19 Nice-Try Tax Breaks Rejected by the IRS

A Novel Idea Doesn't Fly

A successful author who wanted to pay less self-employment tax claimed that a large chunk of the money she got from contracts with publishers and reporters was for the use of her name and likeness. She then reported that portion as investment income on Schedule E of her 1040 (and not as earnings from self-employment, which are generally reportable on Schedule C). The Tax Court didn't buy her argument, saying that her brand was part of her business as an author. The contracts she entered into with the publishing company didn't specifically allocate payments for her name and likeness, and it's common for authors to build their brands and promote their work. She owed self-employment tax on all her income, much to her dismay. An appeals court upheld the Tax Court's decision.

A Little Peace and Quiet

A busy tax preparer ran her business from her home. During tax season, she felt so harassed from clients calling her at all hours of the day and night that she occasionally booked a room at a local hotel for some peace and quiet. On her own return, she deducted the cost of this rest and relaxation as a business expense. Unfortunately for her, the Tax Court ruled that the cost of her good night's sleep was a nondeductible personal expense.

Horse or No Horse

A woman deducted the costs of a horse-breeding activity on her return. The only problem is that she didn't own a horse in the year under IRS audit. She used to own horses, but she sold them over time. Her last horse died in 2008. Still, she took horse-related losses on Schedule C of her 2010 return. When the IRS asked how she could take horse-breeding losses when she didn't even own a horse, she claimed she was in the market for another horse and went to riding events. That's a far cry from active and regular involvement in a business, and the Tax Court nixed her loss.

Investigating Daddy's Mysterious Death

A CPA paid millions of dollars to private investigators and other experts to help him find out whether his father, who died when the taxpayer was a child, was murdered or committed suicide. He deducted the payments on Schedule C as business expenses. He believed that if he gathered enough evidence, the story could become a book or even a movie. The Tax Court categorized his activity as a hobby and nixed the write-off.

My Little Princess

A couple's daughter began competing in beauty pageants at age 9. She won between $1,000 and $2,000 in prize money each year that was deposited into her college savings account. The parents reported the income on their returns and also took large write-offs for the cost of travel, costumes and other expenses.

Because the prize winnings were compensation for the child's services in the pageant, they are included in her income. And only she can deduct the costs, even though the expenditures were made by the parents. So the Tax Court denied the parents' deductions.

Pizza for the Kids

A woman in Washington, D.C., ran her own staffing and consulting business. She hired her three children, ranging in age from 8 to 15, to help her with jobs such as shredding, stuffing envelopes, copying and tending the yard around her home office.

The mother, who was also a paid tax preparer, included the hours her kids worked on time sheets and issued them W-2 forms.

But instead of paying her children in cash, she bought them meals, including pizza, and paid for tutoring. She tried to deduct the kids' "wages" as business expenses, but the Tax Court didn't buy it. In its view, the services that the children performed were more for parental training and discipline than part of the typical activities of employees, so it denied her write-off in full.

Love & Marriage & Self-Employment Tax

A married couple operated separate proprietorships. The wife's operation turned a small profit, but her husband's business generated a sea of red ink. When figuring their self-employment tax bill, the couple claimed the bonds of matrimony allowed them to offset his loss against her income to wipe out any self-employment tax liability.

The IRS disagreed, saying that even though they were married, his losses could not be used to reduce the self-employment tax bill on her income. Playing the referee in this tax dispute, the Tax Court sided with the IRS because the husband had no hand in running her firm. "The fact that they discussed their respective businesses over meals does not establish that [the husband] played a role in operating the realty business," the ruling noted.

Payment for an Affair

After a police officer discovered his wife was having an affair with her doctor, he confronted the doctor and threatened a lawsuit. Eventually, the doctor agreed to pay $25,000 to settle the matter. The police officer claimed the $25,000 was a tax-free gift, but the Tax Court said that the payment is taxed as income because it was offered to settle the doctor's misconduct.

Prostitutes and Porn

A tax lawyer spent more than $65,000 in a year on prostitutes and pornographic materials. He deducted the total as a medical expense, making a novel argument that cited the positive health effects of sex therapy.

However, the Tax Court red-lighted his write-off, saying that his conduct not only was illegal, but also wasn't for the treatment of a medical condition.

Drug Overdose Scandal

The owner of a corporation took his girlfriend and two company employees on a Thanksgiving holiday trip to his vacation home on the Caribbean island of St. Maarten. While vacationing, the girlfriend died at the home of a likely cocaine overdose. The decedent's mother sued the owner and his company for wrongful death. The parties eventually settled for $2.3 million. The company deducted the payment on its federal tax return as a business expense, claiming the settlement was paid to protect the firm's assets and reputation. An Appeals Court denied the write-off because the origin of the lawsuit didn't arise from the corporation's business or profit-making activities.

