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.

Why Do We Keep Vehicle Logs?

  

November proved to be an interesting month here at Galactic Command. Everything changes; we have changed; there is sadness about the change. We may talk about this someday, but for today let’s keep our discussion to matters of tax.

Here is an easy one, but many get it wrong: can you estimate your auto expenses?

The use of estimates in accounting is prevalent: a bad debt reserve, an inventory write-down, even something as prosaic as depreciation.  It has to be this way, otherwise you could not get financial results out in time to be useful. For example, say you have a warranty program on a newer – and significant – product line. You may want to accrue a warranty reserve on this product line, but the line does not have sufficient track record to be statistically reliable.  I suppose you could skip a reserve altogether (not a good answer) or wait until there is enough history before issuing financials (also not a good answer).

Tax returns also use these numbers. Mind you, a tax return has a separate purpose from financial accounting - the purpose of a tax return being to separate you from your money. Depending upon, the IRS may flat-out tell you what accounting method to use. In most cases, though, tax and financial accounting coexist well enough.

There was a case in the 1930s that many tax advisors have studied: Cohan.

George Cohan was a famous Broadway star, producer and manager in the early part of the 1900s. He was known for his over-the-top entertaining of both fans and critics, and entertainment was a significant part of his business expenses. What George was not good at, though, was keeping receipts and records. He got audited, and the IRS proposed to disallow a raft of deductions because Cohan could not substantiate them. The IRS won before the Tax Board of Appeals (think the predecessor to today’s Tax Court).

Cohan had no intention of rolling over. He appealed.

And he won on his appeal.

The Court reasoned that approximating his expenses may be unsatisfactory, but an outright denial of his expenses was erroneous.

So, the Court estimated what his expenses would be. Mind you, there were some guardrails, such as the proving a right to deduct the expenses and providing some basis for the deduction (restaurant booking registers, for example), such that an independent person could agree that an expense was incurred and when.

This estimating of expenses has since been known as the Cohan rule.

But you know who did not like the rule? Congress. They wrote the following into the tax Code:

Section 274(d)

               (d) Substantiation required

No deduction or credit shall be allowed—

(1) under section 162 or 212 for any traveling expense (including meals and lodging while away from home),

(2) for any expense for gifts, or

(3) with respect to any listed property (as defined in section 280F(d)(4)),

unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating the taxpayer’s own statement (A) the amount of such expense or other item, (B) the time and place of the travel or the date and description of the gift, (C) the business purpose of the expense or other item, and (D) the business relationship to the taxpayer of the person receiving the benefit. The Secretary may by regulations provide that some or all of the requirements of the preceding sentence shall not apply in the case of an expense which does not exceed an amount prescribed pursuant to such regulations. This subsection shall not apply to any qualified nonpersonal use vehicle (as defined in subsection (i)).

Yes, it reads like gobbledygook but note the phrase “unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating the taxpayer’s own statement.” Congress was saying that – for certain expenses – Cohan would be insufficient to save the day. One of those expenses was “listed property” which normal people refer to as a car or truck.

The Cohan rule will not save you when it comes to car and truck expenses. You have to keep records, such as a log or something similar for the business use of the vehicle.

Lisa Nkonoki deducted $22,936 for vehicle expenses on her 2009 federal tax return. Most of it was for the use of her Mercedes, but there were also rental cars during the year. She did not have a fixed office, meaning that she travelled – a lot.

The IRS wanted that mileage log.

Lisa refused. Off to Court they went.

Now the Court wanted the log.

Lisa told the Court that she had provided the log to the accountant who prepared her return, but the accountant failed to return it to her.

This placed the Court in a tough spot.

Her word alone was insufficient to substantiate the deduction.  The Court knew that her work involved travel – meaning that vehicle expenses were to be expected – but Section 274(d) would not let the Court estimate those expenses.

The Court disallowed her vehicle expenses.

