A taxpayer could not show that payments he made represented interest on purported loans and, while he was able to deduct some commission expenses, the amount was limited due to issues with his records in Moore v. Commissioner, TC Memo 2019-100.[1] 

The taxpayer wanted to expand his tax preparation business and was looking for funds.  As the decision noted:

Petitioner approached five individuals with whom he had had prior business relationships and asked them for money to expand his tax return preparation business. Petitioner referred to these advances at varying times both as investments and as loans. Petitioner prepared nine purported promissory notes, which list a “loan period” and also a “return on investment” percentage. Each purported note specifies a return on investment of 100% or more. Only one of the purported promissory notes is signed.[2]

The taxpayer claimed $161,750 in “investment expenses” related to payments under these notes.  At trial he conceded his claimed deductions was $39,500.  Each of the notes had “return on investment” of 100% or more, which the taxpayer indicated was an interest rate.  The IRS argued that the taxpayer had not shown these advances were true loans, that he had not shown the amounts in his bank account actually came from these creditors, and he had not shown that the payments were ordinary and necessary business expenses.[3]

The Tax Court agreed that the taxpayer had failed to show he was entitled to a deduction.  The Court started by noting the requirements for payments to be interest expense:

For payments to be deductible as interest within the meaning of section 163(a), however, they must be made in connection with a bona fide loan transaction where both parties have an actual, good-faith intent to establish a debtor-creditor relationship at the time the funds are advanced. Id. This relationship exists if the debtor intends to repay the loan and the creditor intends to enforce repayment. Fisher v. Commissioner, 54 T.C. 905, 909-910 (1970). We look at various factors in determining whether this relationship in fact exists, including the presence of: (1) a debt instrument, (2) a statement that interest will be charged, (3) a fixed schedule for repayment, (4) collateral to secure payment, (5) actual repayment, (6) reasonable prospects of advancement and repayment of the funds, and (7) the parties’ conducting themselves as if the transaction were a loan. See Calloway v. Commissioner, 135 T.C. 26, 37 (2010), aff’d, 691 F.3d 1315 (11th Cir. 2012); see also Fisher v. Commissioner, 54 T.C. at 909-910; Kaider v. Commissioner, T.C. Memo. 2011-174, slip op. at 15-16 (citing Welch v. Commissioner, 204 F.3d 1228, 1230-1231 (9th Cir. 2000), aff’g T.C. Memo. 1998-121).[4]

The Court found the taxpayer’s claim for deductible interest failed for the following reasons:

We find that petitioner has not met his burden of proving that these transactions represented bona fide loans and that the payments he made with respect to them qualify as deductible interest. The purported notes, save one, are unsigned and bear no indication of a good-faith agreement between the parties. Petitioner has provided no testimony or other evidence from any of the alleged creditors to prove their intent to act as creditors and to enforce repayment, or how the alleged creditors characterized the transactions. The purported notes did not state interest rates or provide for any type of security interests. Petitioner also has not proven that the eight unsigned purported notes were contemporaneous debt instruments, as they have no execution dates. Finally, as to the one signed purported note, petitioner has failed to prove that the funds allegedly deposited in his account actually came from the alleged creditor; he has introduced no canceled check or other evidence tying the funds directly to the alleged creditor. On this record petitioner has failed to prove that these transactions represented bona fide indebtedness, and consequently, we conclude that petitioner is not entitled to a deduction under section 163(a).[5]

The commission expenses he was claiming related to payments to contractors he used as tax return preparers.  His company was a clearinghouse for processing the returns.  He also provided training and support to the contractors, who maintained and developed their own client base and prepared the returns.[6]

The process of handling tax returns for returns with a refund is described as follows by the court:

When one of petitioner’s return preparers would file a return for a client that generated a tax refund, the refund was deposited into one of petitioner’s bank accounts, which petitioner referred to as a third-party bank account and appears to have treated as an escrow account. Petitioner would then take from the client’s refund the agreed-upon preparation fee, which would be deposited into another of petitioner’s business accounts, and the remainder would be paid to the client. From the preparation fee petitioner would then pay a commission to the individual return preparer, ranging from 60% to 90% of the preparation fee depending on the return preparer’s expertise and client base. Petitioner would retain the rest of the preparation fee.[7]

The taxpayer’s records accounting for the paying such of fees were, to put it mildly, inconsistent and far short of ideal.  Nevertheless, in this case the Court did not agree with the IRS that no deduction should be allowed for any such commissions.  Rather, the Court found that the taxpayer had provided enough information to invoke the provisions of the Cohan decision.[8]

That decision, involving vaudeville producer George M. Cohan, decided that even where records do not completely document a deduction or provide inconsistent information regarding the deduction, a deduction will still be allowed in some portion if:

• The evidence makes it clear that expenses that would be deductible under the IRC have been incurred and

• There exists a reasonable basis for estimating a deductible amount.

However, in allowing the deduction the Court is going to not allow the taxpayer to benefit from his neglect to keep complete and consistent records—or, to put it more practically, the Court will allow an amount on the low end of the available estimates. 

As well, Congress, in response to the Cohan decision, did add provisions that require certain expenses to be deducted or no deduction will be allowed—see IRC §274(d).[9]  But these expenses are not in the list of expenses found in that provision subjected to the heighted documentation rules.

