On May 5, 2021, the Tax Court issued a Memorandum Opinion in the case of Berry v. Commissioner (T.C. Memo. 2021-52). The primary issues presented in Berry v. Commissioner were whether certain amounts characterized as gross receipts of a company should actually be other income to the petitioners, whether the company is entitled to deduct racecar expenses, and whether or not the petitioners substantiated COGS or a depreciation deduction under IRC § 167(a).

Background to Berry v. Commissioner

You may remember our friends, the Berrys, from Berry v. Commissioner, T.C. Memo. 2021-42.  As you will recall, in 2013, Ronald Berry and his son, Andrew, owned and operated Phoenix Construction & Remodeling, Inc., which built houses and developed real estate.  Andrew, however, was a racecar driver at heart.  He wanted to go fast.  In 2014 and 2015 he earned $8,700 and $1,200, respectively, from winning drag racing tournaments. He assigned these winnings to Phoenix. For the years in issue Phoenix paid expenses related to Andrew’s race car driving.

The notice of deficiency for 2014 included adjustments pursuant to the examination of Phoenix’s 2014 return. In the notice respondent determined that petitioners underreported their Schedule E income from Phoenix. Respondent disallowed petitioners’ claimed IRC § 179 deduction and cost of goods sold for building permits.  In the notice of deficiency for 2015, the IRS disallowed an $8,000 depreciation expense.

Deductions, Generally

Deductions, as we have noted time and again, are a matter of legislative grace, and a taxpayer must prove his or her entitlement to a deduction. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). A taxpayer claiming a deduction on a Federal income tax return must demonstrate that the deduction is allowable pursuant to a statutory provision and must further substantiate that the expense to which the deduction relates has been paid or incurred. IRC § 6001; Hradesky v. Commissioner, 65 T.C. 87, 89-90 (1975), aff’d per curiam, 540 F.2d 821 (5th Cir. 1976).

Tax Court Jurisdiction for Redetermining S Corporation Deficiencies

Generally, an S corporation shareholder determines his or her tax liability by taking into account a pro rata share of the S corporation’s income, losses, deductions, and credits. IRC § 1366(a)(1). Where a notice of deficiency includes adjustments for S corporation items with other items unrelated to the S corporation, the Tax Court has jurisdiction to determine the correctness of all related adjustments. See Winter v. Commissioner, 135 T.C. 238 (2010).

Gross Receipts

A taxpayer may not determine the nature of his or her income merely by using a particular form, or by labeling it as he wishes. Walker v. Commissioner, 101 T.C. 537, 544 (1993). Instead, the taxpayer must report his income “according to the economic realities of the situation.” Frank Lyon Co. v. United States, 435 U.S. 561 (1978).

The petitioners contend that Andrew’s race car winnings should be included in Phoenix’s gross receipts. However, the “evidence” failed to show that car racing was part of Phoenix’s business. As turning left at high rates of speed (over and over again) is not technically related to construction, the Tax Court sustained the IRS’s decision to recharacterize the racing income as other income of the petitioners for 2014 and 2015.

Race Car Expenses

IRC § 162 permits taxpayers to deduct all ordinary and necessary business expenses paid or incurred during the taxable year. An ordinary expense is one that commonly or frequently occurs in the taxpayer’s business. Deputy v. du Pont, 308 U.S. 488, 495 (1940). A necessary expense is one that is appropriate and helpful in carrying on the taxpayer’s business. Commissioner v. Heininger, 320 U.S. 467, 471 (1943); Treas. Reg. § 1.162-1(a). Once again, the petitioners failed to show the connection between turning left and Phoenix’s construction business.

Phoenix’s IRC § 179 Deduction

IRC § 179 (Election to Expense Certain Depreciable Business Assets) provides that a taxpayer may elect to treat the cost of any IRC § 179 property as an expense that is not chargeable to a capital account. If a taxpayer makes this election, the cost is allowed as a deduction for the taxable year in which the IRC § 179 property is placed in service. IRC § 179(a). IRC § 179 property includes tangible property that is IRC § 1245 (Gain from Dispositions of Certain Depreciable Property) property, which is required for use in the active conduct of a trade or business. IRC § 179(d)(1)(B).

As with any deduction, an IRC § 179 deduction requires that a taxpayer must maintain records reflecting how and from whom the IRC § 179 property was acquired, as well as when the property was “placed in service.” Treas. Reg. § 1.179-5(a). Thus, although Phoenix properly elected to treat a utility trailer as IRC § 179 property, the company utterly failed to substantiate the IRC § 179 deduction.  Indeed, the only evidence that the petitioners presented was Andrew’s testimony that the trailer was purchased to store materials at a remote jobsite. The IRS, however, presented actual evidence that, in 2018, Andrew had listed the trailer for sale as one used to transport race cars.

Costs of Goods Sold (COGS)

Cost of goods sold (COGS) is an offset, not a deduction. Metra Chem Corp. v. Commissioner, 88 T.C. 654, 661 (1987). COGS are subtracted from gross receipts in determining gross income.  Treas. Reg. § 1.61-3(a); Treas. Reg. § 1.61-6(a). Amounts claimed as cost of goods sold must be substantiated, and taxpayers are required to maintain records sufficient for this purpose. IRC § 6001; Nunn v. Commissioner, T.C. Memo. 2002-250, *16; Treas. Reg. § 1.6001-1(a).

Depreciation Deductions

If property is used in a trade or business or held for the production of income, the Code permits a taxpayer to take depreciation deduction for the reasonable exhaustion, wear, and tear of that property. IRC § 167(a). An IRC § 167 deduction, like any deduction, requires substantiation. To substantiate entitlement to a depreciation deduction, a taxpayer must establish the property’s depreciable basis by showing the cost of the property, its useful life, and the previously allowable depreciation. Cluck v. Commissioner, 105 T.C. 324, 337 (1995) (holding that depreciation deductions “cock-a-doodle-do” need to be substantiated). In addition, a claimed deduction with respect to any “listed property,” a category including “any passenger automobile”, is subject to the heightened substantiation requirements under IRC § 274(d)(4). See IRC § 280F(d)(4) (defining “listed property”).

The petitioners failed to provide any shred of information even remotely resembling evidence of the cost of the truck, when it was placed in service, the business percentage use of the vehicle, and the previously allowed depreciation. Accordingly, the Tax Court made quick work of sustaining the IRS’s disallowance of the depreciation deduction for 2015.

(T.C. Memo. 2021-52) Berry v. Commissioner

Add to favorites