Taxpayer could not deduct personal and unsubstantiated expenses
Cottrell, TC Summary Opinion 2008-101
The Tax Court held that a taxpayer was not entitled to deduct various expenses because either the expenses were nondeductible in nature or not adequately substantiated. This case illustrates the consequences of a taxpayer who both goes overboard in trying to deduct every expense with even the slightest connection to a deductible purpose and loses out on deductions to which the taxpayer is legitimately entitled because of the taxpayer's inadequate record keeping.
Facts. In 2003 and 2004, the taxpayer worked full time as an automotive service supervisor for Maryland and part time for UPS as an aircraft loader at Baltimore Washington International Airport (BWI). He was a member of both a state employees union and a union in conjunction with the UPS job.
The taxpayer drove his personal vehicle from home to BWI when working for UPS. After finishing his shift with UPS, he drove straight to his job site for the state (four to five miles). He generally worked both jobs five days a week.
The state required the taxpayer to wear a uniform and provided two types of uniforms that he had professionally laundered. He also purchased rain gear, boots, thermal underwear, and other items to wear when he was loading aircraft for UPS. This clothing was general-purpose attire and could be worn at other places.
The taxpayer used his personal mobile phone on his state job because it got better reception. He discussed projects and orders on his phone and estimated that he used it for business purposes at least four to five times a day. He said he incurred extra charges for excess minutes used to place calls related to his state work.
The taxpayer bought tools and supplies in 2003 and 2004 to make improvements to his home. The items were not required for or related to either of his jobs.
In 2004, the taxpayer refinanced his personal residence. At the closing, he paid $1,068 in advance to the lender for six months of county property taxes, $540 in state mortgage recordation taxes, and $6,318 in points.
The taxpayer engaged a tax return preparer to prepare his income tax returns for 2003 and 2004. He gave the return preparer receipts to support expenses and a mileage log of his business-related driving. On the preparer's advice, the taxpayer, for the 2003 tax year, deducted expenses for: (1) tools and supplies he used for home improvements; (2) mobile phone charges; (3) work clothes worn at the UPS job; (4) uniform cleaning; (5) automobile mileage; (6) union dues; and (7) tax preparation. For the 2004 tax year, the taxpayer deducted these expenses, as well as expenses for (8) grooming and (9) mortgage refinancing.
In notices of deficiency for 2003 and 2004, for the items above, the IRS allowed an itemized deduction for only the dues paid to the state employees union.
The Tax Court pointed out that deductions are a matter of legislative grace, and the taxpayer bears the burden of proving entitlement to any claimed deduction. Furthermore, the Service's determination set forth in a deficiency notice is presumed correct, and the taxpayer bears the burden of showing that the determination is in error.
The court said that Section 162(a) allows a deduction for all ordinary and necessary business expenses incurred during a tax year in carrying on a trade or business (which generally includes performance of services by an employee). Reg. 1.6001-1(a) requires that the taxpayer maintain records sufficient to substantiate the amount of deductions
Vehicle expenses. The taxpayer deducted expenses for driving to, from, and between his two jobs. The court said that expenses relating to the use of an auto while commuting between the taxpayer's residence and place of employment are nondeductible personal expenses. It acknowledged, however, that expenses incurred between places of business may be deductible. Section 274(d) requires a taxpayer to substantiate:
(1) The amount of the vehicle expense.
(2) The time and place of the expense.
(3) The business purpose of the expense.
(4) The business relationship of the expense to the taxpayer.
Unfortunately for the taxpayer, the court said that he provided no evidence to support the expenses he incurred driving between his jobs. Although he claimed to have provided mileage logs to his return preparer, he did not introduce them or other records at trial to support the deductions. According to the court, he also failed to explain what appeared to be inflated claims for business mileage on his returns, beyond claiming that he occasionally returned to work for UPS after his state job. Although the court did accept that he drove between his two jobs, the court could not use the Cohan doctrine to estimate expenses covered by Section 274(d). (For a discussion of this doctrine and its applicability, see Schloemer, “Cohan Rule Still Secures Some Deductions Despite Statutory Limits,” 81 PTS 91 (August 2008).) Accordingly, the taxpayer was not entitled to a deduction for the business-use of his auto.
Union dues. The taxpayer claimed a deduction for union dues paid to two labor unions in 2003 and 2004. The court agreed with the IRS that the state union dues should be allowed, while the UPS union dues should be disallowed for lack of substantiation. Although the court was satisfied that the taxpayer did indeed pay dues to two unions, he introduced no evidence to augment his testimony as to the amount he paid in union dues while employed by UPS.
