Deducting Business Interest From Personal Credit Cards

The case caught my eye because it involves a very common fact pattern:

A small business owner obtains credit cards in his/her personal name and uses it/them for business purchases and activities.

Question: Can the business deduct the interest on the credit cards?

I doubt that there is a tax practitioner out there that hasn’t deducted this, but a recent case points out minimum requirements in case the IRS challenges the deduction.

Let’s look at C.A. Simmons, TC Memo 2026-34.

I admit that I was expecting some technical dive into the interest deduction, but this case is not that. It is a reminder that one has to get to first base before being able to reach home plate. Strike out and the rest is meaningless.

Cathryn Simmons and her sister owned a specialty store (called Stuff) in Kansas City, Missouri. They had sold handmade and small-batch goods since 1996. As is too common, Stuff struggled to obtain credit in its own name, so the sisters used personal credit cards and loans to finance the business. They used QuickBooks for their accounting, and they did try to segregate the credit cards between those used for business and those used personally.  

COMMENT: I suspect most clients I have advised can remember my standard sermon:

·      Establish a separate business account. Business deposits and expenses go through the business account. Personal expenses do not. I understand that the bank is going to charge for a business account, and it might be cheaper to lean into a personal account. Do not do that. You already incurred that expense when you started the business.

·      I understand that you might not be able to get a credit card in the business name and may have to use a personal card. Use one card for business and the rest for personal. Do not intermingle the two.

·      If you are using a personal card, I might have the business recognize it as a loan from you. We will formalize it with a note, mention an interest rate and make some reference to repayment. Do not be surprised if the interest rate on the note is the same as the credit card.

·      Keep records of all business deposits and expenses. At a minimum, buy an expanding file and file the paperwork by month. When we finish the tax return for the year, combine the return and its paperwork into a file or folder for the year, and hold onto it.

Back to Stuff.

The IRS looked at the 2017 business return and 2017 and 2019 personal returns. They expanded the business audit to include cost of goods sold, advertising, vehicle expenses, travel, meals and entertainment, charitable and promotion, and interest. We will discuss only the interest deduction today.

Stuff field a partnership return, and each sister’s share of the 2017 business profit was less than $3 grand.

There was a little chop with the interest deduction because it included both interest on the credit cards and interest on the personal loans. I point it out because the Court says the following about the personal loans:

As an initial matter, … fails to establish that the purported interest amounts Stuff paid to her and her sister arose from Stuff’s own indebtedness. The record contains promissory notes … but no ‘loan papers’ establishing Stuff’s indebtedness to the sisters.”

… we cannot conclude from these payments and the sisters’ testimony that Stuff had an actual legal obligation to pay interest to them.”

I get it but … harsh. I suppose Stuff was not following the terms of the promissory notes. We would - of course - redraft the terms of the notes. This is low hanging fruit.

What about the credit cards?

Ms. Simmons likewise fails to demonstrate that Stuff was entitled to deduct the credit card interest and finance charges recorded on its QuickBooks account. The evidence shows that Ms. Simmons obtained and used credit cards in her own name to finance Stuff’s business expenses given its inability to obtain credit on its own. Ms. Simmons fails to show that any credit card interest and finance charges constituted Stuff’s own indebtedness rather than her personal indebtedness, and thus no deduction is appropriate.”

Stop. I am having a problem here, as I am quite aware of Reg 1.163-8T.

Seems to me that if (1) I trace a business expense from the credit card statement to (2) the QuickBooks, I have at least a good chance of meeting the requirement that “debt is allocated by tracing the disbursements of the debt proceeds to specific expenditures.”

Back to the Court:

Assuming arguendo that credit cards opened by Ms. Simmons constituted an indebtedness of Stuff, the records before us would not substantiate the amounts claimed. Although the sisters testified that they used the six designated credit cards exclusively for Stuff’s expenses, they failed to establish the amounts and business purposes of the underlying expenditures that resulted in the interest and finance charges at issue.”

They failed to establish the amounts and business purposes …?

I believe two things happened here:

(1)  Stuff could not document a lot of expenses. On quick review, I see the IRS disallowing almost $13 grand of vehicle expenses, $22 grand of charitable and promotion expenses, and so on.

(2)  If those expenses ran through the credit cards, then I understand an allocable portion of the interest being disallowed.

