In Anna M. Armstrong v. Commissioner, T.C. Sum. Op. 2020-26 (Sept. 17, 2020), Judge Panuthos teaches that substantiation does not just mean showing the amount of an expense; it means showing entitlement to deduct that expense. It's an exemplary lesson in substantiation, including a review of the Cohan doctrine, and of the home office deduction. Along the way, we learn just how tax practitioners can give value to their clients: teach them that receipts are not enough.
At first glance, this case might seem unimportant because it concerns below-the-line miscellaneous itemized deductions for unreimbursed employee expenses. Section 67(g) totally disallows those types of deductions for tax years 2018-2025.
But I think this opinion is worth your time.
First, COVID. Congress might actually re-authorize the deduction of unreimbursed employee expenses for tax year 2020 as part of the next COVID relief bill. I do not have any inside knowledge on this, but some in Congress might view reviving unreimbursed employee expense deductions as a benefit to taxpayers forced to work from home during COVID shutdowns. Others might believe that Congress gave enough relief in the Economic Impact Payments. And this tax benefit is one that invites conflict and, hence, litigation. Regardless of what Congress does, those taxpayers who are independent contractors continue to qualify for a home office deduction and this opinion teaches how to substantiate that use. I give a couple of COVID thoughts at the end of the post.
Second, Judge Panuthos gives a wonderfully compact, lucid explanation of what taxpayers and their representatives need to know about substantiation. I repeatedly tell my students that when you want to understand the law, find a good trial court opinion that explains it. This is one of those opinions. It’s a great teaching case.
Finally, some readers might find current utility from these lessons because 2017 and possibly 2016 are still open years. Besides, taxpayers frequently stumble over the substantiation rules, especially for establishing a home office, whether or not they are taking deductions above or below the line. For all those reasons I invite you to continue reading....
Law: In General “Employee Expenses” Must be “Unreimbursed.”
Taxpayers who are employees may deduct expenses they incur on behalf of their employer when those expenses are both (1) allowed and (2) unreimbursed.
First to be allowed, an expense must first meet the requirements of §162 by being ordinary and necessary for the carrying on of the taxpayer’s trade or business. If the expense thus allowed by §162 is also “of a type generally considered to constitute entertainment, amusement, or recreation” then deduction is now disallowed by §274(a).
Employees qualify for §162 deductions because being an employee is an employee’s trade or business. Just because an employee’s services are provided to, or on behalf of, a single employer does not alter the fact that the employee is engaged in an activity for profit. Primuth v. Commissioner, 54 T.C. 374 (1970) (employee accounting executive allowed to deduct job search expenses in switching employers).
Second, to qualify as an unreimbursed expenses it is not enough that the taxpayer was in fact not reimbursed by the employer. To be unreimbursed means that the employer must not offer the taxpayer the opportunity to be reimbursed. If an employee could be reimbursed for an expense but chooses not to, the employee had better have a darned good business reason for not taking the reimbursement. Otherwise, courts will hold that the choice to remain unreimbursed is a personal choice and, hence, a deduction will be disallowed by §262. See Heidt v. Commissioner, 274 F.2d 25 (7th Cir. 1959).
Law: Car Expenses
One common employee expense is the use of the employee’s personal car for work purposes. Such use might either be deductible business travel or a non-deductible commute. Rev. Rul. 99-7 gives a very useful typology keyed to whether the taxpayer (1) has a regular office outside the home; (2) has a home office; or (3) has no office at all! For more detailed lessons about commuting v. travel away from home, see (1) Lesson From The Tax Court: Where Is a Retirees Tax Home? TaxProf Blog (June 18, 2018); (2) Lesson From The Tax Court: How a New Work Location Becomes a Tax Home, TaxProf Blog (July 29, 2019).
The main point for today’s lesson is that if one has an office outside the home, the Rev. Rul. says travel from one’s home to a different work location in the same metropolitan area is also a non-deductible commute. This is true even though it is well settled that travel between two business locations in the same city is deductible travel. See Daniel-Berhe v. Commissioner, T.C. Summ. Op. 2013-33 (2013) (collecting authorities). For example, an attorney who goes to the office and then to the courthouse can deduct the travel expense between the office and the courthouse, but cannot deduct travel directly between home and the courthouse. At least that’s what Rev. Rul. 99-7 says.
It’s one thing to incur an expense. It’s quite another to prove it. As the Tax Court never tires of reminding us, taxpayer bear the burden to prove up their claimed deductions. [Insert your favorite cite here]. If the taxpayer establishes that they actually incurred a deductible expense, but cannot prove the specific amounts, the Tax Court will guesstimate for them, so long as the taxpayer gives the Tax Court some reasonable basis to make the guess. We call that the Cohan rule. You can find out why in Lesson From The Tax Court: Substantiation and the Cohan Rule, TaxProf Blog (Oct. 30, 2017).
