The IRS is always challenging taxpayers on matters ranging from business expenses to legal settlements to unusual assets. Thousands of these disputes annually wind up in US Tax Court, an independent judicial authority created by Congress for taxpayers fighting IRS determinations. Whether the result is a taxpayer victory or defeat, court rulings often provide insight into matters that you may be dealing with and that could help reduce what you owe. Notable cases from 2021…
Deducting Business Expenses
Ronald Berry and his family, including his son, Andrew, owned Phoenix Construction & Remodeling, Inc., a California real estate developer and builder. The company purchased a 1968 Chevy Camaro racecar body, parts and engine for $121,903 so that Andrew could restore and race the car. Because the Camaro could be a way to advertise the family’s business, Berry deducted the car’s cost against the company’s income.
IRS position: The racecar was a hobby for personal gratification, and the business was not entitled to a deduction. Consequently, Phoenix Construction under-reported its income on its tax returns.
Tax court ruling: The IRS was correct. The $121,903 was not a legitimate business expense or eligible as a deduction. Section 162(a) of the US Tax Code gives business owners great leeway to deduct expenses paid or incurred in carrying on a trade or business as long as the expenses are “ordinary” (ones that commonly or frequently occur in the taxpayer’s business) or “necessary” (appropriate and helpful in carrying on the taxpayer’s business). But Berry failed to prove there was a proximate relationship between the Camaro expenses and the business operation. No logo or branding was visible in the photograph of the car presented at trial. Nor did Berry produce evidence that contacts at racing events had led to business for Phoenix. Also, the expenses for the car weren’t reported as advertising on the company’s tax returns but were “buried” among other construction expenses.
Lesson: Business owners often struggle to walk the tightrope between legitimate expenses and quasi-personal purchases. To claim a questionable expense as a deduction, be prepared to quantify to the IRS what value it added to your business…and maintain records to adequately substantiate the nature, amount and purpose of the expense.
Cash from a Settlement
When Carol Holliday got divorced in Texas, she retained a lawyer and negotiated an agreement to divide her marital property and assets with her ex-husband. She later had misgivings and sued her lawyer for breaching his fiduciary duties by improperly influencing her to sign the agreement for $74,864 less than she should have gotten and failing to file an appeal for her. The divorce lawyer settled out of court with her for $175,000. After paying her malpractice attorney’s fee, Holliday received a check for $101,500. She did not report it as income because she reasoned that property received in a divorce agreement is nontaxable, and the settlement money was compensation that she rightfully should have received from her divorce.
IRS Position: The malpractice settlement of $175,000 should have been reported on her income taxes as taxable income. The $73,500 fee for the malpractice attorney should have been listed as an itemized deduction.
Tax Court ruling: The IRS was correct. A deciding factor was that Holliday “did not allocate any of the settlement proceeds toward any particular claim or type of damages.” In other words, her settlement said she was being compensated for legal malpractice. If the settlement said the money was for the return of nontaxable lost capital from her divorce agreement, it’s likely that the $101,500 would have been excluded from taxes.
Lesson: Most legal settlements constitute taxable gross income. Even if they do not, the exact wording of the settlement is significant and can trigger taxation. Do not rely on your attorney for tax guidance or expertise before you sign off on a settlement. And consult a tax expert before initiating a lawsuit and before signing the settlement agreement.
What Are an Estate’s Assets Worth?
Pop singer Michael Jackson died in 2009, at age 50, leaving most of his estate to his mother and three children. On his estate’s tax returns, Jackson’s executors valued Jackson’s image and likeness at $2,105 (a figure they later raised to $3 million). The executors reasoned that Jackson’s reputation was in tatters after years of declining record sales, disastrous financial mismanagement, a lurid criminal court case and details about his drug use. When Jackson died, he hadn’t made a new album or toured for years and had received almost no revenue related to his image in the previous decade. The executors valued Jackson’s other two major assets at $2.2 million—his partial ownership of Sony/ATV Music Publishing whose catalog included the rights to 175 Beatles songs…and the Mijac music catalog which owned the rights to music that Jackson had written. The valuations for the music catalogs were very low, in part because Jackson had taken millions of dollars in loans against them to support his extravagant lifestyle.
IRS Position: The Jackson estate’s value was grossly underestimated by nearly a half-billion dollars. At the peak of his career, Michael Jackson was one of the most famous people on Earth, with some of the most popular records ever released. And since his death, he had become one of the world’s top-earning celebrities, with his estate taking in tens of millions of dollars annually. The IRS’s own expert valued Jackson’s image and likeness at $161.3 million and his catalog interests at $320.6 million.
Tax Court ruling: Michael Jackson’s estate prevailed over the IRS on several key issues. The court found that the estate overall was worth $111.5 million, four times less than the IRS claimed. It found Jackson’s name and likeness were worth $4.15 million, not the IRS figure of $161.3 million. The court noted that the IRS reached its valuations by including the potential revenue from future ventures. While many ventures came to fruition, unforeseeable events cannot be used to value an estate. Only the valuation at the time of death should be considered. In 2009, the Court noted, “Even a rational and undistressed hypothetical seller would have been hardpressed to avoid fire-sale prices.”
Lesson: Estate-tax cases can come down to disputes by each party’s experts over valuations. If you have high-profile or speculative assets in your estate—say, a piece of artwork, collectibles or a business—consider having valuations done regularly while you are alive to establish a viable track record in case the IRS challenges the item’s value after you die. If you fear that a high valuation on an estate asset will saddle your heirs with a large estate-tax bill, strategize ways to lower your estate’s value by gifting assets to your heirs and charities while you are still alive.