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Court Rejects IRS Attempt to Put S Corporation on Cash Method; Disallows Deductions for Fossil Contributions.

(Parker Tax Publishing July 28, 2015)

A taxpayer could not deduct charitable contributions of fossils because he did adequately satisfy the substantiation requirements. However, a majority of disputed expenses of the taxpayer's wholly owned S corporation were allowed because the S corporation was an accrual basis taxpayer and not a cash method taxpayer as argued by the IRS. Isaacs v. Comm'r, T.C. Memo. 2015-121.


Veterinarian James Isaacs owned and operated two veterinary clinics. One was owned through Calabasas Veterinary Center, Inc. (CVC), a wholly owned S corporation, and the other through Encino Veterinary Clinic, Inc. (EVC), a wholly owned C corporation.

In 2006 and 2007, Dr. Isaacs donated trilobite fossils to California Academy of Sciences (CAS), a Code Sec. 501(c)(3) organization. With respect to the donations, he claimed charitable deductions of $136,500 and $109,800. Dr. Isaacs filed Forms 8283, Noncash Charitable Contributions, and Part IV, Donee Acknowledgment, was signed by an individual on behalf of CAS acknowledging the contribution. Neither the acknowledgments on Forms 8283 nor letters and related correspondence attached to Dr. Isaacs' tax returns stated whether CAS had provided goods or services in exchange for the gifts. Both of Dr. Isaacs' Forms 8283 bore the signature "Jeffrey R. Marshall" in Part III, Declaration of Appraiser. The CVC tax returns for years 2006-2008 reported losses of approximately $73,000, $53,000 and $275, respectively, which were passed through to Dr. Isaacs' personal tax returns.

The IRS disallowed deductions for the fossil contributions and disallowed certain passthrough deductions reported on CVC's 2006-2008 tax returns. According to the IRS, CVC improperly accrued certain expenses at year end despite otherwise maintaining its books on a cash basis. The IRS also assessed accuracy-related penalties. Dr. Isaacs disagreed with the adjustments, arguing that CVC's books were kept on the accrual basis and, thus, the disputed expenses were deductible.

One of the disputed CVC deductions was an $85,000 expense recorded in Quickbooks as "Due to/Due from CVC" and a corresponding adjusting journal entry for EVC for the same amount on the same date. Dr. Isaacs testified that these journal entries reflected reimbursements by CVC to EVC for inventory items ordered in bulk and paid for by EVC but distributed to CVC during the year. Dr. Isaacs further testified that EVC had included in income the reimbursements it received from CVC. The IRS contended that, although EVC's 2006 tax return reported such income on the accrual method, CVC was a cash method taxpayer and thus could not deduct the $85,000 expense because it had not actually been paid. The IRS further argued that Dr. Isaacs did not substantiate the $85,000 deduction. Dr. Isaacs said that he could not provide the log book substantiating the deduction because his former bookkeeper had stolen it along with other business records and refused to return them.

The IRS also disallowed a $100,000 deduction by CVC for office overhead for 2007. Dr. Isaacs testified that this $100,000 expense consisted of a management fee paid by CVC to EVC for 2007, pursuant to interoffice policy, and introduced checks substantiating the payment of $51,000 of this amount in 2007 and the remainder in 2008. Tax returns reflected that EVC included the $100,000 in income in 2007. The IRS argued that the cash method more clearly reflected CVC's income and thus, the entire $100,000 could not be deducted in 2007.

Deductions for Fossil Contributions Denied

In order to deduct charitable contributions, certain substantiation requirements must be met. First, for all contributions of $250 or more, a taxpayer generally must obtain a contemporaneous written acknowledgment from the donee and the acknowledgment must state, among other things, whether the donee provided any goods or services in exchange for the gift. Second, for noncash contributions in excess of $500, a taxpayer must maintain reliable written records with respect to each donated item. Third, for noncash contributions of property with a claimed value of $5,000 or more, a taxpayer must obtain a "qualified appraisal" of the donated item(s) and attach to his or her tax return a fully completed appraisal summary on Form 8283.

At trial, Jeffrey Marshall, who the court recognized as an expert appraiser of fossils, identified the signature on Dr. Isaacs' 2006 and 2007 Forms 8283 as his own, but did not recall signing the forms. He similarly identified his signature on two letters that purported to be appraisals of the fossils but said he did not write or even recognize the letters. Dr. Isaacs admitted during trial that he had written the letters himself and presented them to Mr. Marshall for signature.

The Tax Court held that Dr. Isaacs could not deduct any amounts for the contribution of the fossils to CAS. Dr. Isaacs, the court observed, introduced no evidence other than his Forms 8283 of the approximate dates and manner of the fossils' acquisition, their costs or other bases, or the method by which their purported fair market values were determined. In addition, there was no qualified appraisal and no acknowledgement that no goods or services were provided in exchange for the donation. The court noted that, of the three requirements Dr. Isaacs was required to meet in order to substantiate the charitable deductions, he met none of them.

Attempt to Put CVC on Cash Method Rejected

With respect to the disputed $85,000 expense, the Tax Court held that the expense was deductible. Dr. Isaacs, the court said, had established that CVC's former bookkeeper, Ms. Lopez, stole business records and refused to return them. The bookkeeper's egregious conduct, the court concluded, was not reasonably foreseeable. Thus, because the business records were lost as a result of circumstances beyond Dr. Isaacs' control, the court allowed him to substantiate expenses with other credible evidence.

The court found that Dr. Isaacs' description of the reason for the $85,000 expense, his introduction of an interoffice policy to support that explanation, and his uncontroverted testimony that EVC included the $85,000 in income for 2006, constituted enough evidence to support the deduction. The court similarly determined that the $100,000 management fee was also deductible.

The Tax Court rejected the IRS's attempt to put CVC on the cash method. The court found that, although mixed, the evidence tended to show that CVC computed its income for tax purposes under the accrual method. The court also noted that (1) CVC reported small opening and closing balances for accounts receivable and payable on its balance sheets, (2) the IRS had not made any determinations under Code Sec. 446(b) in the notice of deficiency purporting to change CVC's method of accounting, and (3) the notice of deficiency made no reference to CVC's method of accounting, thus making the change in the method a new matter before the court, which the court would not consider.

For a discussion of the recordkeeping and substantiation requirements for property contributions, see Parker Tax ¶84,190. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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