Section 274(d) jacks up the substantiation rules for certain types of expenses, notably travel expenses (including meals) and any expenses related to “listed property,” which §280F(d)(4) defines to include cars and “any property of a type generally used for purposes of entertainment [or] recreation.” Section 274(d) overrides the Cohan rule for those expenses.
Under §274, taxpayers must not only prove the amount, but also prove the reason. It’s that last requirement that snags taxpayers. It’s not enough to keep receipts. The regulations require taxpayers to create contemporaneous records (e.g. diary, log, statement, trip sheets, or a similar records) that show the time, place, and business purpose of the expense. That is on top of keeping receipts or other “documentary evidence” of the amount. You can find the details in Temp. Treas. Reg. 1.274-5T(b), (c). Those are very difficult requirements for most taxpayers. It’s hard enough to keep receipts. It’s really hard to find time in our hectic lives either to document every reason we do something, whether immediately or on a daily or even weekly basis.
Law: Home Office
Deductions for working from home center around the concept of a home office. That is, §280A(a) disallows all deductions “with respect to the use of” a taxpayer’s residence. However, §280A(c) removes that barrier if the taxpayer uses a portion of the home “exclusively and on a regular basis” for any one of three purposes: (1) as the taxpayer’s principal place of business; (2) as “a” place of business where the taxpayer meets with patients, clients, or customers to whom the taxpayer provides services; or (3) in any way reasonably connected with the taxpayer’s trade or business if and only if the physical area so used is an outbuilding, “a separate structure which is not attached to the dwelling unit.” For an example of that last idea, see Walker v. Commissioner, 101 T.C. 537 (1993)(self-employed logger’s separate shed exclusively used to store and maintain logging equipment qualified as home office).
In Commissioner v. Soliman, 506 U.S. 168 (1993), the Supreme Court created a pretty narrow two-part test for whether a taxpayer’s home was a “principal place of business”: (1) the work done at home had to be more important than work done elsewhere and (2) time spent in working at home had to be more than working outside the home. There, an anesthesiologist did all his administrative worked from home because none of the hospitals where he performed services gave him office space. While he won in Tax Court and the Court of Appeals, the Supreme Court decided that his services in the hospitals were more important and he spent more time in those places.
In the Tax Reform Act of 1997, 111 Stat. 788, 881, Congress reversed Soliman’s specific result by amended §280A(c) so that a “principal place of business” can include “administrative or management activities” if there is no other office available. Otherwise, Soliman remains the test.
For today’s lesson, check out §280A(c)’s flush language, which provides that an employee can also use any of those three tests to establish a home office, but “only if the exclusive use referred to in the preceding sentence is for the convenience of [the] employer.”
The tax year at issue is 2015. That year Ms. Armstrong was employed by Ace Relocation Systems (“Ace”), a global moving and storage company, at its office in Long Beach, California, a city part of the Los Angeles metropolitan statistical area.
Ms. Armstrong appears to have been employed to sell her company’s services to prospective clients. During the days in 2015 Ms. Armstrong worked in the Ace office or else traveled to offsite client meetings or trade shows or conferences to represent the company. During evenings and on weekends, Ms. Armstrong worked at home, using a “nook” in her kitchen. There she worked on client contracts and “other sales-related activities.”
Ms. Armstrong traveled a lot for her employer. She used her own car. Ace paid her a flat monthly car allowance of $500 and she was not eligible for further reimbursement on the car. However, Ace also allowed employees to be reimbursed for other employee expenses as long as the reimbursements were claimed within 90 days of the expense.
On her 2015 return, Ms. Armstrong claimed a deduction for just over $20,000 in unreimbursed employee expenses. She got there by adding up: (1) $8,000 for use of her car for travel; (2) $1,700 for parking, tolls, and non-car transportation; and (3) $16,800 for undifferentiated “business expenses.” Then she subtracted the $6,000 worth of monthly car allowances.
The IRS disallowed all three of these categories. The Tax Court sustained. Each category teaches a lesson.
Lesson 1: Substantiating Travel Expenses
Ms. Armstrong was unable to meet the §274(d) substantiation rules for her claimed travel expenses. She showed Judge Panuthos “records of her client contracts for each year on which she added handwritten notes estimating the miles driven to and from each client site. It is unclear whether the handwritten notes were created contemporaneously with petitioner’s work trips or were added later to the documents in order to estimate her total mileage driven for the year.” Op. at 4. Based on those records Ms. Armstrong testified that she drove 11,520 miles from her home to Ace’s Long Beach office and 1,477 miles between either that office and another work location or between her home and another work location. She could not break it down any further.
Judge Panuthos was very sympathetic, finding that the taxpayer was credible and that he had “no doubt that she traveled significant distances for sales meetings with clients.” But even though what she provided would have given the Court a reasonable basis to guesstimate under the Cohan rule, it fell far short of the §274(d) rules because the records did not “detail specific dates or times of travel, the names of events or meetings attended, or the departure and arrival locations for each trip.” Op. at 4.
