This article analyzes the recent Tax Court Memorandum decision, Zajac v. Commissioner, T.C. Memo. 2025-33, providing a detailed overview of the case for tax practitioners. The case involves a taxpayer, Joseph J. Zajac, III, who contested the Commissioner of Internal Revenue’s (Respondent) determination of deficiencies and accuracy-related penalties for the taxable years 2007 through 2009.

Facts of the Case

The deficiencies arose from the disallowance of various deductions claimed by Mr. Zajac on his Schedules C, Profit or Loss From Business, attached to his Forms 1040, U.S. Individual Income Tax Return, as well as other deductions claimed on Schedule A, Itemized Deductions. The disallowances included car and truck expenses, depreciation, legal and professional fees, meals and entertainment, other expenses (write-off billables), rent, travel, moving expenses, noncash charitable contributions, and job-related and miscellaneous expenses. Additionally, the Commissioner determined that Mr. Zajac improperly excluded settlement proceeds from gross income.

The genesis of a significant portion of the dispute stems from Mr. Zajac’s arrest in 2004 for domestic assault and battery. He subsequently filed a claim against the Town of Bolton, Massachusetts, alleging physical and emotional injuries, as well as violations of his constitutional and state law rights. This claim was settled in 2007 for $35,001. Following his arrest, Mr. Zajac also sought psychological therapy. During the years in issue, Mr. Zajac worked as an executive business consultant as an independent contractor for Performance Improvement Partners, LLC (PIP), and later for Richmont Graduate University (RGU).

Taxpayer’s Request for Relief

Mr. Zajac sought to exclude the entire $35,001 settlement proceeds from his gross income under § 104(a)(2), which excludes damages received on account of personal physical injuries or physical sickness. He also contested the disallowance of the various deductions he had claimed, arguing their legitimacy as ordinary and necessary business expenses under § 162(a) or as other allowable deductions. Furthermore, Mr. Zajac contested the imposition of § 6662(a) accuracy-related penalties, suggesting his tax preparation software was partly to blame for any errors.

Court’s Analysis of the Law and Application to the Facts

The Tax Court addressed each issue separately:

