APPEAL OF PROPOSED DEFICIENCY
Business Expense
TAXPAYER NAME
Submitted by:
Student’s name, Student Attorney
Philip C. Cook Low-Income Taxpayer Clinic
P.O. Box 4037, Atlanta, GA 30302-4037
Ph. (404) 413-9230
Fax (404) 413-9229
e-mail: taxclinic@gsulaw2.gsu.edu
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TABLE OF CONTENTS
Relief Requested ........................................................................................... .3
Procedural Background Of Matter ................................................................. .3
Statement Of Facts ....................................................................................... .4
Applicable Law .............................................................................................. 5
Application Of The Law To The Facts.............................................................7
Conclusion..…………………………………………………………….……..……10
Exhibits
A.
B.
C.
D.
E.
F.
G.
H.
I.
J.
K.
L.
M.
N.
O.
P.
Q.
R.
Form 2848 - Power of Attorney
Account Transcript 2009
Tax Returns for 2007-2009
IRS Notice dated June 4, 2012
Notice of proposed changes dated August 13, 2012
Protest Letter from Ms. TAXPAYER dated September 28, 2012
Wage and Income Transcripts for 2007-2009
Statement from Ms. TAXPAYER
Roster of Customers
Log Book
Customer profile cards
Map of customers by zip code
Map of downstream recruits by zip code
Leased car odometer disclosure form
Direct Sales provided 1099 Income information for 2009
Receipts for advertising purchased in 2009
Description of Direct Sales “Income Opportunities”
Commission payment statement from Direct Sales for 2009
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APPEAL OF PROPOSED DEFICIENCY
RELIEF REQUESTED
Briefly state the Taxpayer’s name, what you are requesting the IRS to do, and the
Code section(s) applicable.
TAXPAYER’S NAME respectfully requests the Internal Revenue Service to
reconsider its disallowance of her business expenses for tax year 2009 and eliminate the
proposed deficiency for that year. Ms. TAXPAYER was entitled to claim ordinary and
necessary business expenses paid in the operation of her Direct Sales business under
I.R.C. § 162. (If IRS challenges that the client was even in a business then include
this issue.) If Ms. TAXPAYER is found not be engaged in a trade or business, under
I.R.C. § 183 she should be allowed to deduct expenses up to the amount of her gross
income from her Direct Sales activity.
PROCEDURAL BACKGROUND OF TAX MATTER
Include the following information in this section:
 Filing history of the year or years at issue
 Brief discussion of issues that gave rise to the liability.
 Discussion of the issuance of the notice or IRS correspondence that
triggered this memo and who in the IRS issued it (Examination, Appeals,
Collections). Include a copy
 Discussion of whether the client or the Clinic filed something to give rise to
this memo, e.g. who filed or entered an appearance in Tax Court, the date of
Counsel’s Answer, etc… and whether the Clinic entered an entry of
appearance and the date of Counsel’s Answer.
 Discussion of where current jurisdiction lies (Appeals, Counsel or
Collections or Taxpayer Advocate) and what transpired at lower level of IRS.
Ms. TAXPAYER filed a return for tax year 2009 on February 18, 2010 (see Exhibit
B which includes an Account Transcript for 2009). On her 2009 Form 1040 Schedule C,
Ms. TAXPAYER reported income of $6,593 from the sale of cosmetic products. She also
claimed business expenses in the “Car and Truck” and “Other” categories of $7,456 and
$624, respectively (see Exhibit C which is her 2009 return). In an examination notice
dated June 4, 2012, the IRS notified Ms. TAXPAYER that her 2009 Schedule C was
under review (see Exhibit D which includes the notice). Ms. TAXPAYER requested
additional time to gather supporting documents. (see Exhibit D which is a letter dated July
3, 2012). Before Ms. TAXPAYER could gather the documents and prepare a response,
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the IRS issued an examination report dated August 13, 2012 disallowing the business
expenses entirely, without giving credit for the deductions to the extent of the Direct Sales
gross income, increasing her adjusted gross income by $8,080 and proposing changes in
the amount of income tax due (see Exhibit E which includes form 4549 – Income Tax
Examination Changes). Ms. TAXPAYER disputes the proposed changes and is providing
documentation to support and substantiate her claims. The settlement jurisdiction for the
2009 tax return lies with Appeals.
STATEMENT OF FACTS
Use this section to provide the applicable facts addressing the issue, as well as
contextual information to help the IRS understand the Client’s personal and
financial situation. Use exhibits to substantiate your claims, and make reference to
all exhibits (e.g., “see Exhibit xx which is a ____ showing _____.