I am curious why Nkonoki did not provide an alternative:

Using her e-mail, telephone and credit card records, could she have recreated an alternate log of her travel, including clients, dates and distances? We think of a log as being created at the moment (“contemporaneous”), but the Courts have noted that is not the correct meaning. Contemporaneous also encompasses other information (think e-mails) created at or near the time the expenses were incurred. Perhaps one transcribes that information into more usable form at a later time (such as a Tax Court hearing), but the information underlying such transcription was created at or near the time – that is, it was contemporaneous.

Our case this time was Nkonoki v Commissioner, T.C. Memo 2016-93.

A Real Estate Course – And Dave

 

The case made me think of Dave, a friend from long ago – one of those relationships that sometimes surrenders to time, moving and distance.

Dave was going to become a real investor.

That was not his day job, of course. By day he was a sales rep for a medical technology company. And he was good at sales. He almost persuaded me to join his incipient real estate empire.

He had come across one of those real estate gurus – I cannot remember which one – who lectured about making money with other people’s money.

There was even a  3-ring binder or two which Dave gave me to read.

I was looking over a recent case decided by the Tax Court.

The case involved an engineer (Eason) and a nurse (Leisner).

At the start of 2016 they owned two residential properties. One was held for rent; the other was sold during 2016.

COMMENT: Seems to me they were already in the real estate business. It was not a primary gig, but it was a gig.

Eason lost his job during 2016.

A real estate course came to his attention, and he signed up – for the tidy amount of $41,934.

COMMENT: Say what?

In July 2016 the two formed Ashley & Makai Homes (Homes), an S corporation. Homes was formed to provide advice and guidance to real estate owners and investors.  They had business cards and stationary made and started attending some of those $40 grand-plus courses. Not too many, though, as the outfit that sponsored the courses went out of business.

COMMENT: This is my shocked face.

By 2018 Eason and Leisner abandoned whatever hopes they had for Homes. They never made a dime of income.

You know that $40 grand-plus showed up on the S corporation tax return.

The IRS disallowed the deduction.

And tacked on penalties for the affront.

This is the way, said the IRS.

And so we have a pro se case in the Tax Court.

Respondent advances various reasons why petitioners are not entitled to any deductions …”

The respondent will almost always be the IRS in these cases, as the it is the taxpayer who petitions the Court.

And we have discussed “pro se” many times. It generally means that a taxpayer is representing himself/herself, but that is not fully accurate. A taxpayer can be advised by a professional, but if that professional has not taken and passed the exam to practice before the Tax Court the matter is still considered pro se.

Back to the Court:

          … we need to focus on only one [reason].”

That reason is whether a business had started.

Neither Homes nor petitioners reported any income from a business activity related to the disputed deductions, presumably because none was earned.”

This is not necessarily fatal, though.

The absence of income, in and of itself, does not compel a finding that a business has not yet started if other activities show that it has.”

This seems a reasonably low bar to me: take steps to market the business, whatever those words mean in context. If the context is to acquire clients, then perhaps a website or targeted advertising in the local real estate association newsletter.

Here, however, the absence of income coupled with the absence of any activity that shows that services were offered or provided to clients or customers […] supports respondent’s position that the business had not yet started by the close of the year.”

Yeah, no. The Court noted that a business deduction requires a business. Since a business had not started, no business deduction was available.

The Court disagreed with any penalties, though. There was enough there that a reasonable person could have decided either way.

I agree with the Court, but I also think that just a slight change could have changed the outcome in the taxpayers’ favor.

How?

Here’s one:  remember that Eason and Leisner owned a rental property together?

What if they had broadened Homes’ principal activity to include real estate rental and transferred the property to the S corporation? Homes would have been in business at that point. The tax issue then would have been expansion of the business, not the start of one.

Our case this time was Eason and Leisner v Commissioner, T.C. Summary Opinion 2024-17.

Caleb William’s NFL Contract

 It may be that the NFL saved him from bad tax advice.

