Illustrates importance of identifying proper party for tax deductions
In Garcia v. Commissioner, T.C. Summary Opinion 2018-38, taxpayers were contesting the IRS imposition of a tax deficiency of about $27,000, plus another $5,000 of penalties. These amounts are not large when compared with many other tax cases, but the Garcia case serves as a reminder that in some situations it is important to answer the question: who is the proper person or entity to claim a tax deduction and is there proper documentation to demonstrate the conclusion?
The Garcia case involved an S corporation that had claimed a deduction that should instead have been claimed by its owners. The IRS denied the deduction, and the Tax Court upheld the IRS’ assessment of tax and penalties.
The Garcias had invested in a stock of a South African company. The South African company was a victim to fraudulent activity by a third party. Along with other minority investors in the South African company, the Garcias engaged in litigation to recovery their investments. As part of that process, the Garcias funded a portion of the litigation expenses.
Later, Mr. Garcia formed an S corporation that was engaged in rental real estate activity unrelated to the South African investment. In the S corporation’s minutes, the Garcias purportedly assigned the Garcias’ interest in the South African shareholder litigation.
The S corporation claimed deductions for the South African litigation expenses on its U.S. income tax returns, and the Garcias did not directly claim the deductions on theirs. Because the deductions were reported on the S corporation’s returns, the deductions were claimed as business expenses rather than investment expenses. If directly reported on the Garcias’ returns, the deductions would have been investment expenses and subjected to deduction limitations applicable to miscellaneous itemized deductions.
The Garcias made some of the litigation expense payments, and the S corporation made others. Who pays an expense, however, generally does not by itself determine who can deduct the expense. It is more important which party benefitted from the payment than which party actually paid the expense.
For some types of expenses, including the legal expenses at issue in Garcia, the origin of the payee’s claim for payment is determinative. Here, the payment funded the South African litigation, which sought a judgment or settlement in favor of the Garcias and other minority shareholders in the South African company that would allow them to recover their investments. The S corporation board minutes did not remove the Garcias’ obligations to continue funding the shareholder litigation. There was no convincing documentation that transferred the obligations and rewards of the litigation to the S corporation. The Tax Court accordingly found that the litigation expenses were not deductible business expenses of the S corporation.
It is often important to determine which person or entity should claim a tax deduction, as the Garcia case illustrates. Taxpayers making this type of determination generally should consult with their tax advisors.