Expense Does Not Qualify as Compensation but Does Qualify as Theft Loss

Expenses and Deductions

The Tax Court held that amounts that an abusive man took from his live-in girlfriend’s business did not qualify as deductible compensation expenses but did qualify as deductible theft losses.

Background

In 1991, Mona Lisa Herrington began a relationship with a man who eventually moved in with her. Her boyfriend, she later learned, had an extensive criminal record and a violent temper. The boyfriend subjected Herrington to frequent intimidation and physical abuse. Despite his ill treatment of her, Herrington was afraid to leave him because of his threats of violence to her and her children if she did.

In 1996, Herrington acquired two Louisiana video poker licenses in her own name. In order to comply with the terms of the licenses, she opened two sandwich shops next door to each other in Farmerville, Louisiana, each with a video poker machine. The boyfriend took charge of the finances and the books and had check-signing authority on the business bank accounts. Virtually all the shops’ income resulted from video poker revenue.

Herrington and her boyfriend had no agreement regarding his compensation, and Herrington testified that the boyfriend set his own compensation by writing checks to himself or to cash, signing either his name or the petitioner’s name. He withdrew $114,000 during 1997 and $96,000 during 1998 from the businesses’ bank accounts. He used these funds to pay his personal expenses, including his child support obligations.

Herrington knew her boyfriend was writing checks and taking money out of the business accounts, but she did not know beforehand when he might write checks or for how much. Consequently, she was constantly uncertain about the balances in the accounts. Therefore, she worked out an arrangement with a friend at her bank to ensure that she knew when she needed to deposit money in the accounts to avoid overdrafts.

As a condition for maintaining her video poker licenses, Herrington had been required to submit copies of her federal income tax returns annually to the Louisiana state police. Her boyfriend had prepared her 1997 federal income tax return, and she had signed it. According to Herrington, her boyfriend told her that he would file the return, but he never did. She attached a copy of the return to her state video poker application and signed a release allowing the police to verify that she had filed the return with the IRS.

This led to the revelation that Herrington’s 1997 and 1998 returns had never been filed. Resulting inquiries led to an IRS criminal investigation, and in 2004 Herrington pleaded guilty to willful failure to file tax returns under Sec. 7203 for tax years 1997 and 1998.

During the course of the criminal investigation, her boyfriend, who was also under criminal investigation, contacted Herrington and told her that he needed to file his own tax returns and needed a statement from her regarding the amount of money he had received from her businesses. After reviewing the books, they agreed that the boyfriend had received $114,000 in 1997 and $96,000 in 1998. At the boyfriend’s urging, they signed affidavits stating that during each of the years 1997 and 1998 the boyfriend “took cash and paid personal expenses from the two businesses” in the amounts previously agreed upon and that these takings represented “his total compensation as a consultant to the businesses.”

In 2000, petitioner filed her 1997 federal income tax return, reporting income from her two shops, as sole proprietorships, on two Schedules C, Profit or Loss from Business. In 2001, she filed a 1998 federal income tax return reporting the shops’ business income the same way. On these returns, she reported the amounts her boyfriend had received as compensation expenses. The IRS issued Herrington a notice of deficiency for each year, partly as a result of the disallowance of the deduction for the amounts withdrawn from the businesses by her boyfriend.

Herrington challenged the IRS’s determination in Tax Court. She argued that the amounts her boyfriend received were deductible as compensation for personal services rendered and that any of the amounts that were not deductible as compensation were deductible under Sec. 165 as thefts or conversions by her boyfriend.

The Tax Court’s Decision

The Tax Court held that the amounts received by Herrington’s boyfriend were not deductible as compensation. However, it held that, based on Louisiana law, they were deductible under Sec. 165 as theft losses.

The Tax Court, citing its decision in Paula Construction Co., 58 T.C. 1055 (1972), stated that a payment is deductible as compensation only if the payment is made with the intent to compensate, and whether such an intent exists is a facts-and-circumstances determination. The court found that although Herrington’s boyfriend performed some services for the video poker business, the record did not suggest any correlation between the services he rendered and the amounts he took from the business. Therefore, it held that the amounts were not properly deductible as reasonable compensation.

Concerning the theft loss argument, the Tax Court explained that theft is defined broadly for purposes of the theft loss deduction and includes any criminal appropriation of a person’s property for use by the taker and that whether a theft took place must be determined under the laws of the state where the loss was sustained. Further, a deduction for a theft loss is not dependent on the conviction or prosecution of the perpetrator of the theft or even any action against the perpetrator by the victim. Under Louisiana law, theft includes

misappropriation or taking of anything of value which belongs to another, either without the consent of the other to the misappropriation or taking, or by means of fraudulent conduct, practices, or representations. An intent to deprive the other permanently of whatever may be the subject of the misappropriation or taking is essential. [LA Rev. Stat. Ann. §14:67]

The IRS argued that the takings by Herrington’s boyfriend could not be thefts because she consented to the takings by never objecting to her boyfriend’s withdrawals from the business accounts and by never reporting them as thefts to the authorities. The Tax Court disagreed, citing Louisiana case law that in order to consent to theft of property, the owner must do more than passively assent to the taking (State v. Johnson, 408 So. 2d 1280 (La. 1982)). According to the Tax Court, based on the long history of abuse by her boyfriend, any consent that Herrington gave was not effective consent because it was induced by force and threats. Therefore, her boyfriend’s taking of the amounts from her businesses were thefts under Louisiana law and were also thefts for purposes of the theft loss deduction.

The Tax Court also found that Herrington had no prospect of recovering the money and that she had proved that the amounts were taken from her businesses in 1997 and 1998. Thus, it held she was entitled to a theft loss deduction under Sec. 165 for the amounts taken in those years.

Reflections

The IRS also had imposed a penalty for fraudulently failing to file her 1998 return. In addition to the video poker businesses, Herrington had also owned a tax preparation business. Despite this fact, which suggested to the court that “she knew or should have known” of her filing requirement, the court refused to uphold the penalty. The court was also willing to overlook her guilty plea, which under Sec. 7203 conclusively established her willfulness in failing to file her 1998 return. The court decided that despite “significant badges of fraud” there was not enough evidence, given the facts of the case, to “conclusively establish her fraudulent intent.”

Herrington, T.C. Memo. 2011-73