Settlement Proceeds: The court began by noting the broad scope of gross income under § 61(a) and the narrow construction of exclusions. Regarding § 104(a)(2), the court emphasized that emotional distress is not considered a physical injury, and damages for emotional distress are excludable only if attributable to a physical injury or sickness [Treas. Reg. § 1.104-1(c)(1)]. The critical inquiry, the court stated, is the payor’s dominant reason for making the payment [Green v. Commissioner, 507 F.3d 857, 868 (5th Cir. 2007), aff’g T.C. Memo. 2005-250]. Analyzing Mr. Zajac’s claim letter to the Town of Bolton, the court found allegations of both physical injury (cuts, bruises, exacerbation of pre-existing conditions) and other harms (constitutional violations, emotional distress). The court concluded that the Town of Bolton made the payment at least in part to settle potential liability for the infliction of pain and physical injury. Exercising its best judgment, the court allocated $17,500 of the settlement to physical injury and emotional distress attributable thereto, excludable under § 104(a)(2), and $17,501 to other claims, includible in gross income under § 61(a).
Disputed Deductions: The court reiterated the general principle that deductions are a matter of legislative grace, and taxpayers bear the burden of proving their entitlement [INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); Rule 142(a)]. Taxpayers must maintain sufficient records to substantiate claimed deductions [§ 6001; Higbee v. Commissioner, 116 T.C. 438, 440 (2001)].
- Moving Expenses: The court reviewed § 217(a), which allows a deduction for moving expenses connected with the commencement of work at a new principal place of work. For self-employed individuals, the time test under § 217(c)(2)(B) requires full-time work for at least 39 weeks during the 24-month period following arrival. The court found that Mr. Zajac did not meet this requirement based on his employment dates with PIP and RGU. Additionally, the court noted insufficient substantiation and the inclusion of nondeductible meal expenses.
- Vehicle Expenses and Depreciation: The court cited § 167(a) for the allowance of depreciation and § 274(d), which imposes strict substantiation requirements for "listed property," including passenger automobiles. The Respondent bore the burden of proof for this disallowance due to asserting it in the Amendment to Answer [Rule 142(a)(1)]. The court agreed with the Respondent that Mr. Zajac failed to keep contemporaneous mileage logs and that his records were irreconcilable with his returns, thus not satisfying § 274(d). Regarding depreciation, the court found that Mr. Zajac had already been allowed depreciation deductions exceeding his basis in the vehicle prior to the years in issue, thus any further deductions were improper under § 167(c)(1).
- Legal and Professional Fees: The court relied on the "origin of the claim" doctrine established in United States v. Gilmore, 372 U.S. 39, 49 (1963), holding that legal fees are deductible on Schedule C only if the matter originated in the taxpayer’s trade or business [Colvin v. Commissioner, T.C. Memo. 2007-157, slip op. at 36, aff’d, 285 F. App’x 157 (5th Cir. 2008)]. The court determined that the fees paid to attorneys for divorce, gun rights, probate, and the settlement with the Town of Bolton, as well as fees paid to the psychologist and economic consultant for matters stemming from the arrest and divorce, were personal in nature and not connected to Mr. Zajac’s consulting business. The court also rejected Mr. Zajac’s argument that some fees were to protect his business reputation, finding his primary intent was to resolve the personal legal issues [Kleinschmidt v. Commissioner, 12 T.C. 921, 924 (1949)]. While acknowledging that § 212(1) could potentially allow a deduction for fees incurred in producing or collecting the non-excludable portion of the settlement, the court found Mr. Zajac’s recordkeeping insufficient to apply the Cohan rule for estimation.
- Meals, Entertainment, and Travel: The court referenced Lucas v. Commissioner, 79 T.C. 1, 7 (1982), stating that a taxpayer cannot deduct reimbursed expenses. For the non-reimbursed amounts, the court found that Mr. Zajac failed to meet the strict substantiation requirements of § 274(d)(1) and (2) due to inconsistent reporting and lack of supporting documentation.
- Writeoff: Billables: The court cited Maniscalco v. Commissioner, 632 F.2d 6, 7–8 (6th Cir. 1980), aff’g per curiam T.C. Memo. 1978-274, holding that a taxpayer cannot deduct the value of their own labor. Mr. Zajac’s claimed deduction for unbilled labor was therefore disallowed.
- Rent and Utilities: The court cited § 280A(a), which generally disallows deductions for the use of a dwelling unit as a residence, with an exception for the portion exclusively used as the principal place of business under § 280A(c)(1). While the parties stipulated to the business use of home deductions (accounted for on Form 8829), the court disallowed Mr. Zajac’s separate deductions for rent and utilities on Schedule C, finding they represented a double deduction for the same expenses.
- Charitable Contributions: The court reviewed the substantiation requirements for charitable contributions under § 170(a)(1) and § 170(f)(8)(A) (contemporaneous written acknowledgment for contributions of $250 or more) and § 170(f)(11)(B) (description and information for contributions over $500). The deduction for the donation to Ginny’s Helping Hand, Inc. ($4,500), was disallowed because Mr. Zajac failed to obtain a contemporaneous written acknowledgment as required by § 170(f)(8)(A). The deduction for the donation to the cellphone recycling center was disallowed because Mr. Zajac failed to demonstrate that the organization met the requirements of a qualified charitable organization under § 170(c)(2)(B).
- Job-Related and Miscellaneous Expenses: The court noted that Schedule A was not the proper place to deduct business expenses for an independent contractor, which should have been reported on Schedule C. Furthermore, the court reiterated its disallowance of vehicle depreciation and professional fees claimed elsewhere and found no substantiation for the remaining expenses.
Penalties: The court considered the § 6662(a) accuracy-related penalty for negligence or disregard of rules or regulations or a substantial understatement of income tax. The burden of production for penalties rests with the Commissioner under § 7491(c) [Graev v. Commissioner, 149 T.C. 485, 493 (2017)]. This burden includes satisfying the supervisory approval requirement of § 6751(b)(1). The court found that the initial penalties were properly approved via email by the supervising agent before the issuance of Letter 5153 and the Examination Report [Palmolive Bldg. Invs., LLC v. Commissioner, 152 T.C. 75, 85–86 (2019); Belair Woods, LLC v. Commissioner, 154 T.C. 1, 15 (2020)]. The court also found that the increased penalties asserted in the Amendment to Answer were properly approved when the Associate Area Counsel’s (AAC) immediate supervisor initialed the relevant documents before filing [Graev v. Commissioner, 149 T.C. at 488 n.3]. The court rejected Mr. Zajac’s reliance on his tax preparation software as reasonable cause under § 6664(c) [Bunney v. Commissioner, 114 T.C. 259, 266–67 (2000); Morales v. Commissioner, T.C. Memo. 2012-341, at *6, aff’d, 633 F. App’x 884 (9th Cir. 2015)]. Consequently, the court sustained the accuracy-related penalties.

Court’s Conclusions

The Tax Court sustained the Commissioner’s determination that $17,501 of the settlement proceeds were includible in Mr. Zajac’s gross income, while $17,500 was excludable under § 104(a)(2). The court further sustained the disallowance of all the disputed deductions claimed by Mr. Zajac. Finally, the court sustained the imposition of the accuracy-related penalties under § 6662(a). The decision serves as a stark reminder of the importance of meticulous recordkeeping, understanding the origin of expenses for deductibility, and properly applying the relevant tax code sections and regulations. Tax practitioners should advise their clients on these crucial aspects to avoid similar adverse outcomes.

Prepared with assistance from Notebook LM.