The Tax Court in Brief – March 7th, 2022 – March 11th, 2022

Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.

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Tax Litigation:  The Week of March 7, 2022, through March 11, 2022

Sherwin Community Painters Inc. v. Comm’r, T.C. Memo. 2022-19 | March 9, 2022 | Goeke, J. |

Dkt. Nos. 4113-19, 4647-19 (Consolidated with Ward v. Comm’r)

Short Summary: The IRS determined separate tax deficiencies against the company (Sherwin) and its individual owners, the Robert and Swanette Ward. Issues presented to the court were (1) whether Sherwin was entitled to certain business expense deductions for office equipment and, among other things, the expense of paying for a non-employee’s (i.e., Ward’s daughter’s boyfriend) tuition for a coding course since he helped with Sherwin’s website; and (2) whether Swanette Ward received constructive dividends from Sherwin by virtue of the IRS recharacterizing a loan from Ward to Sherwin as a disallowed business expense deductions.

Primary Holdings:

  • Yes, Sherwin was entitled to certain business expense deductions, but not the tuition payment. The boyfriend was not an employee and Sherwin had no expectation of a return benefit and thus did not have a business purpose for the payment. And, no, Swanette did not receive a constructive dividend as the records showed that the loan in issue was made from Swanette to Sherwin, and Sherwin’s failure to properly substantiate the business purpose of disallowed deductions did not render the loan a constructive dividend to Ward.

Key Points of Law:

  • IR.C. section 162(a) contains the general rule for allowing a deduction for ordinary and necessary expenses incurred in carrying on any trade or business, including a reasonable allowance for compensation for personal services.
  • As used in section 162, the term “ordinary” means that the expense is normal, usual, or customary in the taxpayer’s trade or business. The term “necessary” means the expense is appropriate or helpful in carrying on the trade or business. The expenses must proximately relate to the taxpayer’s trade or business. All of these are determined by the facts of the case.
  • A constructive dividend arises when a corporation confers an economic benefit on a shareholder without an expectation of repayment where the corporation has current or accumulated earnings and profits. Constructive dividends are includible in the shareholder’s gross income under section 61(a)(7). Where a claimed business expense of a company is disallowed, the amount may be considered a constructive dividend to a shareholder where the shareholder receives an economic benefit from the amount of the disallowed expenses.

Insights: Under Section 162(a), a deductible business expense must be “ordinary” (i.e., normal, usual, or customary in the particular trade or business) and “necessary” (i.e., the expense is appropriate or helpful in carrying on that trade or business). When a company pays for a non-employee’s tuition to learn a trade that may help the business likely does not constitute a deductible business expense under Section 162, especially where that person is the boyfriend of the owners’ daughter and there is no agreement or enforceable expectation for a return benefit him. The IRS may disallow certain business expense deductions and, in the process, classify those amounts as constructive (and taxable) dividends to the benefitting shareholder when the shareholder receives an economic benefit from the expense.

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