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Chancellor v. Commissioner (T.C. Memo. 2021-50)

On May 4, 2021, the Tax Court issued a Memorandum Opinion in the case of Chancellor v. Commissioner (T.C. Memo. 2021-50). The primary issue presented in Chancellor was whether the IRS erred in disallowing deductions the petitioner claimed for certain business expenses, charitable contributions, and state and local tax.

Brief Background

Ms. Viola Chancellor, of Nevada, is a notary and a paralegal.  In 2015, she received $400 from her duties as such.  She reported a whopping $252 in tax due, determined on the basis of a $40,000 pension, itemized deductions of $14,000, and a business loss of $19,000.  These latter two categories caused a bit of a disagreement between the petitioner and the IRS.

The Deductions

The petitioner claimed deductions for, inter alia, charitable contributions of $6,000 in cash contributions and $500 in noncash contributions, as well as a state and local tax deduction of $4,500.

The “Business” Losses

The petitioner reported business income of $400 and expenses of $19,250. In particular she reported the following expenses: advertising ($80), car and truck ($12,600), insurance ($1,030), legal and professional services ($700), supplies ($120), deductible meals and entertainment ($1,480), utilities ($920), and other ($2,320).

The Disallowance and Deficiency

The IRS, setting a deep purple bruise atop her gentle ego, disallowed the petitioner’s deductions for charitable contributions and state and local tax. The IRS further had the nerve to disallow all of the petitioner’s claimed business expense deductions, on the ground that the petitioner had not, technically, “established” that the expenses were ordinary and necessary to her business or, for that matter, that such expenses were even, actually paid during the taxable year. The IRS subsequently sent Ms. Viola Chancellor a timely notice of deficiency for her 2015 tax year.

Though she did not want to ruffle any administrative feathers, or raise a veritable kerfuffle, Ms. Viola Chancellor politely petitioned the Tax Court to redetermine her deficiency.

The Recordkeeping Requirement

When deductions are in dispute, the taxpayer must satisfy the specific requirements for any deduction claimed. See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). Likewise, a taxpayer is required to maintain records sufficient to substantiate items underlying her claimed deductions. See IRC § 6001; Treas. Reg. § 1.6001-1(a); see also Treas. Reg. § 1.6001-1(e) (observing that a taxpayer is obligated to maintain such books or records for “so long as the contents thereof may become material in the administration of any internal revenue law”). The failure to keep and present accurate records weighs heavily against the taxpayer’s burden of proof. See Rogers v. Commissioner, T.C. Memo. 2014-141, *17.

If a taxpayer’s records are lost or destroyed through circumstances beyond her control, she may substantiate expenses through reasonable reconstruction. See Boyd v. Commissioner, 122 T.C. 305, 320 (2004); Treas. Reg. § 1.274-5T(c)(5). Although the inability to produce a record which is unintentionally lost, whether by the taxpayer or by a third party, “alters the type of evidence which may be offered to establish a fact,” it does not ultimately affect the burden of proving said fact. Malinowski v. Commissioner, 71 T.C. 1120, 1125 (1979); see also Tax Court Rule 143. If a reconstruction is necessary, it is crucial that the secondary evidence be credible. See, e.g., Boyd, 122 T.C. at 320. If no other documentation is available, the Tax Court may (read: it doesn’t have to if it doesn’t want to) accept credible testimony of a taxpayer to substantiate an expense. Id.

Substantiation of Charitable Contributions

IRC § 170(a)(1) allows as a deduction any contribution made within the taxable year to an organization described in IRC § 170(c), i.e., a charitable donee. Such deductions are allowable if and only if the taxpayer satisfies statutory and regulatory substantiation requirements. See IRC § 170(a)(1); Treas. Reg. § 1.170A-13; see also Ayissi-Etoh v. Commissioner, T.C. Memo. 2018-107, *11.

The nature of the required substantiation depends on the type and size of the contribution. For contributions of cash, check, or other monetary gift, a donor must maintain a bank record or a written communication from the donee showing the name of the donee organization, the date of the contribution, and the amount of the contribution (e.g., a canceled check or receipt from the donee charitable organization). IRC § 170(f)(17). Otherwise, a donor must maintain reliable written records showing the name of the donee, the date of the contribution, and the amount of the contribution. Treas. Reg. § 1.170A-13(a); see also Hershberger v. Commissioner, T.C. Memo. 2014-63, *9.

The petitioner claimed a charitable contribution deduction of $6,000 in cash contributions and $500 in expenditures incident to volunteer work for her church. For an allowable deduction in either regard, she must have maintained reliable records indicating the donee organization as well as the value and date of the contribution. See IRC § 170(f)(17); Van Dusen v. Commissioner, 136 T.C. 515, 531 (2011). Treas. Reg. § 1.170A-13(a) supplies the substantiation rules for expenditures incident to charitable work.

The petitioner failed to substantiate either.

Given the failure to substantiate either the cash contributions or the volunteer expenditures as required by IRC § 170(f)(17) and Treas. Reg. § 1.170A-13(a), the Tax Court found that the petitioner was not entitled to the charitable contribution deduction claimed on her 2015 tax return.