If you are arguing that the activity was a business, use this space to explain
why the Client started the business, why it was not successful, and why it ended.
Later, you will argue that the Client had a good faith belief that the business would
be profitable. Be sure to give reasons why that belief existed, even when the
business lost money. You may want to have the client write and sign a statement
attesting to their honest belief that they would make a profit. Try to find evidence
that can be used to support each of the nine factors used by the Tax Court
(described below).
If you are arguing that the IRS should allow business expenses, describe
how the business worked and how the business expenses would lead the
generation of income. Try to provide logs and records of the business activity (e.g.,
a calendar of sales calls, a roster of clients with addresses if you’re asking for
travel expenses, etc.). The client can show that the activity was a legitimate
business with his or her books and records, business licenses, invoices from client
and invoices of business expenses.
Ms. TAXPAYER is a 36 year-old single mother of three who lives in Atlanta, GA.
She came to the U.S. from Guatemala when she was seventeen years old, and she is
now a U.S. citizen. Ms. Taxpayer began selling Direct Sales products on a part-time basis
in September 2007. In July of 2008, she lost her full-time job as an administrative
assistant for a shipping company, and she remained unemployed until October 2009.
During that time, she had two sources of income – her Direct Sales commissions and
unemployment benefits (see Exhibit G which are Wage and Income transcripts for 20072009).
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Direct Sales is a company providing cosmetic products which are sold to the
general public through independent sales representatives like Ms. TAXPAYER. The
representatives receive commissions for their sales and a portion of the sales of any
representatives they recruit (see Exhibit Q which is a copy of their website description).
While she started her Direct Sales business as a part-time supplement to her
income, she worked at it full-time after she lost her job in 2008 (see Exhibit H which is a
statement from Ms. TAXPAYER describing her work with Direct Sales). She was initially
successful with Direct Sales, but as the economy deteriorated in late 2008 and throughout
2009, her sales decreased and her downstream recruits failed to meet their sales targets.
Even so, in 2009 she received $6,593 in gross income from Direct Sales business (see
Exhibit C which is a copy of her 2009 tax return). Ms. TAXPAYER also drew $11,985
worth of taxable unemployment compensation in 2009, and she earned $5,389 as a case
worker at a homeless shelter from October through the end of 2009 (see Exhibit G which
is a Wage and Income Transcript for 2009).
Ms. TAXPAYER reported losses for her Direct Sales activities in tax years 20072009. The majority of each loss was due to her deduction for Car and Truck expenses
(see Exhibit C which includes transcripts of her returns for 2007-2009).
Describe the day-to-day activity in operating the business. Remember, for a
deduction, you must show that the expenses are ordinary and necessary, and
provide documentation.
From the beginning of her tenure with Direct Sales, Ms. TAXPAYER attended
weekly Direct Sales-sponsored training seminars in the Atlanta area. Her business
activities occurred over a wide geographic area that extended beyond metropolitan
Atlanta. She drove extensively to meet with her existing clients and her downstream sales
representatives, and to gain new customers and new sales representatives (see Exhibit I
which is a roster of customers, see Exhibit K which is her customer profile cards, see
Exhibit L which is a map of the location of Ms. TAXPAYER’s customers by zip code.). She
kept a record of her trips to these meetings and sales calls in her log book (see Exhibit J
which is a copy of her log book).
Ms. TAXPAYER attempted to increase her sales by advertising her products in
local gyms and restaurants (see Exhibit P which are receipts for advertisements placed).
Explain why the Client persisted in a business even after she had a loss.
Because of the number of downstream recruits, Ms. TAXPAYER was recognized
as a Sales Director in December 2008. This title came with access to a car leased by
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Direct Sales in her name, with the requirement that she or her recruits place orders for at
least $5,000 of product each month. Ms. TAXPAYER picked up the car in January 2009
and returned it in October 2009 (see Exhibit N which is documentation of the lease,
including a statement of the car’s mileage during the lease period).
Describe the end of the Client’s business as evidence that she undertook the
activity to make a profit, and when it became evident that a profit would not be
coming, she stopped.
Ms. TAXPAYER worked diligently at her Direct Sales business, but when she
eventually stopped selling Direct Sales products and gave back the automobile they had
provided her, the commissions from her remaining active recruits were garnished by
Direct Sales to offset the wholesale purchases of product that Ms. TAXPAYER was
unable to sell (see Exhibit R which is a statement of commissions paid by Direct Sales in
2009). She no longer sells Direct Sales products.
