To: Dr. Ott
From: Jordan King
Re: Case 3 Business Expense Deductions
Executive Summary:
A taxpayer, who became a 25% owner with Oil Company, paid back certain creditors of Oil Company when the Oil Company went bankrupt. The taxpayer is also a partner of an architectural firm whose primary customers were also creditors of Oil Company. The taxpayer deducted the debt repayment as a business expense of the firm. The IRS argues that the repayment is not an “ordinary and necessary” expense of the architectural firm and therefore cannot be deducted. It is determined that this case will be ruled in favor of the taxpayer.
Facts:
* Richard is a partner at a well-established architectural firm. * Richard invests enough to become a 25% owner of Oil Company. Oil Company goes bankrupt due to a drop in foreign oil prices. They cannot pay back their creditors. * Many of the creditors to Oil Company are also customers to Richard’s architectural firm. * The architectural firm starts to lose profits. Richard firmly believes this is due to his involvement with Oil Company. * Richard and his partner agree to use earnings of the architectural firm to pay back the creditors of Oil Company. They both believe this will improve their business profits. * The IRS is disallowing these deductions claiming they are neither ordinary nor necessary.
Issues:
According to Sec 162(a), There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered, traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business, and rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity. The key issue in this case is determining whether the repayment of debt to the creditors of Oil Company by the taxpayer’s architectural firm is both an ordinary and necessary expense of the architectural firm. It is also important to determine if the taxpayer’s intent was to improve the profits of his business and its reputation or merely to improve his personal reputation and avoid embarrassment in his community, as these differences will provide for different outcomes and have been brought up as a defense by the IRS. In addition, the IRS argues that there is no proof that the reason the business started to fail was due to the debt owed to those creditors of the Oil Company that were also customers to the taxpayer’s architectural firm.
Authoritative Support:
The IRS first brought up the Supreme Court case Welch v. Helvering. In this case the petitioner was the secretary of the E. L. Welch Company, a Minnesota corporation, engaged in the grain business. The company declared involuntary bankruptcy and had a discharge from its debts. Thereafter the petitioner made a contract with the Kellogg Company to purchase grain for it on a commission. In order to re-establish his relations with customers whom he had known when acting for the Welch Company and to solidify his credit and standing, he decided to pay the debts of the Welch business so far as he was able. The Supreme Court ruled against the taxpayer in this case, stating that while men do at times pay the debts of others without legal obligation, they do not do so ordinarily, not even though the result might be to heighten their reputation for generosity [WELCH v. HELVERING 12 AFTR 1456 (54 S. Ct. 8), 11/06/1933]. The taxpayer was quick to point out the differences between their case and Welch v. Helvering and I am inclined to agree. The taxpayer in Welch v. Helvering paid back creditors to build a new business reputation, while the taxpayer, Richard, already had an upstanding business which was suffering due to the failings of Oil Company.
The IRS also argued that the taxpayer was not allowed a deduction for the reason that the debt repayment was to protect his personal reputation and cited William A. Thompson, Jr., Tax Court Memo. In this memo, the taxpayer had acquired one half of the stock in company called Cardinal Gem, and is president of the company titled Thompson & Litton, Inc (which is where taxpayer’s main business, civil engineering, has been conducted through). Cardinal Gem goes out of business. Many of the creditors of Cardinal Gem were clients of Thompson & Litton or did business with its clients. The taxpayer was greatly concerned with his "moral obligation" to see that all of his creditors were repaid and felt that his personal reputation would become tarnished if these debts were not repaid. There was no evidence that failure to pay these other former creditors of Cardinal Gem would have had any direct relationship upon the petitioner's professional reputation or that of Thompson & Litton. In general, payment of another’s debts is not an ordinary and necessary expense deductible under Section 162. However, expenditures incurred by a taxpayer to protect his business reputation have been regarded as deductible. A payment to protect personal reputation is not deductible. The final ruling was that only those payments that were made to protect the petitioner’s business reputation were allowed a deduction (William A. Thompson, Jr., TC Memo 1983-487). It is clear that the payments made by the taxpayer, Richard, were indeed made to protect the reputation of his business because they were done with the consent of the taxpayer’s business partner and with the earnings of the business. I would also like to point out that with the above memo, the courts argued that there was no proof that payment would have any effect on the business, but that with the current case, there is proof that the architectural firms profits had declined.
The final argument by the IRS that needs to be addressed is that the taxpayer does not have proof that the failings of the architectural firm were due to the debt owed by Oil Company to its creditors who were also customers to the taxpayer’s business. In addressing this argument, I will look to Dunn & McCarthy v. Commission. The president of the taxpayer there had committed suicide after having borrowed from seven of taxpayer's top ranking salesmen. Although the taxpayer was under no legal obligation to make good these losses, they did so, and the Tax Court upheld the Commissioner's deficiency assessment, rejecting taxpayer's deduction of these payments as ordinary and necessary expenses. However, this decision was reversed. The Court of Appeals believed that, while no salesman had quit and no customer had withdrawn their account, this did not mean that failure to pay would have had no effect upon the loyalty of the salesmen or the good will of the customers and the decision was reversed [DUNN & McCARTHY v. COM'R OF INTERNAL REVENUE, 31 AFTR 1043 (139 F.2d 242), 12/10/1943].
The taxpayer cited Lutz v. Commissioner in their defense, stating that the repayment of Oil Company’s debt was an integral part in the success of their architectural business. In that case, the taxpayer’s payment of debts of his controlled Idaho and Oregon produce corporations were held deductible by him as an ordinary and necessary business expense. If he had not made good the obligations of these corporations, he would not have been permitted to retain his personal license as a provision merchant, and, hence could not have continued to operate his profitable Texas business [LUTZ v. COMM., 6 AFTR 2d 5503 (282 F.2d 614), (CA5), 09/09/1960].
Conclusion:
The cases argued by the IRS have distinct differences to this case and each created a stronger case for the taxpayer. It is important to note that every case regarding deductions of business expenses will be unique to each taxpayer. “Generally speaking, business men should be free to exercise their own ingenuity in devising methods of increasing business” [A. HARRIS & CO. v. LUCAS, Cite as 9 AFTR 1082 (48 F.2d 187), 03/30/1931]. The taxpayer firmly believed that failure to repay these debts would impair his business’s reputation and create a going concern issue in the future. It is not up to the Courts to determine whether certain expenses are necessary to the future of a business. That should be left up to the discretion of the taxpayer, who has far greater knowledge of their business. The case will be ruled in favor of the taxpayer. The repayment of the debt by the taxpayer shall be allowed as a deduction under Section 162.