Uniform cleaning and UPS clothing. The taxpayer claimed business expense deductions for the costs of cleaning his state uniforms and purchasing clothing to keep warm and dry while working for UPS. The court said that costs to purchase and maintain work clothing may be deductible under Section 162 if the taxpayer established that:
(1) The clothing is required or essential in the taxpayer's employment.
(2) The clothing is not suitable for general or personal wear.
(3) The clothing is not so worn.
Although the taxpayer did satisfy the requirements for the deductibility of the uniform cleaning, the IRS disallowed the deduction for lack of substantiation. The court accepted the taxpayer's testimony that he paid to have the uniforms cleaned, and said that he was entitled to deductions for the cleaning. Because he did not provide any information as to the frequency or cost of his uniform cleaning, the court estimated his expenses and allowed $10 per week, or $500, for uniform cleaning for 2003 and 2004.
Although UPS required that the taxpayer wear clothing appropriate to the weather conditions at BWI, the clothing purchased by the taxpayer was also suitable for general wear. Because general-purpose clothing is considered a personal expense, the court ruled that the taxpayer was not entitled to a deduction for his UPS clothing.
Tools and supplies. The court said that the taxpayer was not entitled to deductions for tools and supplies he used for home improvements. Not only can taxpayers not deduct personal expenses under Section 262(a) , under Section 263, they cannot deduct capital expenditures, which include amounts paid for permanent improvements to increase the value of property.
Mobile telephone expenses. The taxpayer used his personal mobile phone to communicate business matters related to his state employment, and in 2003 and 2004, he deducted work-related mobile phone expenses. The court pointed out that unless substantiation rules are met, Section 274(d) disallows deductions for travel expenses, gifts, and meals and entertainment, as well as for “listed property,” which is defined in Section 280F(d)(4) to include mobile phones. The court said that the taxpayer failed to substantiate his work-related mobile phone expense, and thus was not entitled to a deduction for the business use of the phone.
Haircuts. The taxpayer claimed a deduction in 2004 for the cost of maintaining a haircut for his state job. The court stated that: “Grooming remains an inherently personal expense and is not deductible, regardless of whether an employer requires a particularly neat appearance.”
Tax preparation fees. The taxpayer's 2003 and 2004 returns were professionally prepared, and both reported a $100 tax return preparation fee. Although the taxpayer introduced no evidence proving he paid the fees, the court found it “unlikely that a paid preparer would list as a deduction an apparently reasonable fee for tax return preparation on a client's tax return and not collect that fee.” Therefore, it said the taxpayer was entitled to the deductions for the tax preparation fees.
“Settlement” taxes. The taxpayer's deduction for “settlement taxes” included $1,068 for county property taxes paid into escrow at closing and $540 for state recordation taxes paid in 2004. The court said that the taxpayer failed to demonstrate that taxes paid into escrow were actually paid to the county taxing authority in 2004 (as opposed to his paying funds in advance into the lender's property tax escrow account for the lender to pay later to the county on the taxpayer's behalf). Therefore, the court concluded that the taxpayer could not deduct the $1,068 in 2004.
The court pointed out that Section 164(a) allows a taxpayer to deduct only certain taxes, of which only two of the five categories were even potentially relevant in the present case: (1) state and local real property taxes and (2) state and local personal property taxes. The court said that the recordation tax was a fee charged for recording the taxpayer's new mortgage and was not a tax on a property interest. Therefore, the taxpayer was not entitled to deduct the $540 recordation tax.
Mortgage points. The taxpayer deducted the $6,318 in mortgage points paid when he refinanced the mortgage on his residence. The court pointed out that interest paid on home indebtedness is generally deductible under Section 163(h)(2)(D). Prepaid finance charges, to the extent such charges represent deferred interest on a loan, are generally deductible under Section 461(g) over the life of the loan. Points are considered prepaid interest.
Section 461(g) requires a cash-method taxpayer to amortize prepaid interest over the life of the loan. However, Section 461(g)(2) provides an exception that allows a taxpayer to deduct the payment of points if they were paid “in connection with the purchase or improvement of, and secured by, the principal residence of the taxpayer.” Points paid when a taxpayer refinances a personal residence to obtain a lower interest rate, are not “incurred in connection with the purchase or improvement” of the taxpayer's residence. Such points are not immediately deductible and must be amortized.
The court said that the taxpayer did not introduce any evidence to demonstrate that his refinancing was in connection with his purchasing or improving his home. Thus, he could not deduct the points entirely in 2004, but instead had to amortize the prepaid interest over the life of the 30-year loan, which produced a $211 annual deduction. Because the refinancing occurred at the beginning of December 2004, the court concluded that the taxpayer was entitled to deduct only $18 in 2004 for one month's amortization of prepaid interest.
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