Ms. TAXPAYER is currently employed as a part-time sales clerk at a department
store. She continues to look for a full-time job. Her family’s finances are strained (the
family receives $200 per month in Supplemental Nutrition Assistance – food stamps).
APPLICABLE LAW
Under this section don’t put facts, only law. The section should begin with
statutory references, then cases, then regulations, then other authority.
If you’re discussing deductions, look to the Code and Treasury Regulations
for any limits that Congress or the IRS may have placed on categories of expenses
(e.g., § 274 and limits on meals and entertainment).
Burden of Proof
In general, the IRS’s determination of the existence of a tax liability is presumed to
be correct, and the burden is on the taxpayer to prove otherwise. Tax Court Rule 142;
Welch v. Helvering, 290 U.S. 111, 11 (1933). However, the burden may shift where a
taxpayer produces credible evidence with respect to any factual issue relevant to
ascertaining his income tax liability. I.R.C. Section 7491 (a)(1); see also I.R.M. 35.4.1.6.1
(08-11-2004).
Business Expenses
I.R.C. § 162(a) provides a deduction for all the ordinary and necessary expenses
paid or incurred during the taxable year while carrying on any trade or business. Ordinary
expenses are those that are common and accepted in the taxpayer’s trade or business.
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Deputy v. du Pont, 308 U.S. 488, 495 (1940). Necessary expenses are those that are
helpful and appropriate for the trade or business. Commissioner v. Heininger, 320 U.S.
467, 471 (1943). Regulations § 1.162-1 further limits deductible business expenses as
those “directly connected with or pertaining to the taxpayer’s trade or business.” These
are said to include the “supplies. . . advertising and other selling expenses.” Further, Reg.
§ 1.162-1 specifically allows a deduction for “operating expenses of automobiles used in
the trade or business.”
Regulations § 1.162-17(d) discusses the substantiation of ordinary and necessary
business expenses. While Reg. § 1.162-17(d)(1) states that the Commissioner may
require any taxpayer to substantiate expense in determining tax liability, Reg. § 1.16217(d)(2) describes one method of substantiation as “ the preparation of a daily diary...
maintained in sufficient detail to enable him to readily identify the amount and nature of
any expenditure,” while also admitting that “it is often difficult . . . to maintain detailed
records” for all expenses.
Because it is often difficult to maintain detailed records, courts have allowed
approximations of business expenses under the Cohan rule. Cohan allows estimations of
deductible expenditures by taxpayers who have not maintained sufficient definite proof of
those expenses and might otherwise suffer the loss of the deductions. Cohan v.
Commissioner, F. 2d 540 (2nd Cir. 1930), limited, though by Code section 274(d). Reg. §
1.162-17(d)(3) goes further and allows the amount of the expenditures to be established
“by approximations based upon reliable secondary sources of information and collateral
evidence” while giving “due consideration … to the reasonableness of the stated
expenditures” in relation to the nature of taxpayer’s income and occupation.
Certain expenses do not fall under Cohan. For these, IRC § 274 requires actual
substantiation. The following excerpt from a Tax Court opinion explains:
“For certain kinds of business expenses, section 274(d) overrides the Cohan
rule. See Sanford v. Commissioner, 50 T.C. 823, 827-828 (1968), aff'd, 412 F.2d 201
(2d Cir. 1969). Under section 274(d), a taxpayer must satisfy strict substantiation
requirements before a deduction is allowable. These requirements apply to any
traveling expense, including meals and lodging away from home, to any item with
respect to an activity in the nature of entertainment, and to the use of listed
property, as defined in section 280F(d)(4), including passenger automobiles and
cellular phones.
“To satisfy the requirements of section 274(d), a taxpayer must maintain
records and documentary evidence that in combination are sufficient to establish
each element of an expenditure or use. Sec. 1.274-5T(c)(1) and (2), Temporary
Income Tax Regs., 50 Fed. Reg. 46016-46017 (Nov. 6, 1985). While a
contemporaneous log is not required, corroborative evidence created at or near the
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time of the expenditure to support a taxpayer's reconstruction "of the elements * *
*. * * * of the expenditure or use must have a high degree of probative value to
elevate such statement" to the level of credibility of a contemporaneous record.
Sec. 1.274-5T(c)(1), Temporary Income Tax Regs., supra.”
