Tax Court Permits Write-Offs in Two Unusual Cases

Just joining us? The first three parts discussed IRS administrative rulings and court cases on whether write-offs for business expenses comply with the “ordinary and necessary” requirements imposed by Code Section 162. More on those kinds of requirements in part four, as well as a fascinating Tax Court case.

Tax break for “stay-away” corporate director. Was it ordinary and necessary for a closely held company with two shareholder-directors to pay one of them to stay away from the business? Yes, said the Tax Court in a 1983 decision. Here’s how it played out. 

Brothers Jim and John Shea co-owned all the shares of Fairmont Homes. As Jim saw things, John’s participation in the business adversely affected Fairmont and its reputation. Moreover, Jim feared a threatened lawsuit by John would create additional problems. 

The IRS saw things much differently. The agency contended that Fairmont’s payments to John were nondeductible outlays to acquire a capital asset—that is, Fairmont stock—a contention that was rejected by the court. 

It noted that payments to ward off the threat of litigation are deductible, as are payments made to induce a partner or employee to take a course of action favorable to the business. In this case, although John agreed to limit his participation in management, he retained his rights in the corporation. 

Voluntary repayments of moral obligations. As a general rule, businesses flunk the “ordinary and necessary” tests and lose out on deductions when they voluntarily pay someone else’s obligation. One exception allows you to deduct the repayment of a “moral obligation” when you do so “to protect or promote your own ongoing business.” 

The Tax Court applied the exception in favor of the late Harold Jenkins, better known as country-music singer Conway Twitty. It approved a deduction of $97,000 for Conway, who felt honor-bound to repay investors and creditors of a corporation involved in a failed franchising business known as Twitty Burger Fast Food Restaurants.

IRS officials described his reimbursement of the investors as “very nice,” but nondeductible since he failed to link his payments of the corporation’s debts to his business as a performer. Conway, though, struck a far more responsive chord with the court, which was convinced that he made the payments primarily to safeguard his personal reputation with his fans and his business reputation in the country-music industry. 

Some of the investors were themselves country/western stars, such as Merle Haggard. Several had threatened to sue. As Conway’s lawyer pointed out: “Imagine trying to keep a band together where somebody [meaning Twitty] has stiffed the drummer’s mother.” 

The Tax Court closed with a composition of its own, “Ode to Conway Twitty,” that included these stanzas:

Twitty Burger went belly up 

But Conway remained true.

He repaid his investors, one and all, 

It was the moral thing to do. 

Had Conway not repaid the investors 

His career would have been under cloud, 

Under the unique facts of this case 

Held: The deductions are allowed. 

The generous supervisor. Conway’s triumph notwithstanding, whether the expense in issue is allowable hinges upon the particular circumstances. 

To illustrate, consider the supervisor who wanted to share a portion of her bonus with her subordinates. The supervisor’s employment contract entitled her to additional compensation if the bottom line was black. Though not obligated to do so, she opted to redistribute part of the bonus to her subordinates. But the IRS ruled that the redistribution was nondeductible (Letter Ruling 7737002). 
 

The reason for this hard-nosed approach? An IRS finding that no employer/employee relationship existed between the supervisor and her subordinates. The IRS conceded that an employee who in turn employs others to assist her can deduct payments to them.

When the IRS made that concession, such payments were subject to other limitations. Under the old rules applicable to 2017 and earlier years, unreimbursed employee business expenses, along with most other miscellaneous itemized deductions, were allowable, but only if their total was greater than two percent of adjusted gross income. 

As noted in part one, what complicates things is the Tax Cuts and Job Act that took effect at the start of 2018. The legislation included a provision that ended miscellaneous deductions for the years 2018 through 2025, when the current rules go off the books. As of now, the old rules resume in 2026.

Stay tuned for part five of this series.