However, the Court just nixed the interest deduction altogether.

Seems to me that some of the credit card interest – that allocable to deductions allowed – should be deductible. I presume the accounting was not clean enough to do a side calculation. The IRS will rarely play forensic, and the Tax Court certainly will not.

The Court did reemphasize that it wanted to see linkage between the business activity and the credit cards, but that has been the rule since I have been practicing. There is nothing new here. Somebody just forgot to get on first base.  

Lost Records, A Dead Professional And A Tax Audit

 

I admit I was suspicious when I read the following:

The corporation had a bookkeeper during the years at issue, Robin Greenslade, who is now deceased. Petitioners trusted Ms. Greenslade to handle the accounting and did not regularly review her work.”

The corporation … also used the bookkeeping services of Joan Falanga during the years at issue. She recorded Mr. Ataya’s capital contributions …, but these records and, indeed, all of her records for the corporation are lost.”

That’s quite a run of bad luck.

By 2008 Hani Ataya had nearly 20 years’ experience in car sales. In 2008 he founded Cost U Less Cars, Inc., a California corporation, with a partner. The partner left in 2012 and Inaam Ataya (Hani’s mother) joined the business shortly thereafter. His mom had an IT degree and had worked for the state of California.

The business was relatively straightforward: it bought cars at auction and resold them. Hani was the primary buyer, and he regularly used cashier’s checks to buy cars. Sometimes he used them all, sometimes he did not. When he did not, he kept the unused checks in a desk drawer for later use.

COMMENT: Not loving this: it is weak control over cash and will look bad in the event of audit.

It appears Cost U Less Cars, Inc was making bank:

             

Wow.

The company then started losing money and ceased operations in 2020.

The company was audited by the IRS for years 2014 through 2017. The audit went poorly.

The company filed with the Tax Court. The filing was thrown out in August, 2023 because the corporation no longer existed under California law. A corporation is an artificial legal entity. It exists because a state says it exists and does not exist when a state says otherwise.

The IRS saw the Ataya’s taking approximately $1.5 million in 2015 via cashier’s checks to purchase a house in Granite Bay, California.

COMMENT: No problem as long as they reported it as income: wages, dividends, Nigerian prince 419 scam, whatever.

They took out additional cashier’s checks in 2016 to pay for flooring and improvements to the place.

COMMENT: Ditto.

The IRS next examined the two shareholder personal returns.

COMMENT: Not an uncommon expansion of the audit, and (frankly) expected in this instance.

Here are proposed adjustments to Hani’s 2015 and 2016 tax years:

     

Here are adjustments to his mom:

How can you miss $1.5 million? You would think they were in Congress or something.

The IRS came in hot. They wanted tax. They wanted penalties. And interest. Hani’s tab alone for the two years was over $600 grand.

The Ataya’s wanted penalty relief.

First up: Cost U Less Cars, Inc was hamstrung during its audit. Key players were gone. Its charter had been revoked, causing difficulties with obtaining alternative records.

Yep, the loss of two key players and business documentation was odd. What accounting remained was questionable, to such a degree that the IRS used bank account analysis to arrive at more solid numbers. Neither fact helped Hani and his mom, as those were outside normal business practices. And that charter thing was self-inflicted.

Next up: reliance on a professional.

I like it.

There were two bookkeepers, and someone (not a CPA) to prepare the tax returns.

Professionals.

Here are the ingredients to arguing reliance:

·       The advisor was competent with sufficient expertise to justify reliance.

·       The taxpayer provided necessary and accurate information to the advisor.

·       The taxpayer actually relied on the advisor’s judgement.

Then I read something I am unsure I have ever read before:

Although petitioners testified that they relied on … and … for bookkeeping services and on Mr. Packey for tax preparation services, the record lacks evidence of their professional qualifications or, in the case of Mr. Packey, evidence of his competence as a tax professional.”

Ouch. I am feeling vicarious pain on behalf of Mr. Packey.

The Tax Court sustained the penalties.

My thoughts?

I would have argued the penalties too. I almost have to, as a professional.

However, when I read the two Tax Court cases (business and personal), I was expecting fraud penalties at the end of the story.

Know when to walk away, folks.

Our case today was Ataya v Commissioner, T.C. Memo 2025-55.

