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Tax Court Corner - Small Business Edition

Here’s a roundup of several recent tax court cases and what they mean for your small business.

Be Reasonable About Compensation

(Hood, TC Memo 2022-15, 3/2/22)

Facts: Clary Hood and his wife founded and were the sole shareholders of Clary Hood, Inc., a C corporation. In 2014, Hood and his advisors concluded that Hood had been under-compensated in prior years. Hood and his wife received a $5 million bonus from the company in 2015, and another $5 million bonus in 2016.

The IRS claimed the bonuses were excessive, issued a notice of deficiency and assessed substantial underpayment penalties of $316,240 for 2015 and $322,622 for 2016. The Tax Court agreed with the IRS, permitting bonus deductions of $1.36 million in 2015 and $3.68 million in 2016.

Tax Tip: While an employer may deduct compensation paid for services performed in a prior year, the compensation must be reasonable in the eyes of the IRS. So research what would be considered reasonable compensation in your industry and pay yourself timely.

Keep Those Receipts! - Part 1

(Wolpert, TC Memo 2022-70, 7/7/22)

Facts: Julian Wolpert, a former university professor, provided consulting services focused on civic engagement. On his 2016 and 2017 tax returns, Wolpert reported vehicle expenses, travel expenses, and payments to independent contractors totaling $63,380 and $54,150, respectively.

The Tax Court upheld the IRS's decision to disallow $38,046 of expenses in 2016 and $34,188 in 2017 and the resulting additional income tax. For the vehicle expenses in question, Wolpert's travel logs lacked specificity and detail as to the purposes of each business use of the vehicles. With regards to the other disallowed expenses, Wolpert was unable to substantiate the amount and business purpose.

Tax Tip: You must have adequate substantiation for all business expenses reported on your tax return. Consider either a physical or digital filing system to store all receipts and documents as corroboration of reported business expenses.

Keep Those Receipts! - Part 2

(Gonzalez, TC Summary Opinion 2022-13, 7/18/22)

Facts: Maribel Gonzalez, a California resident, had a full-time job but also commuted 800 miles round-trip every other weekend for her clothing design business. For the year in question, Gonzalez reported car and truck expenses of $12,256, which the IRS disallowed.

The Tax Court sided with Gonzalez, as she was fully prepared with adequate evidence to support her vehicle deduction. Gonzalez submitted as evidence to the Tax Court a mileage log detailing the dates traveled, distances traveled, and the purpose of each trip. She also submitted vehicle service receipts corroborating the miles driven. Gonzalez also testified credibly to the business nature of her trips.

At trial, the taxpayer submitted a mileage log providing the dates traveled, distances traveled and the purpose of each trip. She also submitted service receipts corroborating the miles driven. In addition, she was a credible witness.

Tax Tip: This case illustrates how proper documentation can fend off an IRS overreach. Spending the time to accurately record information and gather documents as transactions or events occur may be tedious, but doing this can really pay off in the long run if the IRS challenges an otherwise valid business deduction.

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