Paul L. Caron

Monday, November 27, 2023

Lesson From The Tax Court:  Taxpayers Cannot Invoke The 'Augusta Rule' With Unplayable Lie

Camp (2021)In the past few years there have apparently been a lot of excited Tik Tok posts about how closely held businesses can use the “Augusta Rule” to get a double tax benefit: a deduction for the business under §162 and tax free income to the business owner under §280A(g).

In Kunjlata J. Jadhav and Jalandar Y. Jadhav v. Commissioner, T.C. Memo. 2023-140 (Nov. 21, 2023) (Judge Vasquez), the taxpayers get lured by the promise of tax free income under the August Rule into making what turned out to be an unplayable lie on their tax returns.  They did not get a mulligan.  They did get penalties.  The problem was these taxpayers were unable to show that the rental payments their S Corp made to them and their sons were “ordinary and necessary” under §162.  That requirement is not usually a difficult one to meet but when you are trying to play the system, it can be tricky to get through the rough and avoid the hazards to make the hole.

Details below the fold.

The Shape of the Course
To understand today’s Lesson, we need to look at the interplay of two statutes: §162 and §280A.

(1) Section 162It takes money to make money.  Generally Congress allows taxpayers to deduct the money it takes from the money they make.  That’s the idea in §162(a).  And it has deceptively simple language, allowing deductions for all “the ordinary and necessary expenses paid or incurred in carrying on a trade or business.”  At the same time, Congress forbids taxpayers from taking deductions for “personal, living, or family expenses.” §262(a).

So what is the test for whether a given expense is a business expense or a personal one?  The key here is to remember that the burden is on the taxpayer to show that any given expenses was “ordinary and necessary” to the business.  If it is not, it gets classified as a non-deductible personal expense.  That is what we learned way back in Welch v. Helvering, 290 U.S. 111 (1933).  So what is the test?  It’s a WTF!  Calm down.  “WTF” here stands for “Wobbly Table of Factors.”  That is because there is simply no bright line rule, as Justice Frankfurter lamented in this famous passage:

“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 115.

For more on the scope of this WTF test, see Classic Lesson From The Tax Court: Twitty Burgers!, TaxProf Blog (Apr. 2, 2018).

Sometimes, however, there are specific and recurring situations where taxpayers have to draw the line between business expenses and personal expenses.  One such recurring situation is where taxpayer use a residence partly for personal reasons but also rent it out.

That takes us to §280A.  Sure, it’s primarily a provision that denies deductions.  But buried within it is a lovely tax exclusion, called the Augusta Rule!  Justice Scalia was oblivious to this when he famously proclaimed that "Congress ... does not, one might say, hide elephants in mouseholes."  Whitman v. American Trucking Association, 531 U.S. 457, 468 (2001).  Yes, yes, they sometimes do.

Let’s look at this mousehole.\

(2) Section 280A and the Augusta RuleCongress enacted §280A in the Tax Reform Act of 1976, P.L. 94-455, 90 Stat. 1520, 1569, to address situations where personal use of a residence is mixed with business use.  The basic rule in §280A(c)(5) is that deductions associated with the business use may not exceed income from the business activity.  Thus, the effect of §280A is to deny taxpayers the ability to use net losses against other income in the current year.  However, §280A(c)(5)(flush language) permits the taxpayer to carryforward the unusable deductions into the next tax year and apply them, if possible, against the next year’s business activity income.

Section 280A does not apply, however, if the business activity is de minimis.  Section 280A(g) draws a bright-line de minimis rule at 14 days.  That is, if you rent your property out for 14 days or less during the year, §280A(g) says you may not take any deductions.  So sad!  But §280A(g) also says you also do not have to report the income.  So glad!

This hidden gem of an exclusion is called the Augusta Rule because it is widely believed that the exclusion was created either for the benefit of, or at the behest of, those who live near Augusta Golf Course.  So says this Forbes articleThis other commentator, however, suggests a broader rationale: “It didn't seem very sensible to require the inclusion of rental income for a short-term rental that was never intended to be treated as a business.”  (emphasis supplied) I welcome comments on that.

Whatever the true legislative history of the 1976 provision might be, taxpayers who run small businesses have tried to take advantage of the Augusta rule by being clever in how they structure their business.

The Trick Play
It is an ordinary and necessary expenses for a business to rent space to operate.  Hey, it’s right there in §162(a)(3) which explicitly permits deductions for “rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business...”

The trick play is for a small business owner to create a separate business entity (and make it a pass-through entity like a partnership or an S Corp) and then have the business entity rent space in the owner (or owners) home (or homes) for exactly 14 days of the year for a legitimate business purpose.  Done right, the small business takes a rental deduction under §162 (thus lowering its net profits) and the small business owner gets tax-free income.  In effect, the small business owner transforms taxable distributions or salary from the business into tax-free rental payments.