Lesson 2: Substantiating Parking, Toll and Repairs
Again, Ms. Armstrong was unable to meet the §274(d) substantiation rules here, but for a different reason. Here, at least, she had contemporaneous receipts showing the amounts she actually paid for parking, tolls, and other non-car transportation costs (I assume Uber or taxi or similar expenses).
It’s not enough to have receipts. While Ms. Armstrong had the necessary “documentation” to satisfy the regulations, what she lacked was the contemporaneous records that tied those amounts to her work for Ace. The parking could have been for anything---a concert or a client meeting—and she had nothing to prove up the connection between these expenses and her work.
Lesson 3: Substantiating Non-Travel Expenses, Including Home Office
The largest group of claimed expenses was $16,800, some of which Ms. Armstrong attributed to the business use of her home and some of which she claimed regardless of the business use of her home. Most of these expenses were not subject to the §274(d) substantiation rules. But the requirement to substantiate still exists. That means the taxpayer must still prove the business reason for the claimed expenses.
Looking at each group in turn reinforces the lesson: it's not enough to have receipts.
Ms. Armstrong had receipts for various expenses related to her use of her kitchen “nook” as a home office. It was not enough. Note she could not show that she used the nook for client meetings, much less those that were “substantial or integral to the conduct of the taxpayer’s business.” Prop. Treas. Reg. 1.280A-2(c). Note also that because the kitchen nook is not a separate building, the outbuilding exception in §280A(c) does not apply. So her only hope was to show that the kitchen nook was her principal place of business. You are already shaking your head in sorrow. But let’s look at the bright spots first.
First, the kitchen nook needed to be the right kind of space. Generally, the proposed regulations require that a home office must be “a room or other separately identifiable space; it is not necessary that the portion be marked off by a a permanent partition.” So a kitchen nook is not immediately disqualified so long as “there is not use of that [space] at any time during the taxable year other than for business purposes.” Prop. Treas. Reg. 1.280A-2(g)(1). It appears that Judge Panuthos generously accepted that the nook met this requirement.
Second, recall that Ms. Armstrong is an employee and must not only prove exclusive use but also must show that “the exclusive use...is for the convenience of [the] employer.” §280A(c) flush language. That basically means she has to show her employer required it. Ms. Armstrong testified that Ace would not permit her to stay in the office after 5 pm each day but it still required her to get her work done. Again, Judge Panuthos appears to have accepted this testimony as meeting the “convenience of the employer” test for employees.
However, Ms. Armstrong was still unable to substantiate the relative amount of time she spent working at home vs. working at the office or attending business meetings. And “on the basis of petitioner’s testimony the Court views client sales meetings as the most important business activity petitioner conducted in her work.” So she failed the Soliman tests and none of the expenses attributable to her use of her kitchen nook were deductible.
Other Employee Expenses
Ms. Armstrong presented receipts for many other expenses that were not connected to her business use of the home: cell phone and internet services; clothing; personal grooming; client meals. But receipts were not enough. Judge Panuthos found that some of these expenses were inherently personal (grooming, cosmetics, e.g.) and that others were not unreimbursed (client meals e.g.) because Ms. Armstrong was entitled to reimbursement from Ace and could not explain a business reason for not claiming reimbursement.
As for the cell phone and internet, Judge Panuthos really wanted to help Ms. Armstrong by using the Cohan rule, but he was unable to do that because she could not give him any basis for allocating what amounts of the total cell phone and internet bills were for work and what amounts were for personal use (the cell phone plan was in Ms. Armstrong’s daughter’s name, for example).
Bottom line: Ms. Armstrong had receipts but could not substantiate an entitlement to deduction.
COVID Coda 1: The proposed regulations under 280A (proposed in 1988, modified in 1994 and apparently untouched since, don't ask me why) make a point that meetings with clients must be in person and that “conversations....by telephone” don’t count. How quaint! Well, 32 years later we now have Zoom meetings. I would be happy to make an argument that those meetings should count as much as in-person meetings for §280A(c)(1)(B) purposes. Readers might also find some useful guidance in this 1999 Chief Counsel Advisory on deductions for flexiplace.
COVID Coda 2: For self-employed taxpayers affected by COVID stay-home orders, the availability of alternative office space outside the home may become an important factor, even though the Supreme Court rejected it as a factor in Soliman, supra. The Court did think it might be a factor when evaluating whether business use of the home by an employee was due to the convenience of the employer but said “it has no bearing on the inquiry whether a home office is the principal place of business.” COVID may change that. Local or state stay-home orders are quite like an employer saying “stay home.” They are different than a self-employed person choosing to work from home rather than rent an office.
Bryan Camp can substantiate that he is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return every Monday for another Lesson From The Tax Court.