On March 9, 2022, the Tax Court issued a Memorandum Opinion in the case of Sherwin Community Painters Inc. v. Commissioner (T.C. Memo. 2022-19). The primary issues presented in Sherwin Community Painters Inc. v. Commissioner were whether the taxpayer was entitled to certain substantiated certain expenses it claimed were “ordinary and necessary business expenses” and whether Swanette Ward received constructive dividends from Sherwin. Also at issue is how obstinate the IRS can actually be. (Hint: More than you can imagine.)
Held: Mostly.
Held also: The IRS was a recalcitrant ass in this case.
Sherwin Community Painters Inc. v. Commissioner in a Nutshell
The IRS determined a deficiency against Sherwin Community Painters, Inc. (Sherwin), of $8,224 and an accuracy-related penalty under IRC § 6662(a) for the taxable year 2016. The IRS also determined a deficiency against Robert Ward, Jr., and Swanette Ward of $4,890 and an addition to the tax under IRS § 6651(a)(1) for failure to timely file and an accuracy-related penalty under IRC § 6662(a). After concessions, the issues for decision are:
- whether Sherwin is entitled to certain business expense deductions; and
The Tax Court held that Sherwin actually was (with some limitations)
- whether Swanette received constructive dividends from Sherwin;
The Tax Court held that Swanette did not so receive constructive dividends.
Background to Sherwin Community Painters Inc. v. Commissioner
Robbie Jr. and Swanette Ward lived in Wisconsin, because of course they did.
Sherwin was an Illinois C corporation solely owned by Swanette. Robbie Jr. and Swanette jointly filed their 2016 return on October 12, 2017. Trouble was, the return was not on extension; so, it was nearly three months late.
My guess was that it was cow-milkin’ time, and they only had so many hands and too many swollen udders – but then, I’m just spitballing, here. In any event, this was not mentioned as a potential basis for reasonable cause…though it should have been.
The Claimed Expenses
Sherwin is a commercial painting contractor for commercial warehouses, residential complexes, and multipurpose high-rise buildings. Both Mr. and Mrs. Ward work for the business. Sherwin receives customer referrals from property management companies. It claimed business expense deductions for office equipment, office supplies, gas, entertainment, and promotional materials.
Swanette and Sherwin also financed coding courses for their daughter’s (Eloise May “Ellie” Swanettette Ward – for purposes of this summary) future husband.
I imagine that his name was something cornfed. According to the opinion, the young fellow’s given name was Lucas, but we’re going to go ahead and call him Jim Bob (though of course he went by James Robert when he was wearing his tuxedo t-shirt and his dress denim), because it fits the narrative better.
Jim Bob’s Acceptance to Northwestern
To their credit, Robbie Jr. and Swanette offered to pay the tuition to Northwestern if Jim Bob were admitted (laughing about the preposterousness of the proposition all the way to the milking barn).
To no one’s greater surprise than Robbie Jr. and Swanette, themselves, Jim Bob was accepted to Northwestern, even though he had no previous experience with computers or coding.*
The young man would never understand the irony of nearly being killed by electric shock and being brought back by the very same current.
Oh, irony and electricity, thou art cruel, invisible mistresses…but funny as hell, when you’re not on the receiving end of 120 volts.
With respect to the admission to Northwestern, it turned out that Jim Bob was something of an idiot savant. Mostly idiot, but he phoned in the savant for the application. After completing the course in 2017, Jim Bob used the skills that he had learned to update Sherwin’s website over the course of several months and spent a considerable amount of time working on the website. Sherwin did not pay Jim Bob for his work. This just proves that simple, God-fearin’ udder-pullers can be cheap bastards, too.
Jim Bob later married Ellie May (in a twilight ceremony under the same oak tree that Jim Bob used to sit and ponder the universe while holding a lightbulb in his hand and turning it on when he thought really hard about it – a vestige of his past electrocution, and a neat party trick in a pinch). Mary Lee was a bride’s maid.
Not unsurprisingly, an eleven pound baby boy was born nine months later (to the day), with Jim Bob’s brother “Dickie” being the proud–albeit illigitimate–father of the babe…whom Mary Lee declined to name Dickie Jr., Dickie II, or anything remotely Dickie-related. She was always a bit uppity about things like that.
Continued Indenture of Jim Bob
Subsequent to the nuptials, and their honeymoon to Madison for the cheese curd festival, Jim Bob performed additional computer-related work for Sherwin without compensation. Swanette called it being frugal, but Ellie May saw her mother for what she was. She told Jim Bob to stand up for himself, but he remained compliant, forever sitting quietly on the milking-stool of life.