There are several hazards to this trick play, as one sees in Sinopoli v. Commissioner, T.C. Memo. 2023-105.  In that case three doctors formed a small business to run a Planet Fitness franchise.  At first they held occasional meetings in the hospital where they worked, or at a Planet Fitness location.  But then they attempted the trick play and suddenly they were meeting in each other homes very frequently and their business paid them rent (the business purportedly rented each of the three doctor’s home for 12 days a year).

Two hazards tripped them up.

First, to be ordinary and necessary the meetings need to be for legitimate purposes.  In Sinopoli, the doctors had inadequate records of the meetings and could not explain their purpose or frequency.

Second, even if the meetings have a legit purpose, the rental amount must be ordinary.  In Sinopoli, the doctors had researched the sq.ft. rate for hotel meeting spaces in their community and then applied that rate to each house and then rounded up to $3,000.  The IRS auditor used a similar approach, finding that hotel meeting spaces for up to 50 people were available for $500.  So the IRS allowed $500 for 12 meetings per year.  The Tax Court held that amount was generous.  The proper way to determine the proper rental amount, the Tax Court said, was to obtain a formal appraisal of the value of their homes as meeting spaces.  They did not do that.

In today’s Lesson we learn again how these hazards lead to busted scores. \

Mr. Jalandar Jadhav is an entrepreneur.  A Ph.D. chemist, he earned a large salary as an executive for Mobile Rosin Oil Co., Inc. (“For 100 years, we've been making green and sustainable pine chemicals for industry”).  He also operated a side business called KJ Marketing whose profits eventually dwarfed his salary.  That’s where he tried the trick play.

KJ Marketing was in the business of connecting chemical producers with potential customers and earned commissions on resulting sales.  Mr. Jadhav operated KJ Marketing as a family business, although reporting it as a sole proprietorship on Schedule C’s up until 2015.  And note the KJ initials match those of his spouse Ms. Kunjlata Jadhav.  As Judge Vasquez notes:

“For reasons not explained by the record, petitioners named petitioner wife, Kunjlata Jadhav, as the owner of K J Marketing on their tax returns. Petitioner wife, who did not testify at trial, worked as a substitute teacher until 2014.”  Op. at 3.

KJ Marketing was hugely successful.  On their 2014 Schedule C the Jadhavs reported gross receipts of $897k and net profits of $619k.

All that income meant a lot of tax.  Oh the travails of those who are successful!  In 2014, to minimize their tax exposure and provide for succession planning, the Jadhavs forked out $50k to a company apparently called Capital Protection Services, LLC (CPS).  I can find no trace of this company on the web.  While there are various companies called Capital Protection Services they are private security companies and none are LLCs.  And while there are similarly named companies providing wealth management services—such as the Capital Wealth Management, LLC, and Capital Protection Group—none are named Capital Protection Services.  So perhaps it no longer exists.  Or my search skills are lacking.

CPS provided the Jadhavs with a 183-page “Income Tax Plan.”  As relevant to today’s lesson the Plan told the Jadahavs to turn KJ Marketing into an S Corp. and then have it rent space in its owners or employees personal homes for meetings, to take advantage of the Augusta Rule.  That's the trick play.  It was especially attractive to the Jadhavs because of their sons.

The Jadhavs had two sons, Veerendra and Arjun, both of whom were treated as employees of KJ Marketing.  The sons helped their dad research potential connections while they were in college.  Veerendra attended the U. of Alabama, Birmingham, from 2006 to 2015. Arjun attended the U. of South Alabama, located in Mobile, from 2009 to 2015.

To support their sons in college, the Jadhavs bought a house for each of them to live in.  Don’t looked so surprised.  Rich parents do that all the time here in Lubbock for their Texas Tech students.  It’s cheaper that renting dorm rooms or off-campus student housing.  They buy a house and then rent out the extra bedrooms to cover most of mortgage and then resell the house when the kid graduates.

The Jadhavs appears to have followed this strategy.  In 2009 they bought a house in Birmingham for Veerendra.  They sold it in 2015.  In 2010 they bought a house in Mobile for Arjun.  They sold that in 2015 as well.

The Jadhavs themselves lived in a home in Daphne Alabama until 2014 when they moved into home they bought in Spring, Texas.

So in 2014 the Jadhavs owned four homes: three in Alabama (Birmingham, Mobile, Daphne) and one in TX (Spring).  The CPS plan assumed that the Daphne property had a per-day rental rate of $2,500 and that each of the other three properties had a per-day rental rate of $2,000.  But that was just an assumption the Plan used to illustrate the tax play.  The Plan also told the Jadhavs that the rental rates “should be supported by independent [comparables] within a 100 mile radius. CPS also suggested that petitioners retain a professional appraiser to value the rental rate every three years.”  Op. at 5.