State and Local Tax

IRC § 164 provides the rules under which taxpayers choosing to use itemized deductions may deduct certain taxes. See also Figures v. Commissioner, T.C. Memo. 2012-296, *11. Specifically, IRC § 164(a)(3) allows a deduction for state and local income taxes paid during the taxable year. IRC § 164(b)(5)(A) permits a taxpayer to elect to deduct state and local general sales taxes in lieu of state and local income taxes. If a taxpayer deducts the amount of sales tax paid, she is required to produce substantiation. Figures, T.C. Memo. 2012-296, at *11-*12. Alternatively, the IRS (as a matter of administrative convenience) permits taxpayers to calculate the amount of the deduction by using the guidelines that the IRS publishes in the Optional State and Certain Local Sales Tax Tables. Id. at *12; see also IRC § 164(b)(5)(H).

The petitioner failed to substantiate the actual amount of sales tax paid. Nonetheless, the IRS conceded that she was entitled to a deduction for general sales tax based on the optional sales tax tables.  Therefore, the Tax Court allowed a deduction to that extent. See Beaubrun v. Commissioner, T.C. Memo. 2015-217, *12-*13; see also Figures, T.C. Memo. 2012-296, at *11-*12.

Business Expense Deductions

Now we get to the rather stickier of the two wickets in Ms. Viola Chancellor’s case.

Although IRC § 162 permits a taxpayer to deduct all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, a taxpayer’s general statement that expenses were paid in pursuit of a trade or business is wholly insufficient to establish that the expenses had a reasonably direct relationship to any such trade or business. Sham v. Commissioner, T.C. Memo. 2020-119, *58. This is because personal expenses are generally not allowed as deductions.  See IRC § 262(a). The taxpayer bears the burden of substantiating expenses underlying her claimed deductions. See Tax Court Rule 142(a); Treas. Reg. § 1.6001-1(a), (e).

IRC § 274(d) establishes even higher substantiation requirements for expenses related to travel, meals, and lodging while away from home, entertainment, gifts, and “listed property” (a term defined in IRC § 280F(d)(4) to include passenger automobiles and computers). IRC § 274(d) provides that no deduction or credit under IRC § 162 or IRC § 212 shall be allowed with respect to these particular expenses unless the taxpayer substantiates the amount, time and place, business purpose, and business relationship to the taxpayer of the person receiving the benefit for each expenditure by adequate records or sufficient evidence corroborating his own statements. See also Treas. Reg. § 1.274-5T(a), (b), and (c).

In the absence of books, records, doodles, cave paintings, or other substantiation, the Tax Court may estimate the allowable deduction, but only upon a showing by the taxpayer that she paid or incurred a deductible expense and lacks evidence to establish the precise amount. Cohan v. Commissioner, 39 F.2d 540, 543-44 (2d Cir. 1930). Nevertheless, the taxpayer (at the very least) must present some iota, some shred, some mere peppercorn of basis for such estimate. Vanicek v. Commissioner, 85 T.C. 731, 742-43 (1985). In making an estimate under the Cohan Rule, the Tax Court bears heavily upon the taxpayer whose “inexactitude is of his own making.” Cohan, 39 F.2d at 544. The Cohan Rule does not apply to expenses covered by IRC § 274(d); therefore, the Tax Court may not estimate expenses related to travel, meals, and lodging while away from home, entertainment, gifts, and other “listed property.” See Sanford v. Commissioner, 50 T.C. 823, 827-28 (1968), aff’d per curiam, 412 F.2d 201 (2d Cir. 1969).

Meals and Entertainment Expenses

Simply producing receipts or even a handwritten calendar or ledger with no explanations regarding the business purpose of reported meals or the taxpayer’s business relationship to the taxpayer’s dining companions is insufficient under IRC § 274(d). See Alexander v. Commissioner, T.C. Memo. 2016-214, *20-*21 (concluding that); see also Weiderman v. Commissioner, T.C. Memo. 2020-109, *36-*37; DeLima v. Commissioner, T.C. Memo. 2012-291, *27. “Vague and general testimony” about the meals, likewise, is insufficient to establish a connection between a taxpayer’s expenditures and her business. See, e.g., Sham, T.C. Memo. 2020-119, at *58.

Application of the Cohan Rule

As noted above, in order for the Tax Court to apply the Cohan Rule, the taxpayer first must establish that she is entitled to some deduction. See Norgaard v. Commissioner, 939 F.2d 874, 879 (9th Cir. 1991), aff’g in part, rev’g in part T.C. Memo. 1989-390.  Second, the taxpayer must provide some basis for such an estimate. See Vanicek, 85 T.C. at 742-43.

If a taxpayer alleges that her records were lost, and such loss was through no fault of her own, she must reasonably reconstruct the missing records through contacts with third parties and/or other reasonable means. See Gizzi v. Commissioner, 65 T.C. 342, 346 (1975).  For example, the Tax Court will not apply the Cohan Rule when the taxpayer documents were destroyed by wind, hail, sleet, snow, hellfire, brimstone, raining sulfur, etc., if the taxpayer fails to make efforts to reconstruct the records. Harlan v. Commissioner, T.C. Memo. 1995-309, *3, aff’d in part, rev’d in part on other grounds, 103 F.3d 138 (9th Cir. 1996).

(T.C. Memo. 2021-50) Chancellor v. Commissioner

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