Deducting Something You Did Not Pay For

What caught my eye was the amount of penalties at issue:

     Year                       Amount

     2002                       $  100,000

     2003                       $  105,000

     2004                       $1,822,000

     2005                       $1,785,000

     2006                       $1,355,000

The penalties total over $5.1 million. I had to look this case over, even though it weighs in at 123 pages.

It involves Martin Knapp, a CPA. He got his license in 1983.

He had worked at the IRS. He also taught accounting and taxation at Pepperdine and Los Angeles City College.

Not a bad resume, methinks.

He did something I never did: he specialized his practice. He focused on transportation workers, including airline pilots and railroad workers. He especially focused on mariners.

As of 2004 he employed 10 people.

Sounds successful to me.

He began his mariner practice around 1993. Two of his clients wound up in Tax Court, and it is there that our story begins.

The first client was Mr. Johnson, a deep-sea mariner. He would routinely work for four months and then take a two-month vacation.

The second was Mr. Westling, a tugboat captain in and around Alaska. He would work 30-day shifts on the tugboat.

Knapp amended Johnson’s return and prepared Mr. Westling’s return for 1996. He claimed a per diem for every day they were on the boat.

So what, right?

Here is the what: The per diem included a meal allowance, and their employers provided the meals.

I do not get it. How can someone get a deduction if that someone did not incur an expense in the first place?

The IRS flagged the returns, and both went to Tax Court.

Since they presented the same issue, the cases were consolidated.

In September, 2000 the Tax Court decided that neither could deduct meal expenses but they could deduct incidental expenses.

COMMENT: The incidental portion of a per diem is for tips and miscellaneous stuff, such as mouthwash. It is only a few bucks per day and nowhere near the amount allowed for meals. In short, there was a (very) minor victory and a very large defeat.

Mr Kapp did not represent in the Tax Court case, but he did read the decisions. He contacted the attorney who represented the IRS to request a face-to-face meeting. The attorney could not do this, as Kapp was an “interested” party. I could (hypothetically) have met with the attorney (as I had nothing to do with either Johnson or Westling), but Kapp was the CPA and therefore very much an interested party.

Kapp doubled down. He kept advising his clients that they could deduct meals even if meals were provided by their employer.

He tripled down. He created websites promoting his services to mariners and asserting that he could obtain tax refunds for them.

He quadrupled down. He wrote articles for Professional Mariner and The National Public Accountant. Here is an example:

The exciting news for mariners is that two U.S. Tax Court decisions last year settled the legal issue of allowing mariners to claim an almost unlimited amount of travel deductions while working away from home, without ever having to show the IRS any receipts, just like other transportation workers.”

Enter Examining Officer Tiffany Smith, who informed Kapp that he was the target of an IRS investigation for tax shelter promotion.

He sent her a 9-page letter detailing the relevant authority for the mariner deduction and arguing that the IRS does not oppose his position.

Does not oppose…?

Kapp wrote a letter he titled “Why is IRS Harassing Me for Twice Winning in U.S. Tax Court?”

This is going south ….

The investigation was transferred to George Campos, a revenue agent investigating tax promoters and abusive tax return preparers.

There is back and forth with Kapp and his attorney. In August, 2005 Campos and Kapp meet. Campos points out that there is no deduction for something one has not paid. Kapp asserts that “it does not matter if *** receive a meal or not, they’re still entitled to a deduction.”

Campos prepared an injunction.

Kapp’s attorney started to worry. He had an associate research the issue of mariners and meal deductions and memo the same. The result was pretty much the same as the IRS position, which was a bad place to be when you represent Kapp.

In early 2006 the Department of Justice sent Kapp a letter informing him that it was considering filing a lawsuit and providing him an opportunity to call and discuss the matter.

For all that is holy, Kapp, please STOP ….

At this point we are on page 55 of a 123-page court decision, and I am going to end it.

The IRS wanted him to stop. If he stops, he may yet walk away with all limbs still attached. Continue this quixotic quest, however, and he might lose it all.

The Court decided he was wrong and hardheaded. Not being without compassion, however, the Court reduced the penalties to $3,218,000.

There goes a lifetime of savings.