We are talking about Caleb Williams, the 2024 NFL number one overall draft pick by the Chicago Bears. He signed a four-year fully guaranteed contract for $39.5 million.

I can only wish.

But it was two additional negotiating positions that caught my eye.

(1)  He wanted to be paid via an LLC.

(2)  He wanted some/all of his contract to be structured as a forgivable loan.

I read that he was represented by his father, who has experience in commercial real estate but is not a registered agent.

But it helps to explain the LLC. The use of LLCs for real estate is extremely common, so his father would have seen their use repetitively. Still, what is the point of an LLC with an NFL contract?

It might be the expenses that an NFL player might incur: agent fees, union dues, specialized training and related travel, certain therapies and so forth. As those receiving a W-2 know, employee business expenses are presently nondeductible. If Caleb could run his NFL earnings through an LLC, perhaps he could avoid employee business expense classification and deduct them instead as regular business expenses.

There is a hitch, though. None of the four major team sports will pay compensation to an entity rather than directly to the athlete. In contrast, non-team athletes – like golfers – can route their earnings through a business entity. A key difference is that the PGA considers its golfers to be independent contractors, whereas the NFL (or MLB, NBA, or NHL) considers its players to be employees.

There is speculation that Caleb may have preferred an LLC because LLCs – ahem – “do not file tax returns.”   

Not quite. The tax treatment of LLCs is quite straightforward:

(1)  If the LLC has partners, then it will file a partnership return.

(2)  If the LLC elects to be taxed as a corporation, then it will file a corporate return. If an S election in place, it will file an S corporation return.

(3)  If the LLC has a single member, then the LLC is disregarded and does not file a tax return.

Do not misunderstand that last one: it does not say that income belonging to the LLC does not land on a tax return.

Let’s say that Caleb created a single member LLC (SMLLC). SMLLCs are also referred to as disregarded entities. The tax  Code instead considers Caleb and his SMLLC to be the same taxpayer. That is why there is no separate LLC return: all the income would be reportable on Caleb’s personal return.

Could someone have read the above and thought that income routed through an SMLLC is not taxed at all?

If so, Caleb really needs to hire a tax professional yesterday.

What about the loan forgiveness proposal?

I get it: loans are normally not considered income, as any increase in wealth is immediately offset by an obligation to repay the loan.

OK, Caleb receives contract monies, but he is liable for their repayment to the NFL. This potential liability means no immediate income to him. He would have income when the loan is forgiven, and (hopefully) he has some control when that happens.

But the NFL can call his loan, meaning he then must repay.

Oh puhleeeze.

Not to worry, says whoever. The NFL has no intention of calling the loan.

I am a huge NFL fan, but I am not an NFL team owner fan. There is no way I am trusting my money to owners who are monetizing their sport to such a degree that many fans cannot even see the games. Seriously, how many streaming services do they think an average person can afford?

What if Caleb includes conditions and guarantees and collateral and puts and ….?

Listen to yourself. You are leaving loan-land and whatever tax idea you started with. The IRS will come to the same conclusion. You have accomplished nothing, and you may even be exposing yourself to fraud charges.

I suppose Caleb could structure it as deferred compensation, the way Shohei Ohtani did with the Los Angeles Dodgers. Deferred compensation can get into crazy tax tripwires, but at least we are no longer talking about loans. If this is what he wants, then drop the loan talk and negotiate deferred compensation.

That is BTW what I would do. There is enough money here to make Caleb rich both now and later.

The NFL did Caleb Williams a favor by shooting down both proposals. 

Taxing A 5-Hour Energy Drink

 

I am skimming a decision from the Appeals Court for the District of Columbia. I am surprised that it is only 15 pages long, as it involves a gnarly intersection of partnership tax and the taxation of nonresident aliens.

Let’s talk about it.

