In Michael K. Simpson and Cynthia R. Simpson v. Commissioner, T.C. Memo. 2020-100 (July 7, 2020) (Judge Buch) the hapless taxpayers — devotee’s of Stephen Covey’s 7 Habits of Highly Effective People — not only failed to separate personal from business expenses, they also confused entity returns and personal returns. The case is an object lesson on the importance of taxpayers properly accounting for business expenses and personal expenses. Careful accounting is probably the #1 Habit of Highly Successful Taxpayers. Details below the fold.
Background: The Taxpayer Temptation
The structure of deductions tempts taxpayers to account for unreimbursed employee expenses by creating fake entities.
I call it the rule of 62s: Section 262 prohibits deductions for personal expenses. Section 162 permits deductions for expenses sufficiently related to a trade or business. And Section 62 tells you whether allowable deductions go above or below the line. Sure, there are lots of nuances and finer lines drawn by other statutes. But these three are really all we need for today’s lesson: the need for proper accounting.
Taxpayers must first properly account for which expenses go into the §162 bucket of business-related expenses and which go into the §262 bucket of disallowed personal expenses.
Taxpayers must then properly account for the expenses in the §162 bucket. That is where §62 comes in. Section §62 lists those deductions taxpayers can subtract from gross income (GI) to determine adjusted gross income (AGI). We call those above-the-line deductions because they are accounted for literally above the AGI line on the relevant Form 1040.
Section 62 allows most §162 business expenses to be taken above the line with one big exception: unreimbursed employee expenses. I have to explain this to my students and you might have to explain it to your clients. Here’s one way to do that.
Being an employee is itself a trade or business and thus the ordinary and necessary expenses of being an employee have long been allowed under §162. See Primuth v. Commissioner, 54 T.C. 374 (1970). Section 62(a)(1) says §162 deductions are generally to be taken above the line but not if those deductions relate to “the performance of services by the taxpayer as an employee.” However, §62(a)(2) then creates an exception to the exception. It allows employees to take a deduction allowed by §162 above the line if they have been reimbursed for the expense “under a reimbursement or other expense allowance arrangement with [their] employer.”
The reason for that exception to the exception is because the reimbursement itself is gross income. That is why the regulations say that if the employee’s expense is reimbursed under an accountable plan, the employee does not have to report any income or deduction to the extent the reimbursement is a wash. Treas. Reg. 1.162-17.
But because unreimbursed employee expenses are not listed in §62, one must look for authority elsewhere to see where one can deduct them. That would be §63.
Section 63 allows taxpayers to determine taxable income (TI) by subtracting from AGI either a set amount (the standard deduction) or by adding together eligible deductions that the taxpayer was not able to take from gross income because they were not listed in §62(a). We call those “itemized deductions.”
Section 67 then divides itemized deductions into two groups: those subject to a 2% floor and those not. Those that are subject to the 2% floor are called “miscellaneous itemized deductions” and §67(b) says those are all deductions except the ones specifically listed in §67(b). So if the deduction is listed in §67(b) it is an itemized deduction but not a “miscellaneous itemized deduction.” If you read §67(b) you will nowhere find listed expenses relating to “the performance of services by the taxpayer as an employee.”
In sum, one accounts for properly allowable deductions as follows:
Bucket 1: Above-The-Line Deductions, listed in §62(a).
Bucket 2: Itemized Deductions, taken below the line. Those are deductions not listed in §62 but instead listed in §67(b).
Bucket 3: Miscellaneous Itemized Deductions, taken below the line, subject to a 2% floor in years a taxpayer may deduct them, but totally disallowed by §67(g) for tax years 2018-2025.
Unreimbursed employee expenses always fall in Bucket 3. Even in normal times that creates an incentive to try and move those expenses into Bucket’s 1 or 2. One method taxpayers use is to stuff employee deductions into a businesses return, so taxpayers can claim the expenses are NOT related to “the performance of services by the taxpayer as an employee.”
That is what happened in today’s case. Let’s take a look.
