Here’s a roundup of several recent tax court cases and what they mean for you.
Thou Shalt Not Commingle Funds
(Vorreyer, TC Memo 2022-97, 9/21/22)
Don’t let sloppy record keeping prevent you from deducting legitimate business expenses. The Tax Court agreed with the IRS that business expenses must first be deducted on that business’s tax return before flowing to the owner’s tax return.
Facts: A married couple, the sole shareholders of an S corporation, operated a family farm in Illinois. In 2012 they paid the farm’s utility bills of $21,000 and property taxes of $109,000 from their personal funds, then deducted these payments on their individual Form 1040 tax return as business expenses.
Even though the utility and property tax bills were legitimate business expenses, the deduction was disallowed because the expenses should have first been deducted on the farm’s S corporation tax return, then flowed through to the shareholder’s individual tax return.
Tax Tip: To pay an expense on behalf of your business, first make a capital contribution to your business, then have your business pay the expense. Then include this expense on your business’s tax return.
Adding Tax Insult to Injury
(Dern TC Memo 2022-90, 8/30/22)
Payments received to settle a physical injury or illness lawsuit are generally considered non-taxable income. But you better be sure that the lawsuit you file is actually to compensate for a physical injury or illness, and not something else.
Facts: Thomas Dern, a sales representative for a paint products company in California, was hospitalized for acute gastrointestinal bleeding and a subsequent heart attack. When the company fired him because he could no longer do his job, he sued for wrongful termination. The parties eventually reached a settlement.
Dern argued in Tax Court that his illness led to his firing, and therefore the settlement should be classified as non-taxable income. The payment he received, however, was to settle a discrimination lawsuit and not a physical injury. The settlement therefore did not qualify to be non-taxable income.
Tax Tip: Pay attention to the tax consequences of settlement payments so you don’t get surprised with an unexpected tax bill.
You’re Stuck With the Standard Deduction
(Salter, TC Memo 2022-49, 4/5/22)
Facts: Shawn Salter, a resident of Arizona, requested and received a distribution of $37,000 from his retirement plan after being laid off from his job in 2013. Salter failed to file a tax return for 2013, so the IRS created a substitute tax return for him using the standard deduction of $6,500 for a single taxpayer. The IRS also assessed an early withdrawal penalty of 10% on the distribution.
Salter, arguing that the distribution was to pay for medical expenses which aren’t subject to the 10% early withdrawal penalty, eventually did file a 2013 tax return with $25,000 of itemized medical expenses. The Tax Court disallowed the $25,000 of itemized deductions, stating that once a substitute return is created by the IRS using the standard deduction, the taxpayer can no longer claim itemized deductions for that year.
Tax Tip: Try to avoid a situation where the IRS files a substitute tax return on your behalf. Once this happens, you have no choice but to use the standard deduction for that tax year.
— By Nancy J. Ekrem, CPA
DME CPA Group PC
Certified Public Accountants & Business Consultants