Car & Truck expenses are not travel. Travel is “overnight travel for business
while away from your tax home.” However, § 280F(d)(4) applies to the expense of
operating most vehicles.
Section 162 deductions are limited to those expenses incurred and paid while
carrying on a trade or business. The Internal Revenue Code does not define “carrying on
a trade or business,” but the courts have given a definition, at least indirectly. The primary
case is Higgins v. Commissioner, 312 U.S. 212 (1941), in which the Supreme Court held
that the determination of whether a taxpayer is carrying on a trade or business requires
an examination of all the facts and circumstances of each case. In general, courts have
required some showing that:
1) The taxpayer has a good faith intention of making a profit or producing income,
(whether or not the expectation is reasonable reasonable expectation), Groetzinger
v. Commissioner, 771 F. 2d (7th Cir. 1985);
2) by engaging in an extensive activity over a substantial period of time, McDowell
v. Ribicoff, 292 F 2d 174 (3rd Cir. 1961);
3) in an activity already actually begun, Johnsen v. Commissioner, 83 T.C. 103
(1983) (applying Richmond Television trade or business test to differentiate
between deductible trade or business expenses from preliminary capital
expenses);
4) in which the taxpayer has held themself out “to others as engaged in the selling
of goods and services;” Gajewski v. Commissioner, 723 F. 2d 1062, 1065 (2nd Cir.
1983).
If the activity is not engaged in for profit, the deduction of these ordinary and
necessary business expenses are further limited by I.R.C. § 183(a). However, I.R.C. §
183(b)(2) allows expense deductions up to the extent of gross income from the activity.
Section § 183(d) creates a rebuttable presumption that an activity is not engaged in for
profit if the gross income does not exceed the deductions attributed to the activity for
three years out of a five year period.
For an activity that claims losses for more than two years in a five year period,
“[t]he essential factor in determining whether an activity is conducted for profit is whether
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the taxpayer had an actual and honest objective of realizing a profit from the activity,
regardless of the reasonableness of the expectation of profit.” Harris v. Commissioner,
T.C.M. 1992-638.
Regulations § 1.183-2(b) provides nine factors relevant when determining if an
activity is engaged in for profit. The court has applied these factors in Minnick v.
Commissioner, T.C. Summary Opinion 2002-147. The factors are:
1)
2)
3)
4)
5)
6)
7)
8)
9)
Manner in which the taxpayer carries on the activity
Expertise of the taxpayer or his advisors
Time and effort expended by the taxpayer
Expectation that assets would appreciate in value
Taxpayer’s success in other activities
Taxpayer’s history of income or losses
Amount of occasional profit
Financial status of the taxpayer
Elements of personal pleasure or recreation
When determining if an activity is engaged in for profit, the court looks to the
totality of the circumstances surrounding the activity. “All of the facts and circumstances
with respect to an activity are taken into account in determining whether an activity is
engaged in with a profit objective and no single factor controls.” Harris, T.C.M. 1992-638.
APPLICATION OF THE LAW TO THE FACTS
New facts should not be mentioned. All facts must be set forth in the facts section.
Make sure you discuss the nine factors and state whether they favor the taxpayer
or not. See a case where the court does this. (We will link a case for purposes of
showing how this is done.)
The following application of the nine-factor Minnick analysis provides support that
Ms. TAXPAYER’s Direct Sales activities were a business.
Factor 1 – Manner in carrying out the activity. Ms. TAXPAYER conducted her
Direct Sales activities in a businesslike manner by keeping separate business records,
continuously holding sales events, and setting recruitment goals.
Ms. TAXPAYER’s business records consist of customer profiles, activity
statements for recruited consultants, and a business log of her sales meetings. While she
did not maintain a separate business checking account, Ms. TAXPAYER received activity
reports from Direct Sales.
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Her sales events are tracked in her log book, which consistently records multiple
events per week. Ms. TAXPAYER actively managed her customers and her recruits
through these activities, which took a downturn as the economy soured during the
economic crisis that began in 2008 and deepened in 2009.
A business person will want to measure and keep track of their success. Discuss
how the Client was able to appraise the progress of their business.
Ms. TAXPAYER’s Direct Sales-related goals were measured by the number of
recruits and recognition from Direct Sales. Ms. TAXPAYER was able to monitor her
recruits’ activities through online reports from Direct Sales. She also closely followed the
awards and titles she received from Direct Sales.