AI Practicing Tax Law

 

I was working with a younger accountant this busy season who is a fan of AI in tax research. He uses it quite a bit. He also has a client who in turn has used AI to review his work. This has not amused my friend, and I understand he intends to fire the client.

Irony, methinks.

There has always been research in tax practice, and AI is just the newest and shiniest model on the lot. My concern about AI is that previous research alternatives did not invent answers - that is, hallucinate. This can be a problem, especially for a young(er) practitioner learning the ropes. An experienced hand may recognize when AI leaves the pavement. That is small comfort, as I question whether an experienced hand would rely heavily on AI.

As we have commented before: you don’t know what you don’t know.

Let’s look at the Clinco case.

Peter Clinco was an attorney in California. He mostly practiced real estate and business law. He was also an entrepreneur and spent much of his time running MedCafe Westwood, a restaurant and bar near the UCLA campus. It started off as a partnership, but over the years Clinco wound up owning the place by himself. MedCafe had approximately 60 employees but did not have strong accounting for sales and tips. This would become an issue.

Clinco personally prepared his 2015 tax return, although he filed it late (2018). He reported restaurant gross receipts of approximately $1.6 million, with enough expenses to show a net loss of $400 grand. We do not know whether filing late was an issue, but 2015 got pulled for audit. There were two areas on that return the IRS clearly wanted to look at:

• The restaurant
• Two rental properties

Why do I say “clearly?”  See a tax return the way I do: where are your subtractions – that is, your deductions? More specifically, where are your biggest deductions? That is where an auditor would want to look, because that is where the dollars – and audit adjustments – are.

The exam started in 2019, when Clinco was already quite ill. The accountant stepped in for Cinco, but this was after Clinco commented to the revenue agent that an estimated 10% of the restaurant’s revenues were in cash.

Clinco planted a bug in the auditor’s ear. The auditor responded by using a common-enough technique: comparing known credit (and debit) card transactions to reported cash transactions. While the ratios can vary (in this case, 90/10), it is a starting point. Sure enough, the auditor decided something was off and expanded her audit.

What does it mean to “expand”? Easy. She requested Forms 1099 issued to MedCafe. The IRS would have those as a matter of routine.

She also requested copies of bank statements.

COMMENT: The bank deposit analysis is virtually de rigueur for all Schedule C audits at this point (MedCafe was a Schedule C because Clinco owned 100%). The concept is easy: all deposits are income unless proven otherwise. Fail to prove otherwise and you have a problem. I had an audit – with deposit analysis – a few years ago. A son (my client) intermingled his business deposits with his father’s (both were contractors). Why? Who knows. It is not normal business practice; I had a difficult time understanding why he did this; the auditor had a difficult time believing either of us; and his foolishness made the audit much more difficult than it needed to be.

The IRS thought actual revenues were about $3.8 million – approximately $2.2 million more than the $1.6 million reported on the tax return.

Yep, you can see that train a ‘coming.

What was Clinco’s first line of defense?

COMMENT: Somewhere during this Clinco passed away. Technically the matter would have been pressed by his estate and agents.

Clinco challenged whether one of the early procedural steps - the Notice of Deficiency – needed to be signed by the IRS in fresh ink.

This is well-trod road with (very) low risk of victory, but Clinco’s attorney (Mr. Wagner) brought novelties to the party:

He cites ‘Cacchillo v Commissioner’ … as a case where the taxpayer challenged the validity of the notice of deficiency because it lacked an official signature. He claims we held the IRS’s failure to issue a valid signed notice of deficiency ousted us out of jurisdiction.”

Mr. Wagner claims ‘Cacchillo v Commissioner’ … overturned ‘Miller v Commissioner’ and ‘Tefel v Commissioner’ ….”

Here is the Court:

Neither of these cases exist as cited.”

OK.

There is no case named “Tefel v Commissioner …”

Going down folks.

The bouillabaisse of case names, reporter citations and legal propositions suggests something cooked up by AI.”

Hard landing imminent.

Their presence is unacceptable.”

So…  I would say that the IRS was not required to hard-sign the Notice of Deficiency.

On to the audit adjustments.

Cash deposit analysis is a long-standing technique. The Court granted an adjustment when Clinco could prove that a deposit was not income, but it was not going to reject the entire analysis.

