Are You Sure That Expense is Deductible?

The Tax Court recently denied a deduction for an expense that the taxpayer thought was an ordinary and necessary business expense. The expense was an educational expense for a non-employee, and even though the tax law allows flexibility to taxpayers in deducting business expenses, it does have limits.

The tax law regarding business expense deductions allows significant flexibility to taxpayers. It allows a deduction for ordinary and necessary expenses paid during the taxable year in carrying on a trade or business. The term “ordinary” means normal, usual, or customary in the taxpayer’s business, and the term “necessary” means appropriate or helpful in carrying on the trade or business.

In Sherwin Community Painters, the taxpayer was a company engaged in the business of commercial painting for commercial warehouses, residential complexes, and multipurpose high-rise buildings. It was owned by an individual. The company paid the costs of a computer coding course for a gentleman (Mr. Kocemba) that was dating the shareholder’s daughter. Mr. Kocemba was not an employee of the company, but after he completed the course, he used his skills over the course of several months to update the company’s website and to perform other computer-related work for it. Mr. Kocemba was not paid for any of those services, and he later married the shareholder’s daughter.

On its corporate income tax return, the taxpayer claimed a business expense deduction for the cost of Mr. Kocemba’s tuition for the computer coding course. The IRS disallowed the deduction on audit and assessed a deficiency.

The Tax Court ruled in favor of the IRS and denied the deduction even though it found that the value of the services Mr. Kocemba provided to the company likely exceeded the cost of the tuition payment made on his behalf. The court focused on the facts that Mr. Kocemba was not an employee of the company and there was no agreement that he would perform services in exchange for the tuition payment when it was made. In the words of the court, the taxpayer “paid the tuition without any expectation of a return and thus did not have a business purpose for the payment.” It found the payment was a personal expense, presumably of the shareholder.

This case serves as a reminder that businesses need to have a business purpose in order to claim a tax deduction for their expenses. Not every payment is deductible as an ordinary and necessary business expense. The line between business and personal expenses is not always clear, especially in the case of small businesses where dealings are often made with family and friends. In these cases, it is important to spell out the terms of the transaction in advance and to ensure proper documentation. That might have helped the taxpayer in Sherwin Community Painters, if the payment was intended as compensation when it was made, rather than as a gift to the future husband of the sole shareholder’s daughter.