Taxing Lessons From Court Decisions

Decisions — A Tale of Two Burdens

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Does it matter who has the burden of proof in tax court?

Generally, the IRS’s determination in a notice of deficiency of whether you owe additional tax is presumed to be correct. It’s up to you to provide the proof that the IRS is wrong. However, in some situations, the burden of proof shifts to the IRS.

For example, under tax court rule 142(a) , when the IRS increases the deficiency amount, the IRS bears the burden of proof. In addition, under internal revenue code section 7491, the IRS bears the burden of proof for factual issues when you produce “credible” evidence, comply with substantiation requirements, maintain required records, and cooperate with reasonable IRS requests.

In T.C. Memo. 2013-40 (McMillan), the taxpayer, who ran a business from her home, claimed a deduction for legal expenses. The taxpayer incurred the expenses for a lawsuit she filed against her homeowners association. She claimed them on the Schedule C for her business for tax years 2007 and 2008.

The court said the taxpayer provided incomplete records and so the burden of proof remained with her. In reaching a decision that the legal fees were nondeductible, the court said the taxpayer did not explain how the lawsuit was related to her business.

In T.C. Memo. 2015-109 (McMillan), the same taxpayer deducted additional legal fees on her 2009 return. The legal fees were related to the same lawsuit and were deducted on the Schedule C for the same business.

In this case, the original IRS notice of deficiency resulted from the taxpayer’s failure to include a retirement account distribution on her return. She eventually conceded the IRS was correct and that the distribution was income.

The IRS accepted her admission and revised the notice by disallowing the legal expenses, which increased the deficiency. The court said this increase (along with the new matter of a related penalty) put the burden of proof on the IRS.

The legal fees in question began in 2003, when the taxpayer filed a lawsuit against her homeowners association. According to the lawsuit, the association failed to respond to three of the taxpayer’s complaints: 1) “complaints of dogs running wild, dogs barking, and dogs defecating throughout the Association’s common areas”; 2) construction defects related to the “presence of mold in her bathroom, growing between the tiles themselves and between the tile wall and the tub rim”; and 3) construction defects leading to excessive “noise intrusion.”

The litigation was settled in June 2010. In 2009, in connection with the litigation, the taxpayer was involved in a separate legal action involving misdemeanor criminal charges connected with her attempt to gather evidence for the litigation. The legal expenses totaled $26,312.

The taxpayer says the expenses are related to her business. She lives in a condominium overseen by the homeowners association and maintains a home office in the condo. In addition, she says the IRS allowed her legal expenses in full on a prior year return.

The IRS says the taxpayer can’t deduct the legal expenses because they are personal and therefore not deductible under internal revenue code section 262(a). The IRS argues that to be deductible on Schedule C, the legal expenses would have to meet the “ordinary and necessary” requirement of internal revenue section 162. Expenses meet that requirement when they arise from, or are proximately related to, a business activity. The origin and character of the claim (being business connected) rather than its consequences to the fortunes of the taxpayer are determinative.

The IRS did not challenge other expenses deducted on the taxpayer’s Schedule C, nor argue that the activity was not a business.

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided to read the entire case.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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For the Taxpayer.

The taxpayer claimed a deduction for the legal expenses on the Schedule C. That Schedule C describes a business activity and reports a net profit.

Besides the legal expenses, the taxpayer claimed on the Schedule C deductions for a substantial home office expense, car and truck expenses, a depreciation expense, an office expense, and an expense for supplies.

The IRS has challenged none of those expense deductions, nor argued that the activity was not a trade or business.

The dispute giving rise to the legal expenses arose principally on account of the taxpayer’s claims of noise and other factors interfering with her use and enjoyment of her property. Certainly, if her claims are true, the noise and other factors would interfere with her use and enjoyment of the condominium unit as a residence, and any expenses in connection with a legal action to eliminate or mitigate the interference would not be deductible as ordinary and necessary business expenses under section 162.

However, the taxpayer reported a 50% business use of the condominium unit, and the IRS has failed to prove that she used any lesser percentage of the unit for business or that the complained-of noise and other factors did not affect her business use of the unit.

Because the IRS has failed to make those showings, we cannot sustain the argument that the legal expenses were exclusively personal. On the basis of the taxpayer’s reporting a 50% business use percentage, we will sustain 50% ($13,156) of the taxpayer’s claimed Schedule C deduction of $26,312 for legal expenses.

The taxpayer’s argument that, for a prior year, the IRS allowed her legal expense deduction in full as a miscellaneous itemized deduction on Schedule A, Itemized Deductions, is without merit. Each tax year stands by itself, and the IRS is not bound by treatment of an item for a previous year.

 And while for 2007 and 2008, we denied the taxpayer a deduction for legal expenses incurred in those years, we did so because she failed to prove facts entitling her to a deduction.

Here, the IRS bears the burden of proof and has failed to carry that burden.

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