In general, partnerships are not treated as a taxable entity. A partnership is a reporting entity; it reports income and expenses and then allocates the same to its partners for reporting on their tax returns. Mind you, this can get mind-numbing, as a partner in a partnership can itself be another partnership. Keep this going a few iterations and being a tax professional begins to lose its charm.

A partner will - again, in general - report the income as if the partner received the income directly rather than through the partnership. If it was ordinary income or capital gain to the partnership, it will likewise be ordinary income or capital gain to the partner.

Let’s introduce a nonresident alien partner.

We have another tranche of tax law to wade through.

A nonresident alien is fancy talk for someone who does not live in the United States. That person could still have U.S. income and U.S. tax, though.

How?

Well, through a partnership, for example.

Say the partnership operates exclusively in the United States. A nonresident alien generally pays tax on income received from sources within the United States. Let’s look at one type of income: business income. We will get to nonbusiness income in a moment.

The tax Code wants to know if that business income is “effectively connected” with a U.S. trade or business.

The business income in our example is effectively connected, as the partnership operates exclusively in the United States. One cannot be any more connected than that.

The partnership will issue Schedules K-1 to its partners, including its nonresident alien partner who will file a U.S. nonresident tax return (Form 1040-NR).

Question: Will any nonbusiness income on the K-1 be reportable on the nonresident?

The tax Code separates business and nonbusiness income because they might be taxed differently for nonresidents. Nonbusiness income can go from having 30% withholding at the source (think dividends) to not being taxed at all (think most types of interest income).

What if the Schedule K-1 reports capital gains?

I normally think of capital gains as nonbusiness income.

But they do not have to be.

There is a test:

If the income is derived from assets used or held for use in the conduct of an effectively connected business – and business activities were a material factor in generating the income  – then the income will taxable to a nonresident alien.

Think capital gain from the sale of farm assets. Held for use in farming? Check. Material factor in generating farm income? Check. This capital gain will be taxable to a nonresident.

Forget the K-1. Say that the nonresident alien sold his/her partnership interest altogether.

On first impression, I am not seeing capital gain from the sale of the partnership interest (rather than assets inside the partnership) as meeting the “held for use/material factor” test.

Problem: partnership taxation has something called the “hot asset” rule. The purpose is to disallow capital gains treatment to the extent any gain is attributable to certain no-no assets – that is, the “hot assets.”

An example of a hot asset is inventory.

The Code does not want the partnership to load up on inventory with substantial markup and then have a partner sell his/her partnership interest rather than wait for the partnership to sell the inventory. This would be a flip between ordinary and capital gain income, and the IRS is having none of it.

Question: have you ever had a 5-hour Energy drink?

That is the company we are talking about today.

Indu Rawat was a 29.2% partner in a Michigan partnership which sells 5-hour Energy. She sold her stake in 2008 for $438 million.

I can only wish.

At the time of sale, the company had inventory with a cost of $6.4 million and a sales price of $22.4 million. Her slice of the profit pending in that inventory was $6.5 million.

A hot asset.

The IRS wanted tax on the $6.5 million.

Mind you, Indu Rawat did not sell inventory. She sold a partnership interest in a business that owned inventory. That would be enough to catch you or me, but could the hot asset rule catch a nonresident alien?

The Tax Court agreed with the IRS that the hot asset gain was taxable to her.

That decision was appealed.

The Appeals Court reversed the Tax Court.

The Appeals Court noted that there had to be a taxable gain before the hot asset rule could kick in. The rule recharacterizes – but does not create – capital gain.

This capital gain does not appear to meet the “held for use/material factor test” we talked about above. You can recharacterize all you want, but when you start at zero, the amount recharacterized cannot be more than zero.

Indu Rawat won on Appeal.

By the way, tax law in this area has changed since Rawat’s sale. New law would tax Rawat on her share of effectively connected gain as if the partnership had sold all its assets at fair market value. Congress made a statement, and that statement was “no more.”

Our case this time was  Indu Rawat v Commissioner, No 23-1142 (D.C. Cir. July 23, 2024).