Overdone Overdrafts

A couple who owned two struggling dry-cleaning businesses couldn't get a loan from their bank because they were judged to be a bad credit risk. But they worked out a deal to regularly overdraw their account and then satisfy the overdraft after the bank called them. This odd financing method caused them to incur more than $30,000 a year in overdraft charges, which they deducted as a business expense.

This didn't wash with the Tax Court, which nixed the write-off, saying the charges were unreasonably high. Not surprisingly, the pair wound up filing for bankruptcy.

Billing Mommy

A wife was sent to jail for killing her husband. Although she was named as the primary beneficiary of his 401(k) plan, state law barred her from receiving any of the funds because of her crime. So the account was paid to their son instead as the secondary beneficiary. He claimed that his mother should be taxed on the payout as the intended beneficiary. An appeals court gave him an A for effort but an F in taxation, ruling that he owes tax on the distribution.

Lunch with Cohorts

A partner in a law firm met every day with his colleagues at lunch to discuss the firm's business, such as case assignments and settlements. But the IRS balked when he asked Uncle Sam to pick up part of the tab. The Tax Court came down on the IRS' side, saying that the cost of the meals was a non-deductible personal expense, even though business was discussed. The moral of the story is that while the partner can have his cake and eat it for dessert, he can't get a subsidy from other taxpayers for his meals.

A Fish Tank

A couple's tax returns were filed late and were riddled with questionable deductions, such as the cost of dining room furniture and a fish tank. That piqued the IRS's attention. After an audit, the couple was slapped with a late-filing penalty and a big tax bill. They claimed that their late filing should be excused because their accountant had been sent to jail for killing her husband and the person who took over her office was incompetent. The Tax Court refused to cut them any slack.

Red Blood Cell Depletion Allowance

A woman with a rare blood type made more than $7,000 in a year as a blood plasma donor. She sought to offset the income by claiming a depletion deduction for the loss of both her blood's mineral content and her blood's ability to regenerate.

While depletion is a proper write-off for firms that remove natural deposits of minerals such as coal and iron ore from the ground, the Tax Court decided that individuals cannot claim depletion on their bodies.

A Trophy Collection

Large charitable deductions are one way to attract IRS attention (especially when they're so big that they have to be claimed over multiple years.) If they're in the form of non-cash contributions, where the question of "what's it worth?" is at stake, the likelihood of an audit goes up.

Claiming a $1.43 million write-off for animal hides, skulls, horns and other hunting specimens he donated to charity is how a big-game hunter found himself in the crosshairs of the IRS. The hunter claimed there was no way to determine a market price for his "museum quality" collection and based his deduction on what it would cost to replace them—that is, to return to Africa and the other locales where he'd hunted these trophies, shoot more animals, and ship them home.

The IRS objected, allowing a deduction of $163,045. In court, a variety of experts on taxidermy presented testimony. Ultimately, the Tax Court was convinced by the IRS's expert, who testified that there had "always been a market" for such items, and that, in any case, the donated items were just "remnants and scraps" worth a fraction of what the hunter claimed; in fact, far less than the IRS was willing to let him take.

Burning Down the House

Homeowners who want to tear down their homes and rebuild sometimes ask firefighters to burn them down. This training exercise serves the public good. But to get a deduction, an Appeals Court said that the homeowner must show that the value of the donation exceeded the value of the demolition services provided. Since the house in the case before the court had to be destroyed anyway to make room for its successor, its value was negligible and didn't exceed the value of the demolition services that the owners received, so the homeowner's charitable deduction was denied.

Deconstructing the House

A couple who bought residential property wanted to demolish the existing house and build another one to live in. They ended up conveying the old structure to a nonprofit that hires disadvantaged people to deconstruct buildings and salvage the materials. Neither the couple nor the charity recorded the conveyance in the state's land record. The couple took a charitable write-off for the house's full value. But an appeals court axed the deduction, saying the fact that the couple didn't transfer their entire real property interest precludes claiming any deduction for the donation.

Piling on the Points

Credit card rewards or points earned for credit card purchases are generally not taxable. That's because the rewards don't result in the receipt of gross income. Instead, they are treated as a reduction in the property purchased by the customer. This proposition was tested in Tax Court, in a unique case in which an individual manipulated American Express's credit card rewards program and racked up the points. He bought VISA gift cards with his credit card, earned cash rewards for the purchases, and used the gift cards to buy money orders that he deposited into his bank account. He also bought reloadable debit cards and money orders directly with his credit cards. Over a two-year period, he spent $6 million on these purchases and earned $300,000 in rewards. According to the Tax Court, the rewards earned through the purchase of the VISA gift cards are tax-free. But rewards earned on the direct purchase of money orders and reloadable debit cards are taxable.