Lesson From The Tax Court: Substantiation Means More Than Receipts

It's the day after Labor Day.  So it's fitting for a post about a taxpayer who labored for a good cause only to learn that the Tax Code does not allow deductions for the cost of providing such labor unless linked to a trade or business.  Yes, this is a §162 travel-away-from home case.  Deductions claimed under §162 for business travel away from home most often get cut down by the buzz saw of the substantiation requirements in §274.  Today’s short lesson reminds us that substantiation means more than meeting §274’s demand for adequate receipts.  It requires meeting §162’s requirement for an adequate connection between those expenses and an identifiable trade or business.

While §162 is a pretty low bar, the taxpayer in George C. Luna v. Commissioner, T.C. Summ. Op. 2022-18 (Sept. 1, 2022) (Judge Carluzzo), was unable to meet it.  Sure, he had adequate receipts for his travel to Brazil.  But he could not connect them to the labor he did for a living, in Los Angeles.  He could connect them to his separate labor of studying the impact of social media on Brazilian children to help them deal with those impacts.  While laudable, however, that activity was not a trade or business.  Details below the fold.

Law
Today’s lesson is about §162(a), that workhorse deduction statute that gives broad authority for taxpayers to deduct the “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” 

As my students learn to their astonishment, almost all the words and phrases in §162(a) are terms of art.  Two of them are relevant for today’s lesson:  “ordinary” and “trade or business.”  Let’s take a look.

The Meaning of Ordinary.
Whether an expense is ordinary is basically in the eyes of the beholder.  And the gimlet eyes of the IRS tax examiner may not always see matters in the same way as the taxpayer.  The law gives preference to the gimlet eyes.

The leading case on what makes a expense “ordinary” within the meaning of §162 remains Welch v. Helvering, 290 U.S. 111 (1933).  Readers will recall that in that case Mr. Welch’s first business went bust and he was legally discharged from its debts.  But he wanted to continue working in the same line of business.  So he started a new business.  To reassure potential customers, he paid off the discharged debts from his first business, even though he had no legal obligation to do so.  He then deducted those repayments.

In ruling that the expenses were not ordinary, Justice Cardozo gave a really unhelpful formulation of the test, basically throwing up his hands and concluding: “One struggles in vain for any verbal formula that will supply a ready touchstone. The standard set up by the statute is not a rule of law; it is rather a way of life. Life in all its fullness must supply the answer to the riddle.” 290 U.S. at 114-115 (internal citations omitted).

When you put the Welch know-it-when-you-see-it test together with the presumption of correctness that a Notice of Deficiency enjoys, you quickly see that the law trusts the eyes of the tax examiner more than the eyes of the taxpayer.

Alert readers will note that while Mr. Welch was unable to deduct the repayments as an expense, at the tail end of the opinion the Court left open the possibility that the repayments might be treated as a capital expenditure and thus go into the basis of his second business.  Still, I think the dog in the case was the Court’s conclusion that “we should have to say that payment in such circumstances, instead of being ordinary, is in a high degree extraordinary. There is nothing ordinary in the stimulus evoking it, and none in the response.” Id. at 114.

The Meaning of Trade or Business.
What constitutes a trade or business has fluctuated over time.  The current standard for what constitutes a trade or business is found in Commissioner v. Groetzinger, 480 U.S. 23 (1987).  There, the Supreme Court defined the phrase in relation to the motivation of the taxpayer in engaging in the activity.  If the motivation was to make money, and if the taxpayer demonstrated by their actions that they were substantially engaged in really trying to make money, then the activity would be a trade or business.

Here’s how the Groetzinger Court put it: “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity, and that the taxpayer's primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify.”  480 U.S. at 35.

The Court thus explicitly rejected the prior idea that a trade or business must involve the public offering of goods or services.  The Tax Court had already knocked down that idea in Primuth v. Commissioner, 54 T.C. 374, 377 (1970), when it found that employees working for a single employer are engaged in a trade or business ... of being an employee.  Groetzinger kicked that idea out the door.  As a consequence, those who gamble for their living—whether at the horse track, the casino, or the stock market—are engaged in a trade or business for §162 purposes.

Facts
In 2015, the year at issue, Mr. Luna was involved in two organizations whose missions sought to make the world a better place.  He was doing good in the world.

First, he was the Executive Director of a California non-profit organization called the Center for Health Justice (CHJ).  It appears he still is.  As stated on its website, CHJ’s mission is to provide health education and services to those with a history of incarceration.  It is located in Los Angeles and its 2022-2024 strategic plan focuses on helping those in the Los Angeles community.  In 2015, CHJ’s Form 990 reported gross revenue of just over $700,000, two-thirds of which went for program staffing costs, including a modest $75,000 salary for Mr. Luna.

Second, he was also a board member of E.S.S.E. Mundo Digital (EMD), a Brazilian organization.  Op. at 2.  While I don’t read Portuguese, it appears from EMD’s Facebook and Instagram pages that it studies the impact of social media on Brazilian youth and attempts to be a resource for them to navigate social media.  This is Google’s translation of part of their Facebook page: “In the search for autonomy and their own identity, [children] face interesting and surprising opportunities [in the digital world], but also dangers and risks to health, safety, as well as ethical, legal and educational issues.”

