On September 3, 2020, the Tax Court issued a Memorandum Opinion in the case of Franklin v. Commissioner (T.C. Memo. 2020-127). The primary issues before the court in Franklin v. Commissioner were whether the petitioner was entitled to meal, entertainment, and travel expense deductions and whether the petitioner was entitled to deduct certain business losses.
Creating Substantiation in Franklin v. Commissioner
The petitioner was in the real estate investment consulting business, which appears to be a fancy way of saying he told rich people what to buy. The petitioner and timely filed his Form 1040 for 2014. After receiving notice of the IRS was examining his 2014 return, the petitioner created three travel logs to substantiate his travel expenses.
The first travel log was created immediately after he received notice of examination of his 2014 return and was submitted with the petition. This first travel log was an incomplete record of his travel expenses and was created in large part from memory. He subsequently created a second travel log based on his credit card statements, bank account statements, and receipts for 2014, and he submitted this second travel log with accompanying receipts to Appeals after he filed the petition.
None of the travel logs, however, explained in any detail the connection between the expenses listed and the petitioner’s business. The petitioner also created a meal log that he submitted to Appeals after filing his petition. Once again, however, no explanation of the connection between his business and the meal expenses were provided.
Sales of Business Property
Petitioner reported substantial losses on his Form 4797 (Sales of Business Property) which consisted of two worthless loans, a loss of software, and an abandoned timeshare. The petitioner had made to $25,000 loans to a company that produced software used by real estate investors. On his Form 4797, the petitioner reported these two loans as worthless and deducted their entire $50,000 value minus allowable appreciation.
The petitioner, however, did not submit any information with his return establishing that the loans were worthless or how you determined the allowable depreciation. With respect to the loans, the petitioner lacked any specific knowledge about the value of the business’s assets or liabilities. Although it “became clear…that the business was struggling and was on the path to failure,” the petitioner never attempted to collect on the note and never brought a suit to collect on the note. With respect to the computer software, the petitioner’s computer crashed in 2014 wiping out expensive software used in his real estate consulting business. Nonetheless, the petitioner did not know his initial cost basis and the software or the method of depreciation used for the period before the computer crash in 2014.
Schedule C Expenses
IRC § 162(a) allows as a deduction all the “ordinary and necessary expenses” paid or incurred during the taxable year in carrying on any trade or business. Petitioner bears the burden of proving that reported business expenses were actually paid and were ordinary and necessary. See IRC § 162(a); Rule 142(a). An expense is ordinary if it is normal, usual, or customary in the taxpayer’s trade or business, and it is necessary if appropriate or helpful for such a business. See Deputy v. du Pont, 308 U.S. 488, 495 (1940); see also Lingren v. Commissioner, T.C. Memo. 2016-213.
IRC § 274(d) imposes strict substantiation requirements for deductions claimed for travel, meals, entertainment, and vehicle expenses. No such deduction is allowed unless the taxpayer substantiates, by adequate records or by sufficient evidence corroborating his own statements, the amount, time and place, and business purpose for each expenditure. IRC § 274(d); Treas. Reg. § 1.274-5T(a), (b), and (c).
Adequate records for this purpose require the taxpayer to maintain an account book, log, or similar record and documentary evidence that together are sufficient to establish each element of the expenditure. Id. para. Treas. Reg. § 1.274-5T(c)(2)(i). In order to be adequate, records must be prepared or maintained in such a manner that each recording of an element or expenditure is made at or near the time of the expenditure or use. Treas. Reg. § 1.274-5T(c)(2)(ii). While a contemporaneous log is not required to substantiate the deduction, a taxpayer’s subsequent reconstruction of his or her expenses does require corroborative evidence with a high degree of probative value to support such a reconstruction, in order to elevate that reconstruction to the same level of credibility as a contemporaneous record. Treas. Reg. § 1.274-5T(c)(1).
To be deductible, travel expenses must be ordinary and necessary, have been incurred while the taxpayer was away from home, and have been incurred in the pursuit of a trade or business. Liljeberg v. Commissioner, 148 T.C. 83, 92-93 (2017), aff’d, 907 F.3d 623 (D.C. Cir. 2018). Travel expenses that are lavish or extravagant under the circumstances are not deductible. IRC § 162(a)(2); see Rundlett v. Commissioner, T.C. Memo. 2011-229. If travel is for both business and personal purposes, the taxpayer has the burden to prove the primary purpose of the travel. Johnson v. Commissioner, T.C. Memo. 1982-517, aff’d, 729 F.2d 1447 (3d Cir. 1984).
Creation of Logs Contemporaneous with Examination not Adequate
The Tax Court held that the travel logs the petitioner created after he received the notice of examination fails the “adequate records” test under 274(d). Similarly, the meal logs created after the fact were not adequate, nor did they demonstrate to the Tax Court at the meal expenses were for business purposes rather than personal ones. As such, the petitioner did not meet the strict substantiation requirements under IRC § 274(d).
Bad Debt Losses
IRC § 166(a)(1) provides that, for any business or nonbusiness debt a deduction is allowed for any debt which becomes wholly worthless within the taxable year at issue. Treas. Reg. § 1.166-3(b). Worthlessness is a question of fact based on all the relevant circumstances, which considers, among other things, the debtor’s financial condition and the value of any security. Treas. Reg. § 1.166-2(a). A debt is not worthless to the extent the collateral securing the debt has value. Black v. Commissioner, 52 T.C. 147 (1969). No deduction is allowed to a taxpayer who makes no requests for payment and makes no attempts to collect the debt or to ascertain its worthlessness. Ellisberg v. Commissioner, 9 T.C. 463 (1947).
The petitioner did not establish that any amount of the debt was worthless in 2014. See Treas. Reg. § 1.166-3(a)(2)(iii). Further, the petitioner did not provide any documentary evidence or testimony pointing to specific, identifiable events that caused him to believe the consolidated Sterling loans were uncollectible or became worthless in 2014. See Crown v. Commissioner, 77 T.C. 582, 598 (1981); Flood v. Commissioner, T.C. Memo. 2001-39; Treas. Reg. § 1.166-2(a).
Computer Software
The allowance of losses for the permanent withdrawal of depreciable property from use in a trade or business or in the production of income are governed by regulations covering the applicable depreciation method. See Treas. Reg. § 1.165-2(c); Treas. Reg. § 1.167(a)-8. Computer software which is readily available for purchase by the general public or not acquired in connection with the acquisition of a trade or business may be depreciable under IRC § 167(a). IRC § 167(f)(1)(A); Treas. Reg. § 1.197-2(c)(4).
In general, computer software that is depreciable under IRC § 167(a) must be depreciated using the straight-line method and a useful life of 36 months. IRC § 167(f)(1)(A); Treas. Reg. § 1.167(a)-14(b). Where an asset is permanently retired from use in the trade or business or in the production of income but is not disposed of by the taxpayer or physically abandoned, recognized loss will be measured by the excess of the adjusted basis of the asset at the time of retirement over the estimated salvage value or over the fair market value of the property at retirement. Treas. Reg. § 1.167(a)-8(a)(3).
In order to depreciate property, a petitioner must demonstrate his basis in the software through documentary evidence or testimony. In the present case, the petitioner did not offer documentary evidence or testimony supporting his reported cost basis. Further, the court failed to find the petitioner’s testimony credible. As a consequence, the petitioner was denied a deduction for retirement or depreciation of the software.
(T.C. Memo. 2020-127) Franklin v. Commissioner
