Lesson From The Tax Court: Do The Right Thing

The protests dominating events recently have reminded me of Spike Lee’s classic film “Do The Right Thing.”  It’s a movie that explores how individual decisions that seem “right” from viewpoints blindered by race and class create seemingly inescapable conflicts.  It makes you question your perspective about “the right thing.”

I offer two recent Tax Court as a cautionary lesson that I hope makes tax professionals question their perspective about the right thing to do in tax return preparation and advice.  It’s not about race or class.  It’s about being blindered by client needs and client relationships, both on the part of taxpayers and the IRS.  Both cases show taxpayers, tax professionals, and the IRS all not doing the right thing.  In Enrique Aguilar v. Commissioner, T.C. Summ. Op. 2020-16 (May 26, 2020) (Judge Gerber), the tax professional created a fictional Schedule C.  In Thomas M. McCarthy v. Commissioner, T.C. Memo. 2020-74 (June 3, 2020) (Judge Thornton), the tax professional improperly claimed mortgage deductions on Schedule A.  Details below the fold.

These cases involve several basic tax concepts.  I will first give a quick review of above-the-line and below-the-line distinction and then review the relevant rules for employee expenses and for mortgages.  I expect most readers will just skip this part to the fun stuff about the cases.  But if you are trying to educate someone — a client, say — about doing the right thing, you may find the following very basic explanations useful.

The Law: Above-The-Line and Below-The-Line Deductions
Here’s how I introduce the concept to students.

Broadly speaking, deductions permitted by the Tax Code are either subtracted from gross income to help determine Adjusted Gross Income (AGI), or else are subtracted from AGI to help determine Taxable Income (TI).  We call that first group “above-the-line” deductions because they come before the AGI line on a return.  The second group we call “below-the-line” deductions because they come after the AGI line (literally, below it on the return).  Early in the semester I have students look at various Forms 1040 and “find the line.”  I have fun giving them Roosevelt’s 1934 return because there really was no “line” back then, since AGI was not the same concept it is today. 

Section 62 is what I call the traffic cop statute: it tells taxpayers which deductions go above the line.  It does not itself authorize any deduction, but if a deduction is listed in §62 the taxpayer can take it above the line.  All other deductions go below the line.

Section 67 creates a special restriction for some of those below-the-line deductions.  The disfavored deductions are called miscellaneous itemized deductions.  For tax years before 2018, that restriction was that a taxpayer could deduct miscellaneous itemized deductions only to the extent they exceeded 2% of the taxpayer’s AGI.  For tax years 2018 through 2025 it is much worse: §67(g) completely disallows miscellaneous itemized deductions.  That bites.

Section 67(b) tells you which below-the-line deductions are not the disfavored miscellaneous itemized deductions.  Thus, if a deduction is listed in §67(b) it is not subject to the further restrictions.

Below-the-line deductions are better than a sharp stick or a root canal, but not by much.

First, below-the-line deductions fight with the standard deduction.  That is, §63 makes taxpayers choose to either take the standard deduction or specifically itemize all their below-the-line deductions.  To the extent that one’s below-the-line deductions do not exceed the standard deduction they are as useless as taking a bucket of sand to the beach.

Second, the §162 deductions for ordinary and necessary expenses in carrying on the trade or business of being an employee are even more limited.  That is because they are defined as “miscellaneous itemized expenses” by §67(b) and §67(a) allows a deduction only to the extent that the miscellaneous itemized deductions exceed 2% of the AGI.  For tax years between 2018 and 2025, §67(g) disallows all miscellaneous itemized deductions.

The Law: Reimbursed vs. Unreimbursed Employee Expenses
When an employee travels on behalf of the employer and incurs expenses, those travel expenses are deductible under §162.  How an employee deducts those expenses, however, depends on whether the employer reimburses the employee (either by requiring receipts or using a reasonable per-diem).

Unreimbursed Expenses: Section 62(a)(1) says that for most taxpayers, §162 deductions may be taken from gross income as part of the calculation But §62(a)(1) says that’s not the right thing to do “if such trade or business does not consist of the performance of services by the taxpayer as an employee.”  Whatta stinger!  So the unreimbursed expenses become miscellaneous itemized expenses.  Bummer. 

Reimbursed Expenses: Congress is nicer to employees who are properly reimbursed by their employer for expenses incurred as part of their job.  That is because the reimbursement, standing alone, looks like gross income.  Only when you pair it with the expenses do you see that it does not really increase the employee’s wealth.  That is why §62(a)(2) says that employees who get properly reimbursed can deduct their expenses above the line, washing out the “income” represented by the reimbursement. 