Oh, why, Kapp, why?

Oh Henry!

It is a classic tax case.

Let’s travel back to the 1950s.

Let us introduce Robert Lee Henry, both an attorney and a CPA.  He was a tax expert, but he did not restrict his practice solely to tax.

He was also an accomplished competitive horse rider. After he returned from military service, the Army discontinued its horse show team. In response, he organized the United States horse show civilian team.

He met the wealthy and influential, benefiting his practice considerably.

Then he had to give up riding. Heart issues, I believe.

But he was quite interested in continuing to meet the to-do’s and well-connected.

He bought a boat.

He traded it in for a bigger boat.

He bought a flag for the boat. It was red, white and blue and had the numbers “1040.”

People would ask. He would present his background as a tax expert. He was meeting and greeting.

His doctor told him to relax and take time off. Robert Lee called his son, and together they took the boat from New York to Florida. They then decided to spend the winter, as they were already there.

Robert Lee deducted 100% of the boat expenses.

QUESTION: Can Robert Lee deduct the expenses?

NERDY DETAIL: The tax law changed after this case was decided, so the decision today would be easier than it was back in the 1950s. Still, could he deduct the boat expenses in the 1950s?

The key issue was whether the boat expenses were “ordinary and necessary.” That standard is fundamental to tax law and has been around since the beginning. Just because a business activity pays for something does not mean that it is deductible. It has to strain through the “ordinary and necessary” colander.

In truth, this is not a difficult standard in most cases. It can however catch one in an oddball or perhaps (overly) aggressive situation.

Robert Lee was an accomplished rider, and he had developed a book of business because of his equestrian accomplishments. He monetized his equestrian contacts. He now saw an opportunity to meet the same crowd of folk by means of a boat.

Problem: Robert Lee did not use the boat to entertain or transport existing clients or prospective contacts.

And there is the hook. Had he used the boat to entertain, he could more easily show an immediate and proximate relationship between the boat, its expenses and his legal and accounting practice.

He instead had to argue that the boat was a promotional scheme, akin to advertising. It was not as concrete as saying that he schmoozed rich people in the Atlantic on his boat.

He had to run the “ordinary and necessary” gauntlet.

Let’s start.

He continued to have a sizeable equestrian clientele after he left competitive riding.

Good.

He was however unable to provide the Court a single example of a client who came to him because of the boat, at least until years later. Even then, there still wasn’t much in the way of fees.

Bad.

So what, argued Robert Lee. How is this different from buying a full-page ad in an upscale magazine?

Quite a bit, said the Court. You gave up riding for health reasons. There is no question that you derived tremendous personal enjoyment from riding. You have now substituted boating for riding. Enjoyment does not mean that there is no business deduction, but it does mean that the Court may look with a more skeptical eye. It would have been an easier decision for us if you had bought a full-page ad. There is no personal joy in advertising.

As a professional, I have to develop and cultivate many contacts – business, social, personal, political – retorted Robert Lee. One never knows who one will meet, and it takes money to meet money. That is my business reason.

Could not agree with you more, replied the Court. Problem is, that does not make every expenditure deductible. What you are doing is not ordinary. Let’s be frank, Robert Lee, the average attorney/CPA does not keep a yacht.

They would if they could, muttered Robert Lee.

Even if we agreed the expenses were “ordinary,” continued the Court, we have to address whether they are “necessary.” This test is heightened when expenses may have been incurred primarily for personal reasons. You did sail from New York to Florida, by the way. With your son. And you deducted 100% of it.

I am meeting rich people, countered Robert Lee.

Perhaps, answered the Court, but there must be a proximate relationship between the expense and the activity. What you are talking about is remote and incidental. It is difficult to clear the “necessary” hurdle with your “someday I’ll” argument.

Robert Lee shot back: my point should be self-evident to any professional person.

COMMENT: Folks, do not say this when you are trying to persuade a Court.

The Court decided that Robert Lee could not prove either “ordinary” or “necessary.”

The conclusion that the expenditures here involved were primarily related to petitioner’s pleasure and only incidentally related to his business seems inescapable.”

The Court denied his boat deductions.

Our case this time for the home-gamers and riders was Henry v Commissioner.