The Deductions in General
IRC § 162(a) generally allows a deduction for the ordinary and necessary expenses paid during the taxable year in carrying on a trade or business. The term “ordinary” means that the expense is normal, usual, or customary in the taxpayer’s trade or business.[1] The term “necessary” means the expense is appropriate or helpful in carrying on the trade or business.[2]
The expenses must proximately relate to the taxpayer’s trade or business.[3] The determination of whether an expense satisfies the requirements for deduction is a question of fact.[4]
A taxpayer is required to substantiate the expenses underlying a deduction by keeping and producing adequate records that enable the IRS to determine the correct tax liability, including the amounts paid; and to demonstrate that the deduction is allowable pursuant to some statutory provision.[5] A taxpayer is not entitled to deduct personal, living, or family expenses.[6]
The IRS initially disallowed all of Sherwin’s deductions. At trial, after concessions, the IRS challenged only $6,000 (excluding the cost of tuition). Sherwin, in turn, conceded $2,000. Thus, the parties were fighting over $4,000 and a freshly-sealed wheel of Muenster (again, just guessing here).
The “Office Equipment” Deduction
The unresolved expenses relate to office equipment and supplies and promotional materials. Petitioners have substantiated the amounts of the disputed expenses, and the remaining issue is the business purpose of the expenses. The office equipment expenses relate primarily to the purchase of iPads, iPhones, a speaker, and related expenses for service plans and an accessory.
Robbie Jr. and Swanette asserted that Sherwin’s employees use these items in the performance of their jobs. On the basis of the record, the Tax Court accepted petitioners’ assertion as to the business purpose and found that Sherwin has substantiated the amount and business purpose of each expense.
The Tuition Deduction
In addition to the deductions addressed above, Sherwin deducted the tuition that it paid for the coding course. The petitioners contended that Sherwin received website services in exchange for the tuition. While Jim Bob has provided services to Sherwin free of charge—which the Tax Court admits would have likely cost Sherwin more than the amount of the tuition—it nevertheless found that petitioners did not establish that Sherwin is entitled to deduct the tuition.
- Jim Bob was not an employee of Sherwin.
- The Swanette and Ron did not have an agreement with Jim Bob that he would perform any services in exchange for the tuition payment.
- Sherwin paid the tuition without any expectation of a return and, thus, did not have a business purpose for the payment.
The tuition was, therefore, a personal expense, and Sherwin is not entitled to deduct it.
Grumbling as she left the courtroom, Swanette could be heard saying that she’d be taking out the money from Jim Bob’s pay. How she planned to do this, paying him nothing as it were, no one knew. What they did know was not to cross Swanette when she had that gleam in her eye, like a warm bath of white cheddar whey under the fluorescent lights of the cheese house. She was on a warpath that no chunk of aged gouda would cure.
The IRS can be a Stubborn Ass, as Here
The IRS asserted that Swanette received a $38,000 loan from Sherwin, which qualified as a constructive dividend that was includible in Swanette’s gross income under IRC § 61(a)(7). For the rest of the story, we’ll let the Tax Court narrate:
However, Sherwin records establish that the return reported that the loan was made from [Swanette] to Sherwin. The IRS [obstinately, obdurately, pertinaciously, myopically, resentfully, recalcitrantly, and loathly] refuses to concede its error and instead argues on brief that the disallowed business expense deductions should be treated as constructive dividends to Mrs. Ward. We reject this new position.
Seriously, just chalk this one up to a loss, IRS, and move the hell on.
There is no discussion of whether our old nemesis, Karen the Asshat, was involved.
One has to admit, though, this has all the hallmarks of her work…
The Tax Court goes onto add
There is no relationship between the disallowed expenses and the amount of the purported constructive dividends determined in the notice of deficiency of [Robbie Jr. and Swanette]. Sherwin’s failure to substantiate the business purpose of the disallowed deductions does not render the amount a constructive dividend under the circumstances of these cases. There is no indication that [Robbie Jr. and Swanette] received an economic benefit from the amount of disallowed expenses.
Accordingly, the Tax Court held that Robbie Jr. and Swanette did not receive any unreported dividends from Sherwin.
I have it on good authority from a former LLM classmate who was a clerk for the Tax Court that the clerk who wrote the opinion for Judge Goeke put in a final footnote stating “Suck it, IRS,” but that this was omitted (inadvertently or out of common decorum) from the published opinion. Whether it was left on the cutting room floor due to the fact that it was written in all caps, or whether it was the unironic use of Comic Sans font, no one can be entirely sure.
Sherwin Community Painters Inc. v. Commissioner (T.C. Memo. 2022-19)
Footnotes:
- Deputy v. du Pont, 308 U.S. 488, 495 (1940). ↑
- Heineman v. Commissioner, 82 T.C. 538, 543 (1984). ↑
- Larrabee v. Commissioner, 33 T.C. 838, 843 (1960); Treas. Reg. § 1.162-1(a). ↑
- Commissioner v. Heininger, 320 U.S. 467, 475 (1943). ↑
- IRC § 6001. ↑
- IRC § 262. ↑