It gets better.  Treas. Reg. 162-17(b)(1) has long provided that if the reimbursements match the expenses, then the taxpayer does not even have to report either one.  Nor must the employer report such reimbursements on the W-2.  See IRS General Instructions for Form W-2 and W-3 (2020) at p. 9.

The Law: Mortgage Interest
Generally, §163(h)(1) disallows individuals a deduction for personal interest.  However, if a taxpayer pays interest on a mortgage that was used to buy the taxpayer’s principal residence (or one other residence identified by the taxpayer) and if the mortgage is secured by the residence, then §163(h)(3) permits the deduction as “qualified residence interest.”  While the deduction is a below-the-line deduction (because it is not listed in §62), it is at least not a miscellaneous itemized deduction (because it IS listed in §67(b)).  Taxpayers report it on Schedule A.

If a taxpayer rents out a residence for the entire year, then the interest paid on that property’s mortgage is deductible under §163(a) and, thanks to §62(a)(4), the taxpayer can take the deduction above the line, using Schedule E.

Renting out a residence, however, is deemed to be a passive activity and so triggers the passive activity loss rules of §469(c)(2).  That means any losses from the rental cannot be used to reduce what is called active income, such as compensation income (salary).  The big exception for middle class folks is the $25,000 exception in §469(i).  That subsection allows folks whose AGI is less that $100,000 to use up to $25,000 of Passive Activity Losses (PALs) to reduce active income.  This tax benefit is phased out and becomes totally lost when AGI exceeds $150,000.

The passive activity loss rules mean that while mortgage interest deduction can go above the line, it won’t help the taxpayer in the current year if the rental activity losses cannot be taken against some income. 

Aguilar: Creating Fake Schedule C Is Not Doing The Right Thing
In 2015 Mr. Aguilar was a highly-paid manager for Crevier BMW.  His job involved extensive travel.  Crevier reimbursed him $40,345 for his travel costs in 2015.  Since the reimbursement matched the expenses, it was an above-the-line wash.  Apparently, however, Mr. Aguilar also had some other employee expenses that were not reimbursed by Crevier.  Those would go below the line as miscellaneous itemized deductions, unless they were connected to some business activity outside of his employment with Crevier.

His tax return preparer, one Mr. Contract (I am not making that up), decided to help him by creating a fake Schedule C.  Writes Judge Gerber: “Mr. Contract created this facade by reporting $40,345 on Schedule C as both income and expenses, resulting in a wash.”  Mr. Contract then stuck in a bunch of other alleged §162 deductions to come up with a net business loss of over $22,000 that he used to set off part of Mr. Aguilar’s $140,000 salary. 

Apparently Mr. Contract’s narrow view of doing the right thing prompted him to try and kick below-the-line miscellaneous itemized expenses to above the line using Schedule C.  He also put just over $11,000 as miscellaneous itemized deductions on Schedule A.  Perhaps he thought he was being careful so that if the Schedule C expenses were disallowed his client would get the Schedule A expenses.

In a weird way, the scheme worked.  That is because the IRS examiner was also blindered.  The IRS examiner’s narrow view of doing the right thing meant disallowing all the $40,345 in travel expenses claimed on Schedule C (because they were incurred for his employer) but leaving the entire $40,435 reimbursement on the Schedule C as income — perhaps attempting to hoist Mr. Aguilar by his own petard.  As to the remaining $22,000 of Schedule C expenses, the examiner allowed about $12,000.

It was not until after the trial of the case that the IRS apparently recognized that the Schedule C was entirely fake.  Mr. Aguliar simply had no trade or business in 2015 other than being an employee.  But that revelation came after trial and conflicted with the NOD’s allowance of some $12,000 of claimed Schedule C deductions.  And at trial the parties had stipulated that Mr. Aguliar could substantiate those $12,000 of expenses.

So Judge Gerber did the right thing.  He saw that the Schedule C was a sham but that the IRS had nonetheless allowed some deductions on the fake Schedule C.  The amount was just about the same as the amount it had disallowed on the Schedule A.  Judge Gerber concluded Mr. Aguliar did have some unreimbursed employee expenses in the amount the IRS had allowed on the Schedule C.  So Judge Gerber exercised his §6214(a) power to “redetermine” the deficiency by throwing out the entire Schedule C while ruling that “petitioner is entitled to $12,060 in employee expenses as a Schedule A itemized deduction, subject to any statutory computational limitations.”