Even money-losing businesses, however, can have unreported income.”

There was one more issue.

The IRS wanted some proof for depreciation expense on two rental properties.

Normally, this is not outrageous to provide. One gets a copy of the closing statement. Sometimes the municipality itself maintains those records. Granted, it may not show later improvements and whatnot, but it is a start.

Clinco went in a different direction. Clinco argued that the IRS could not challenge depreciation because they had allowed it in a different tax year.

Folks - with minimal exceptions - this is not the way it works. The IRS not asking about your “fill-in-the-box” deduction in year one does not mean they cannot ask about it in year three. This is long-standing practice and predates me being in school.

Even AI should have picked that up.

Our case this time was Peter L. Clinco, Deceased, C. M. Barone-Clinco, Successor in Interest, and C. M. Barone-Clinco, T. C. Memo. 2026-16

Social Security And A Claim Of Right

 

I am reading a Tax Court case.

I disagree with commentary on the case.

Let’s talk about Michael Smith and his 2022 tax return.

Michael worked a couple of jobs in 2022 and reported wages of $16 grand on his individual tax return. I see that one of his employers was New York City Transit. Michael would not have gotten far in New York with only $16 grand of earnings.

He applied for Social Security disability in April 2022.

I am thinking that he worked, got injured and applied for disability.

In November 2022, the SSA sent a letter saying that he qualified for SSI retroactive to March. He received SSI of $26,802 for the year.

And in April 2023 the SSA wanted the money back.

Why?

The SSA explained:

Your disability payments were stopped as of April 2023 because we learned that you had been working since April 2022.”

Well, so much for my guess that he got injured and stopped working.

Michael repaid what he could and set up a payment plan for the balance.

What makes this a tax case is that Michael left the SSI off his 2022 tax return.

Social security disability is taxed the same as regular social security. There is an unfortunate tax maze here, I admit. Up to a certain income, 50% of one’s social security is taxable. Keep increasing income and up to 85% is taxable. Land somewhere in-between and you almost need software to do the math. It is not a pretty area of the tax Code, frankly.

Michael explained that he omitted the social security because it was “an accidental overpayment” and was “repaid … in full.” He considered it more a loan than taxable income.

I get it, but Michael ran face first into a basic principle in taxation: you have to report what happened during the taxable period. In this case the period was 2022. By the end of 2022 he did not know that he would be required to return the money to the SSA. This was income free-and-clear when the New Year’s ball dropped.

OK, you ask: when would Michael make it right on his taxes?

In 2023, when he found out and returned the money.

How would Michael make it right?

He would do a special calculation on his 2023 return.

The concept here is called “claim of right,” and it goes back to a famous 1932 tax case. It was formalized into the tax Code in 1954 as Section 1341.

Have you ever read or heard a case about a corporate executive or professional athlete having to return money to his/her employer or team? The tax side (almost certainly) involves Section 1341.

How does it work?

First, there have to be (at least) two tax periods at play. If Michael had learned and repaid the SSA by the end of 2022 there would be no tax issue. It is flipping the calendar and starting another period that sets up the claim of right.

Second, there are two calculations, and you use the one yielding the smaller tax.

You run the tax for the year (of repayment) with the deduction, and

You (re)run the tax for the original year (that is, the claim of right year) with the deduction.

You use the smaller tax.

And yes, there can be trap here.

What if the repayment year has much less (or worse, no) income than the claim of right year?

You have a problem because the calculation takes the smaller of the two amounts. The flaw is baked into Section 1341.

The commentary I read speculated that the case may have involved a statute of limitations issue.

Nope, methinks.

Our secret mystery obscure Section 1341 kicks-in for the repayment year, which is 2023 in this case. The 2023 return was due on April 15, 2024. Let’s skip extensions and whatnot: the earliest that statute will expire is April 15, 2027.

No, I don’t think that was it.

Michael went for a long shot and hoped to exclude the income from his 2022 rather than 2023. Why?

Because Michael had no (or little) income in 2023 to absorb the Section 1341 lesser-of calculation.

I am again wondering if Michael was truly disabled in 2022 and subsequently got run over by both the SSA and IRS.

Our case this time was Smith v Commissioner, T.C. Memo 2026-25.