Factor 2 – Expertise. While Ms. TAXPAYER had no prior experience with Direct
Sales or marketing, she used the training and resources provided by Direct Sales to
increase her knowledge of Direct Sales techniques and opportunities. Ms. TAXPAYER
regularly attended Direct Sales-sponsored conferences, seminars, and training sessions
at both the local and regional level. She sought out other Direct Sales representatives to
develop her own knowledge base. During these meetings, Ms. TAXPAYER took notes
and made plans to implement what she was learning in her own sales and recruiting
efforts. Ms. TAXPAYER gained expertise in Direct Sales and marketing during the course
of her Direct Sales tenure, but it could not compensate for the decreased demand for
Direct Sales products during the economic crisis.
Factor 3 – Time and Effort. Ms. TAXPAYER expended considerable time and effort
in developing her Direct Sales business. For the first nine months of 2009, she had no
other employment. She recruited downline consultants, attended and hosted sales
events, and was present at training conferences, seminars, and meetings. Her logbook
for 2009 records multiple Direct Sales events per week. Ms TAXPAYER’s sales occurred
in a wide geographic area that spanned the suburban Atlanta market, and her recruits
were also located in a broad area. For this reason, Ms. TAXPAYER spent a great deal of
time driving from event to event. Ms. TAXPAYER was recognized by Direct Sales for the
speed with which she recruited consultants during her first months with the company, and
she was named a Sales Director.
Factor 4 – Asset appreciation in value. As a direct seller of cosmetics, this factor is
not relevant to Ms. TAXPAYER’s business.
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Factor 5 – Success in other activities. Even though Ms. TAXPAYER has not
participated in other Direct Sales activities, she undertook Direct Sales activities with the
expectation that she would make a profit.
Factors 6 and 7 – History of income or losses. Ms. TAXPAYER was not profitable
in her Direct Sales business. This was the very reason she stopped selling Direct Sales
products in her third year and took a different job. But, she had every intention of making
a profit – money she needed to support her family.
Factor 8 – Financial status. In 2009, Ms. TAXPAYER did not have substantial
income from an outside source. She used all of her income to meet her home mortgage
payments and other necessary living expenses for a family of four. Ms. TAXPAYER saw
her Direct Sales activity as a way to increase her family’s income. When it proved
unsuccessful, Ms. TAXPAYER stopped working with Direct Sales and took a different job.
Factor 9 – Personal pleasure. Ms. TAXPAYER’s sales and recruiting efforts were
substantial. She carried over 130 customers and more than 30 recruits in the early days
with Direct Sales. She did not limit herself to family and friends. Due to the nature of
Direct Sales selling techniques, Ms. TAXPAYER did seek to make friends with her
customers and recruits, and to conduct her sales in social settings. This technique was
primarily intended to gain sales and promote the work of her recruits.
Ms. TAXPAYER’s advertising expenses were directly connected to carrying on her
Direct Sales sales business, and the expenses are substantiated by receipts.
Ms. TAXPAYER is entitled to claim her car and truck expenses because they are
ordinary, necessary and directly connected to carrying on her Direct Sales business.
These transportation expenses were incurred while attending training seminars in the
Greater Atlanta Metropolitan area, soliciting downstream sales recruits, meeting with
potential customers, and dropping off products for existing customers – all of which are
important in a Direct Sales business. She had to maintain an automobile to make sales
and have income, and is entitled to deductions at the standard mileage rate.
This paragraph anticipates an IRS response that the mileage, though documented,
is too high to reflect purely business use. If your Client’s expenses may appear
high to the IRS, provide facts in the section above and a discussion here to argue
that the expense is still ordinary and necessary.
As required by I.R.C. § 274(d), Ms. TAXPAYER’s business mileage is
substantiated by a record of the odometer readings on the leased car. Further, the
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records of her customers, displayed graphically on the accompanying maps, demonstrate
that Ms. TAXPAYER had a widely scattered client base requiring extensive driving.
CONCLUSION
Ms. TAXPAYER is entitled to all the deductions she has claimed under I.R.C. §
162. She engaged in a for-profit business, with the honest expectation of earning a profit.
She properly took deductions for the ordinary and necessary expenses incurred in
carrying out that trade or business.
In the alternative, Ms. TAXPAYER’s deficiency should be reduced to account for
the incorrect inclusion of income from an activity for which she is entitled to deduct
expenses up to the full amount of the gross income under I.R.C. § 183(b)(2).
For the reasons stated above, Ms. TAXPAYER is entitled to relief from the
proposed deficiencies for Tax Year 2009.
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