Mr. Luna’s position on the EMD board apparently grew from a long-standing connection with Brazil.  Judge Carluzzo notes that Mr. Luna had regularly traveled to Rio de Janeiro twice per year since at least 1987.  The opinion is not clear whether the pre-2015 travel was solely for personal reasons or not, but implies so.  However, some of that travel also seems connected at least in part to Mr. Luna’s work as a consultant for the Pan American Health Organization.

On his 2015 tax return, Mr. Luna attempted to deduct $36,000 as miscellaneous itemized expenses, most of which were in connection with his two long trips to Brazil that year.  Since CHJ did not have a policy of reimbursing its employees for travel, those expenses could be eligible for deduction, as unreimbursed employee expenses. See Lesson From The Tax Court: Receipts Are Not Enough, TaxProf Blog (Sept. 21, 2020).

Folks, I don't know who Mr. Luna's tax advisor was, or even if he had one.  But taking a $36k itemized deduction on a return reporting some $75k in wages is not something I would advise unless the deduction was air-tight.  Those numbers just seem begging for a high DiF score!  At least that has long been the thinking  See e.g. Joel Newman, The Audit Lottery: Don't Ask, Don't Tell?, 40 Tax Notes 1438 (1988) (citing to the late mathematician Amir. D. Aczel’s book How to Beat the IRS at its Own Game where Dr. Aczel published the result of his study of almost 1,300 returns).  I am not familiar with any more recent analysis and would welcome any comments on that.

On audit, the gimlet eyes of the IRS did not see any connection between the Brazil trips and Mr. Luna’s work as Director of the Los Angeles non-profit.  Neither did Judge Carluzzo.  And that gives us the lesson.

Lesson:  Trips To Brazil Were Not Ordinary to The Los Angeles Trade or Business
In Tax Court, Mr. Luna had concrete evidence to prove the specific costs of his trips to Brazil.  Judge Carluzzo finds that “the evidence petitioner presented satisfies the substantiation requirements of the relevant portions of section 274 and its regulations.” Op. at 6.

But Mr. Luna had only the vaguest evidence of how those costs connected to his work as Director of CHJ through his testimony.  His basic pitch was that everything is connected!  So the contacts he made in Brazil would ultimately benefit CHJ.  Or at least they could.  Or might!  But he gave no concrete evidence to show how his trips to Brazil were actually helpful to his work in Los Angeles, which is where he earned his living.  Here’s now Judge Carluzzo describes the argument:  “As petitioner sees the matter, the contacts he makes, or has made, from his various travels and professional associations serve to advance the interests of CHJ. According to petitioner, “it helps [CHJ]. There’s no question about it.” As we see the matter, there are some questions about it.” Op. at 6. (emphasis supplied).

Remember, whether an expense is ordinary turns on the Judge’s understanding of the “mainsprings of human life.”  So it’s definitely bad news when the Judge does not share the vision of the taxpayer.  No deduction here for Mr. Luna.

Alert readers will note that Mr. Luna seemed focused on trying to relate his Brazil trips to his Los Angeles activity.  Might he have tried another approach?  I see two other possibilities for deducting the costs of the Brazil trips.  Both seem like losers.  I invite reader comments on each.

Comment 1: What About Schedule C?
Unlikely.  It is possible, but doubtful, that Mr. Luna could have filed a Schedule C for his activity of being on the board of directors for the Brazilian organization EMD.  Taxpayers can certainly be engaged in more than one trade or business.  And there is no reason why doing good could not be also a business.  After all, Mr. Luna was making his living from providing services to a non-profit.  See Primuth, supra.  But remember the Groetzinger definition of “trade or business” requires regular and substantial activity and the activity needs to be motivated by desire for profit, not a desire for a better world.  So while Mr. Luna may have foregone a more substantial salary by working for the California non-profit, he was still earning his living.  That was a trade or business.  In contrast, it is not even clear if Mr. Luna was compensated for his work on the EMD Board.  Even if he was, it still would not rise to the level of self-employment income if it was just “a sporadic activity.” Groetzinger, supra.  Perhaps if he was on multiple Boards for multiple charities and earning decent money he could make himself look more like Mr. Primuth, but not on these facts.

Comment 2: What About §170 Deduction?
Almost surely no.  First, Mr. Luna was providing services to EMD.  Those are not deductible.  Treas. Reg. 1.170A-1(g).  True, assuming the services were substantial enough to justify the trips, the cost of providing those services (the trips) might be deductible, at least if there was “no significant element of personal pleasure, recreation, or vacation in such travel.” §170(j).  But the big hurdle is §170(c).  EMD is almost certainly not a qualified charitable organization under §170(c).  It was not a U.S. organization.

If I’m missing something, feel free to fill in.  That's what the comments are for. 

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return to TaxProf Blog each Monday (or Tuesday if Monday is a federal holiday) for another more-or-less-useful Lesson From The Tax Court.