Facts of the Case
The years at issue were 2012, 2013, and 2014. During these years Mr. Simpson was employed by Franklin Covey to provide coaching and speaking services. Ms. Simpson was employed by a small non-profit private school called Ivy Hall Academy to provide teaching and administrative services. As explained in this video, Ivy Hall’s teaching philosophy and curriculum are closely tied to Stephen Covey’s 7-Habits philosophy.
During the years at issue the Simpsons also owned two entities. First they owned a corporation named Simpson Executive Coaching. Incorporated in 2008, it appears to have been created as a personal service corporation. It’s current website lists Mr. Simpson’s impressive accomplishments and offers his services at the click of a mouse.
The other entity is a Utah limited liability company named e-BACS. I have no clue what e-BACS stands for, and equally little idea of the reason to create the company. The Tax Court opinion says the company owned a website that promoted Simpson Executive Coaching. However, the current website is copyrighted by Simpson Executive Coaching itself. Mr. Simpson testified at trial that e-BACS was also created “to increase enrollment at, and drive revenue for, Ivy Hall.” Mr. Simpson further testified that any revenue e-BACS received was based on enrollment at Ivy Hall. I am going to guess there was commission income for enrollment referrals since e-BACS claimed expenses for travel on behalf of Ivy Hall. But I saw nothing in the record that directly supports my guess.
The Simpsons were---and still are---heavily involved in Ivy Hall, far beyond Ms. Simpson’s employment. Three of their four children attended the school during the years at issue. The Simpsons donated land to the school in 2013. They and another couple currently comprise the School’s entire Board of Directors. According to Ms. Simpson’s web bio: “[b]eginning in 2013, she also planned, organized, and directed Ivy Hall Student World Study experiences in Italy, Peru, and China and American Study experiences in Washington D.C., Philadelphia, New York City, and Boston.” That activity also seems to have involved lots of travel, with Mr. Simpson accompanying Ms. Simpson on trips to D.C. and Italy, presumably in 2013. Op. at 7.
The Simpsons filed joint returns for 2012, 2013, and 2014. Each return claimed between $15,000 and $23,000 of §162 deductions for unreimbursed partnership expenses related to e-BACS. In addition, the 2014 return claimed a total of $62,000 §162 deductions below the line (on Schedule A) for unreimbursed employee expenses. Ms. Simpson’s share was $17,300 for vehicle, travel, meals, entertainment and $4,200 for miscellaneous school supplies. Mr. Simpson’s share was $40,500 for vehicle, travel, meals, and entertainment.
e-BACS filed partnership returns for 2012, 2013, and 2014. On each, unsurprisingly, e-BACS reported substantially more deductions than income. In fact it reported zero income in 2014 but over $24,000 in deductions.
Simpson Executive Coaching filed no return for 2012 and filed corporate tax returns for 2013 and 2014. It is not clear how much business Mr. Simpson did through the corporation. Judge Buch notes that the corporate returns show little more than one payment of $100 to Mr. Simpson as wages.
The IRS audited the Simpsons’ 2012, 2013, and 2014 returns and issued an NOD. The Simpsons petitioned the Tax Court. The parties engaged in discovery and when the dust of mutual concessions had settled what was left for Judge Buch to decide was whether the Simpsons were entitled to the partnership expense deductions for 2012, 2013, and 2014, and the employee expenses deductions for 2014.
It turns out that the Simpsons did not have the #1 Habit of Highly Effective Taxpayers, First, they failed to properly separate personal from business expenses. Second, they failed to properly account for their business expenses on the proper form.
Lesson 1: Being Personally Invested Does Not Create §162 Deductions
At trial both Mr. and Ms. Simpson testified that they viewed their Ivy Hall involvement as an investment. They said they eventually hoped to “take this over so we can run it the way we think it needs to be run in order to make some money.” That profit-seeking talk, however, was not matched by profit-seeking action. Judge Buch notes that during the years at issue Ivy Hall remained a non-profit entity and there was no evidence that either Mr. or Ms. Simpson held any ownership interest in Ivy Hall, either directly or through e-BACS. Besides, e-BACS apparently showed losses for all three years.