McCarthy: Mis-Allocating Mortgage Expenses is Not Doing The Right Thing
Mr. McCarthy is a CPA and has an MBA.  His good friend was John Rogers, also a CPA and a practicing tax attorney in Hermosa Beach, California.  As often happens they their friendship was mixed with business.  Mr. McCarthy used to live in Hermosa Beach and rented a residence from Mr. Rogers.  In 2005 Mr. McCarthy moved to New York City and bought a condo.  He still palled around with Mr. Rogers and visited California regularly, staying in the Hermosa Beach residence, where he apparently had his own space with its own entrance.  It appears they made some arrangement in 2010 to give Mr. McCarthy an equity interest in the Hermosa Beach residence.  In 2014 Mr. McCarthy lost his job in NYC and found other employment in Minnesota where he moved in with his parents.

In 2015, the tax year in issue, Mr. McCarthy lived the entire year in Minnesota.  He had not sold his NYC condo, but instead rented it out for the entire year.  He paid over $18,700 in mortgage interest on the NYC condo.  His rental income, however, did not cover even his non-mortgage expenses.  Even without deducting the mortgage interest, he was going to have passive activity losses on the rental of about $13,000.  Further, he apparently earned too much money to qualify for any §469(i) $25,000 benefit, so he was going to have to put all the PALs in his pocket and carry them forward into later tax years.  Meanwhile, Mr. Rogers rented out the Hermosa Beach residence to his niece, receiving $96,000 in rents from her in 2015.

Mr. Rogers prepared his friend’s 2015 tax return.  Since taking the NYC condo mortgage interest on Schedule E would do Mr. McCarthy little good (it would only increase his unusable PALs) Mr. Rogers decided the right thing to do for his friend was to put the mortgage interest on Schedule A.  Mr. McCarthy also put an additional $30,000 in mortgage interest deductions on Schedule A, saying it was payment on a “seller financed note” created when Mr. Rogers sold a partial interest in the Hermosa Beach residence to Mr. McCarthy for $600,000 in 2010.   Apparently, Mr. McCarthy had taken that deduction for some years without getting caught. 

But now he got caught.  On audit, the IRS disallowed both Schedule A deductions.  It moved the $18,700 interest deduction over to Schedule E.  It disallowed the $30,000 interest deduction for lack of substantiation.

In Tax Court Mr. McCarthy argued that he was entitled to take both deductions on Schedule A.  Judge Thornton said that was not the right thing to do.

As to the $18,700 interest paid on the NYC condo, Judge Thornton rejected Mr. McCarthy’s strained argument that the condo was still his principal residence even though he had rented it out for every day in 2015.  Judge Thornton noted Mr. McCarthy gave no evidence that he had tried to sell the condo in 2015 or that he retained any connection with NYC after he moved to Minnesota in 2014. 

As to the $30,000 of purported interest on the Hermosa Beach residence, Mr. McCarthy had Mr. Rogers come testify in Court.  It did not help.  They also offered some dubious photocopies of doubtful provenance as evidence.  Judge Thornton found it exceedingly odd that two highly educated financial professionals failed to retain any reliable contemporaneous documentation of the transactions they claimed to have engaged in.  Judge Thornton found it “anomalous that neither petition (a C.P.A. and an M.B.A.) nor Mr. Rogers (a lawyers and a C.P.A.), both parties to the purported conveyance, would be more attentive to the recordkeeping of documents purporting to convey a valuable property interest in the Hermosa Beach property.” 

More importantly, even if they had reliable documentation of an actual loan, Mr. McCarthy gave zero evidence that the debt was secured by the residence.  Without being secured by the residence, a debt cannot generate qualified residence interest.  §163(h)(3)(B)(i). 

In short, Judge Thornton found that Mr. Rogers did not do the right thing: “Mr. Rogers’ execution of the promissory note was simply a device to effect petitioner’s preconceived plan to create an artificial tax benefit by means of a paper liability without substance.” 

The silver lining for Mr. McCarthy here was that the IRS messed up the penalty documentation and so he escaped having any penalty asserted on top of the deficiency. 

Conclusion
Tax professionals are constantly tempted by personal and business relations to think that doing the right thing means maximizing tax benefits and minimizing tax liabilities, without much regard for the rules.  Today’s cases show a better view:  doing the right thing means keeping clients in compliance with the rules.  Trite, yes, but still true.  Sure, sometimes it is difficult to discern what is the right thing to do because the rules may be unclear or the IRS may take an unreasonably crabbed view of the law.  That was not the situation in either of today’s cases, however. 

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law