Don’t Make These Mistakes

You may be entitled to claim various deductions and credits, but unless you follow the rules you’ll lose out. Here are a number of recent cases that highlight what you should or shouldn’t do if you want to take the write-offs you’re legitimately entitled to. The following cases illustrate what not to do so you can benefit tax wise.

Transfer of IRAs incident to divorce

If, during the course of marital dissolution, a court orders you to transfer some or all of your IRA to your spouse or former spouse, be sure to do it right. If you do, you won’t be taxed on the transfer. If you don’t, you’ll be immediately taxed on the transfer.

Example: A taxpayer was ordered in a divorce proceeding to transfer $100,000 from his IRA directly into an IRA of his spouse. Instead, he directed the distribution from his IRA to his checking account and then wrote a check to his spouse. Because he didn’t transfer the funds directly from his IRA to his spouse’s IRA, he was taxable on the $100,000 (John R. Kirkpatrick, TC Memo 2018-20).

Business expenses

Most expenditures in running a business are tax deductible. However, it’s up to you to prove your expenses. And for certain costs, such as travel, meals, vehicle use, and business gifts, special substantiation rules apply. If you fail to keep required records, you won’t be able to claim deductions. The Cohan rule, which permits the Tax Court to estimate the amount of a deductible expense, does not apply for vehicle use.

Example: A taxpayer who owned a business providing landscaping and janitorial services deducted the cost of operating three vehicles. He didn’t keep any diary, mileage log, trip sheet, or other contemporaneous record for the use of these vehicles so the Tax Court denied his deduction. The court refused to apply the Cohan rule because the substantiation requirements override this estimation option (Duncan Bass, TC Memo 2018-19).

Bad debts

If you loan money and are not repaid, you may be able to deduct your loss. If the loan is a nonbusiness bad debt, you treat the non-repayment as a short-term capital loss (i.e., up to $3,000 can be used to offset ordinary income in excess of any capital gain offset). If it’s a business bad debt, it’s fully deductible as a business loss. However, to take any write off, you must be able to show that the loan was bona fide (i.e., it was not a gift or other transfer).

Example:  A retiree gave money to an old friend who was starting a scuba business with the understanding that he’d get an “interest” in the business. Throughout the years he advanced more than $11 million to make the business a success. When he couldn’t get any money back, he took a deduction, which the Tax Court disallowed. There were never any formal loan agreements, no date set dates for repayment, and no set rate of interest. He only expected to be repaid when the business was profitable, which is akin to being an owner seeking a return on investment and not as a lender (Michael J. Burke, TC Memo 2018-18).

Conclusion

Be sure to follow the rules for nailing down tax deductions to which you are entitled. If you’re unsure, check with your tax advisor.