Instead, Judge Buch found that e-BACS was a booster entity. His finding of fact was that e-BACS’ purpose was “to support Ivy Hall.” That meant it “was not engaged in a trade or business for the purpose of section 162 because its primary purpose was to support Ivy Hall, a nonprofit school.” Op. at 13.
That meant that all of Mr. and Ms. Simpson’s expenses were personal. It makes me wonder whether some of these expenses might have qualified for a §170 deduction. Certainly they were aware of that possibility because they took a charitable deduction for the donation of land to the school in 2013. But their attempted deductions for the school trips travel to Italy and Washington D.C. were pretty clearly purely personal, as was the deduction Mr. Simpson sought for taking his son to a football game...in Atlanta.
Lesson 2: You Cannot Deduct Another Taxpayer’s Expenses
The other major accounting problem the Simpsons encountered was an inability to keep their entities straight. Judge Buch writes “The Simpsons do not get to choose to whom deductions belong.” Their choices to create separate taxable entities created a duty to properly account for who was incurring what expense.
Thus, the unreimbursed employee expenses Mr. Simpson sought to deduct on the couple’s 2014 return were more properly accountable as expenses of his corporation, Simpson Executive Coaching. Writes Judge Buch: “We need not decide whether those expenses are bona fide business expenses, because even if they are...they are not deductible on the Simpsons’ personal return.” Since the Simpsons had chosen to run Mr. Simpson’s coaching activity through a separately created corporation, Judge Buch held them to that choice: “Mr. Simpson is not entitled to benefit from conducting his activities through a corporation and then benefit again from deducting the expenses of the corporation as an individual.”
Similarly, the Simpsons asked the Court to let them re-characterize Ms. Simpson’s disallowed partnership expense deductions as unreimbursed employee expenses on behalf of Ivy Hall. But, again, Judge Buch held the Simpsons to their initial accounting choices. They had chosen to create e-BACS and run their boosterism activity through that entity. They were stuck with that.
Overall, Judge Buch was pretty frustrated by the Simpsons’ failure to properly account for their expenses, both in mixing personal and business and in creating a confusing set of entities. He writes:
“The record shows the lack of distinction among partnership, corporate, individual business, and individual personal expenditures made by the Simpsons. One of the reimbursement forms contains both e-BACS and Simpson Executive Coaching in the title. This form states that expenses are for e-BACS (as the client) and that Mr. Simpson (as president of Simpson Executive Coaching) is the employee seeking reimbursement. It is not clear what entity incurred the expenses, for what business purpose, or whether the expenses were ever paid or reimbursed by another of the Simpsons’ entities. Personal expenses are also mixed in. We do not find credible, for example, that Mr. Simpson’s travel with Mrs. Simpson and their children on school trips or Mr. Simpson’s taking his son to a football game in Atlanta was incurred on behalf of any business, rather than for personal benefit.”
Coda 1: The Simpson’s abject accounting failure did not result in a total loss for them. That is because winning is sometimes not about being better but is about not being worse. Here, the NOD missed some issues, notably the Simpsons’ huge $62,000 deduction for unreimbursed employee expenses in 2014. The IRS Chief Counsel attorney raised the issue after the Petition was filed, but that meant the IRS had the burden of proof on the issue. Normally, that is not such a big deal in cases like this one because, as Judge Buch explains, the IRS can satisfy its burden by establishing the taxpayer’s failure to substantiate. Chief Counsel did that properly for most of the new matters. However, here “[a]t trial, the Commissioner did not ask whether Mrs. Simpson could produce substantiation for [meal and entertainment] expenses....” So the Court allowed Ms. Simpson her claimed deductions for meals, entertainment, and was able to substantiate about $4,000 in miscellaneous expenses.
Coda 2: This opinion from Judge Buch is a new style. It puts all the cites in footnotes rather than the text. That is different from other opinions. I cannot tell if this format represents a change, either by the Court or by Judge Buch. I personally prefer cites in the text because I compulsively read each footnote. That means, for me, each footnote is a “full stop” that requires me to stop reading the text. I fight with Law Reviews about this all the time because their student editors confuse adding footnotes with adding value.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites you to visit TaxProf Blog each Monday morning for a new Lesson From The Tax Court.