade or business. R.C. § 162(a).  Generally, the performance of services as an employee constitutes a trade or business.  Primuth v. Comm’r, 54 T.C. 374, 377 (1970).  If, as a condition of employment, an employee is required to incur certain expenses, then the employee is entitled to a deduction for these expenses unless entitled to reimbursement from his or her employer.  See Fountain v. Comm’r, 59 T.C. 696, 708 (1973).  An employee business expense is not “ordinary and necessary” if the employee is entitled to reimbursement from his or her employer but fails to seek reimbursement.  See Podems v. Comm’r, 24 T.C. 21, 22-23 (1955).
  • Under the Cohan doctrine, if a taxpayer provides sufficient evidence that the taxpayer has incurred a trade or business expense contemplated by section 162(a) but is unable to adequately substantiate the amount, the Court may estimate the amount and allow a deduction to that extent. Cohan v. Comm’r, 39 F.2d 540, 543-44 (2d Cir. 1930).  But in order for the Court to estimate the amount of any expense, there must be some basis upon which an estimate may be made.  Vanicek v. Comm’r, 85 T.C. 731, 742-43 (1985).
  • The Court may not, however, estimate expenses under Cohan in situations where section 274 requires specific substantiation. See R.C. § 274(d); Sanford v. Comm’r, 50 T.C. 823, 827 (1968), aff’d per curiam, 412 F.2d 201 (2d Cir. 1969).  Deductions for expenses attributable to meals and lodging while traveling away from home, if otherwise allowable, are subject to strict rules of substantiation.  See I.R.C. § 274(d).  With respect to these types of expenses, section 274(d) requires that the taxpayer substantiate either by adequate records or by sufficient evidence corroborating the taxpayer’s own statement (1) the amount of the expense; (2) the time and place the expense was incurred; (3) the business purpose of the expense; and (4) in the case of entertainment or gift expense, the business relationship to the taxpayer of each expense incurred.
  • 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. 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 elements.  Temp. Treas. Reg. § 1.274-5T(c)(3).
  • Under section 62(a)(2)(A), an employee may deduct certain business expenses incurred in connection with the performance of services for an employer under a reimbursement or other expense allowance arrangement. If these expenses are reimbursed by the employer pursuant to an “accountable plan,” then the reimbursed amount is not reported as wages on the employee’s Form W-2 and is exempt from withholding and payment of employment taxes.  Reg. § 1.62-2(c)(4).  If the arrangement fails to meet the requirements of section 62 and the governing regulations, amounts paid under the arrangement will be treated differently as under a nonaccountable plan—i.e., such amounts are included as gross income in the employee’s Form W-2 and are subject to withholding and payment of employment taxes.  Only in the latter case may expenses be deducted, provided the employee can substantiate the full amount of his or her expenses
  • Section 212(3) allows a deduction for costs incurred in the preparation of a tax return. Hughes v. Comm’r, T.C. Memo. 2008-249.

InsightsThe decision in Luna demonstrates that taxpayers must be able to adequately explain, in many instances, the purpose of their claimed deductions.  If such purpose has only an attenuated connection with a trade or business, the deduction likely will be disallowed in full.

Refrence Article: https://freemanlaw.com/tax-court-in-brief-luna-v-commr-disallowance-of-itemized-business-deductions-and-lack-of-substantiation/

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