Putting all this together yielded this restructuring as described by Judge Vasequez:

“In December 2014 petitioners organized KJJJ Marketing, Inc. (KJJJ), under the laws of Texas. Petitioners used KJJJ to conduct the business they had previously done as K J Marketing. Petitioner wife was the sole owner of KJJJ, which elected to be treated as an S corporation for income tax purposes. During 2015, 2016, and 2017, Veerendra and Arjun were employees of KJJJ.  Before [2014] petitioner husband used hotels and restaurants to conduct business meetings for K J Marketing. In 2014 petitioners moved those meetings to the Daphne, Birmingham, Mobile, and Spring Properties. After KJJJ’s incorporation, petitioners began charging rent to the S corporation for the use of those properties. Pursuant to the Plan, KJJJ rented each of their residential properties for a maximum of 14 days.”

The Jadhavs did the same for each of the tax years at issue, reporting that each of the homes they owned in that year were rented out exactly 14 times for either $2,500 or $2,000 per meeting.  KJJJ Marketing thus took deductions totally $119,000 for 2014, $91,000 for 2015, $35,000 for 2016, and $63,000 for 2016.  And, of course, the Jadhavs excluded all of those amounts from income, relying on the Augusta Rule.  A sweet $308,000 of tax free income!

On audit, the IRS disallowed the rental deductions—as well as made significant other adjustments to the various returns and asserted accuracy related penalties.  But our lesson for today concerns only the adjustments for the alleged rental payments.

Lesson:  Hogs Get Slaughtered
The Augusta Rule trick play can work ... if the taxpayer is not greedy.  But here, the Jadhavs got greedy.  As Judge Vasquez properly notes:

"In determining whether the payments in issue are deductible under section 162, the basic question is whether the payments were in fact rent and not something else disguised as rent. *** Only the portion of an expense that is reasonable qualifies for deduction under section 162(a). The reasonableness concept has particular significance in determining whether payments between related parties represent ordinary and necessary expenses.  Because petitioners wholly owned KJJJ, we must consider whether the rental arrangement between the two was reasonable. Having carefully reviewed the record, we find it more likely than not that KJJJ’s payments to petitioners were unreasonable and something other than rent.”

Notice that if these payments were not for rent, then the Augusta Rule would not apply and the Jadhavs would need to report the $308,000 as income.

The Jadhavs asked for a mulligan.  They asked the Court to use the Cohan rule to at least allow them some rent deduction rather than disallowing the entire rent deduction.  But Judge Vasquez properly rejected that request.

The Cohan rule permits the Tax Court to estimate an allowable expense when the taxpayer can show they incurred a ordinary and necessary expense but simply have failed to keep adequate receipts.  Taxpayers often think the Cohan rule is just about receipts.  It’s not.  An overlooked nuance of the rule is that the Tax Court won’t rescue a taxpayer who cannot show an entitlement to the claimed deduction in the first place.  I explain this nuance in Lesson From The Tax Court: The Structure Of Substantiation Requirements, TaxProf Blog (June 1, 2021).

Here, the Jadhavs’ problem was not a lack of receipts.  They had created a good paper trail of invoices to document the rental payments.  Their problem was a lack of entitlement.  The permitted deduction is for reasonable rents that are ordinary and necessary for the carrying on of a trade or business.  Judge Vasquez explained:  “Petitioners’ rental arrangement with KJJJ was another tax reduction strategy CPS had suggested in the Plan. In making that suggestion, CPS advised petitioners to use a reasonable rental rate supported by independent comparables. CPS also suggested that petitioners retain a professional appraiser to determine fair rental values for their properties. Petitioners did not follow that advice.”  Nope.  They got greedy.  In addition, while Judge Vasquez did not discuss this, I wonder what business reason there was to shift from meeting in restaurants and hotels to meeting in personal homes in four different cities in two states with a huge increase in rental payments.  That would seem to be a rather large factor in the Wobbly Table.

Bottom Line: The taxpayers here basically shanked themselves into an unplayable lie on their returns by failing to properly structure their attempt to swing the Augusta Rule.  [Note: my apology if the attempted puns don't work; I have never played golf.] 

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law where he would be glad to rent his home for $2,500 for any corporate meeting.  He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) to TaxProf Blog for another Lesson From The Tax Court.

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"Something other than rent," indeed. This is a favorite way for rich baby boomers in America to steal from the public. Gross, greedy, pigs.

Posted by: Cory Ellenson | Dec 9, 2023 7:17:58 PM

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