The Court found that the taxpayer met the first test (that such expenses had been incurred), noting:

Petitioner has demonstrated that he is entitled to a deduction for commissions paid to his contractors in 2013. At trial he testified credibly that he ran a tax return preparation business. He also testified credibly that he retained independent contractors as return preparers throughout the country to whom he paid commissions based on their experience level and clientele. Moreover, he has introduced numerous canceled checks that he or his payroll company wrote to various individual contractors. Petitioner has also introduced payroll reports generated by his former payroll company that identify contractors petitioner paid and list the amounts he allegedly paid each during 2013. Both the checks and the payroll summary identify many of the same contractors, with the handwritten checks listing “commissions” or similar text in the memorandum line. Additionally, respondent’s list of Forms 1099-MISC filed by petitioner corroborates the identities of numerous contractors and provides payment amounts that broadly align with the sums in the exhibits petitioner provided. We therefore find that petitioner paid the named independent contractors in furtherance of his business and is entitled to a deduction for commission payments.[10]

Many taxpayers manage to clear this hurdle for expenses when their records are poor or nonexistent—it is clear they operated a business and that such a business would necessarily require a certain expense to be incurred in some amount.  Most attempts by the taxpayer to use Cohan fail on the second prong of the test—the evidence to allow a reasonable estimate of the expenses.

But Mr. Moore’s records, while leaving a more than a bit to be desired and being inconsistent, nevertheless gave the Court enough information to make such an estimate:

We also find that petitioner has provided a reasonable basis from which we can make an estimate of his actual commission expenses. As noted above, the amounts of the canceled checks and the amounts reflected in the payroll company reports petitioner provided broadly align with the amounts shown on the Forms 1099-MISC list respondent provided. Taken together, these exhibits provide upper and lower limits for a range of potential payment amounts, bracketing our estimate and ensuring that it does not amount to “unguided largesse”. Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957).[11]

The Court used the following method to come to an allowed amount of expenses:

To start, we note that petitioner’s business records for tax year 2013 are so woefully disorganized and incomplete that petitioner has not been able to provide a credible and reliable statement of his total commission expenses. Instead, he has asserted three different numbers at varying stages of this case. The exhibits in the record provide no less than nine potential sums, ranging from just over $400,000 to $750,000. We are convinced that petitioner paid commissions to independent contractors, but we also are concerned about the fluid state of the evidence he introduced. Consequently, we will sustain deductions only for amounts clearly established by the record, and we will resolve ambiguities against petitioner.

With that in mind, we find that petitioner’s check registry, Exhibit 11-P, and gross pay report, Exhibit 16-R, and the list respondent provided of Forms 1099-MISC filed by petitioner, Exhibit 17-R, to be the most credible evidence in the record.3 While the record provides a wide range of potential sums, we can limit this range by relying on these exhibits. Cf. Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 84-87 (2000), aff’d, 229 F.3d 221 (3d Cir. 2002).

On the basis of the records described above and summarized in the appendix, we find that petitioner is entitled to a deduction of $414,157. As shown in the appendix, we limit our dataset to include only those individuals identified in all three exhibits, excluding petitioner. We then look at the totals generated by the exhibits: $536,398, $414,157, and $536,414. Our analysis begins by recognizing [*16] that the totals generated by Exhibits 17-R and 11-P are quite close, but we cannot discard the total provided by Exhibit 16-R. To account for the variance, where Exhibit 16-R provides a lesser payment amount for a given contractor, we will consider only that lesser amount. Cf. Green v. Commissioner, 66 T.C. 538, 544-549 (1976). Doing so, we conclude that $414,157 is the appropriate amount of the allowable commission expenses deduction because it reflects the substantial amount of commission payments we believe petitioner made, but does not reward petitioner for “inexactitude[s] * * * of his own making.” Cohan v. Commissioner, 39 F.2d at 544.[12]

While the taxpayer escaped with a partial deduction for commissions, the fact he ran a tax preparation business and held himself out as a tax expert doomed his request for penalty relief.  As the opinion notes:

Although petitioner is not an accountant or an attorney, he organized and ran a multistate tax return preparation business. He held himself out as a tax professional, advising others on preparing returns and otherwise applying the requirements of the Code to individual taxpayers, but he failed to keep accurate documentation about his largest reported expenses: the commissions he paid to his independent contractors and the purported interest payments he made to alleged creditors. Given petitioner’s background and business in tax return preparation, this is unreasonable. We find, therefore, that he did not have reasonable cause for his underpayment and that he is liable for the accuracy-related penalty under section 6662 to the extent that the Rule 155 calculations show that he substantially understated his 2013 income tax.[13]

[1] https://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=12022, August 15, 2019, retrieved August 16, 2019

[2] Ibid, p. 3

[3] Ibid, p. 9

[4] Ibid, p. 10

[5] Ibid, p. 11

[6] Ibid, p. 4

[7] Ibid, pp. 4-5

[8] Cohan v. Commissioner, 39 F.2d 540, 544 (2d Cir. 1930)

[9] For instance, a taxpayer must have documentation to support claimed business automobile expenses or no deduction will be allowed—the law requires a complete denial of deduction in that case.

[10] https://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=12022, August 15, 2019, retrieved August 16, 2019, pp. 13-14

[11] Ibid, p. 14

[12] Ibid, pp. 14-15

[13] Ibid, p. 18