Distinguished physicist, Albert Einstein, once said, “The hardest thing in the world to understand is the income tax.” Likewise, the constantly growing Internal Revenue Code is difficult to understand. But perhaps it is even more difficult to understand when one cannot read, or one is suffering from a debilitating illness. In a recent memorandum opinion, the Tax Court dealt with a taxpayer who (1) argued that a deduction qualified under either Section 162 or 165, and (2) argued that he should not be subject to the addition to tax under Section 6651(a)(1). While the taxpayer’s inability to read and illness excused the assessment under Section 6651(a)(1), the taxpayer’s arguments to claim a tax deduction ultimately failed.

Sections 162 and 165

As a general rule, a trade or business shall be allowed a deduction for all of the ordinary and necessary expenses paid or incurred during the taxable year.[1] Expenses are “ordinary” if they are ordinary, usual, or customary or is related to a transaction of common or frequent occurrence for a given type of business.[2] Additionally, expenses are “necessary” if they are helpful and appropriate to the taxpayer’s business, though the expenses need not be essential.[3]

A taxpayer may also recognize a deduction for certain losses:

(a) General Rule

There shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise.

(b) Amount of Deduction

For purposes of subsection (a), the basis for determining the amount of the deduction for any loss shall be the adjusted basis provided in section 1011 for determining the loss from the sale or other disposition of property.

(e) Theft Losses

For purposes of subsection (a), any loss arising from theft shall be treated as sustained during the taxable year in which the taxpayer discovers such loss.[4]

 Section 6651(a)

Further, a taxpayer may be assessed an “addition to tax” if the taxpayer fails to file a tax return for a given tax period:

(a) Addition to the Tax

In case of failure—

(1) to file any return required under authority of subchapter A of chapter 61 (other than part III thereof), subchapter A of chapter 51 (relating to distilled spirits, wines, and beer), or of subchapter A of chapter 52 (relating to tobacco, cigars, cigarettes, and cigarette papers and tubes), or of subchapter A of chapter 53 (relating to machine guns and certain other firearms), on the date prescribed therefor (determined with regard to any extension of time for filing), unless it is shown that such failure is due to reasonable cause and not due to willful neglect, there shall be added to the amount required to be shown as tax on such return 5 percent of the amount of such tax if the failure is for not more than 1 month, with an additional 5 percent for each additional month or fraction thereof during which such failure continues, not exceeding 25 percent in the aggregate . . . .[5]

And that “addition to tax” may be substantially increased if any failure to file a tax return is fraudulent.[6]

Torres v. Commissioner[7]

On June 2, 2021, the U.S. Tax Court issued its decision with respect to Mr. Torres’ petition, pursuant (in part) to Sections 162, 165, and 6651(a)(1). Mr. Torres cofounded a business—Water Warehouse—with Ms. Ruzendall. Post-2010, Ms. Ruzendall was no longer owner but managed the books and records of the business. During 2016, Mr. Torres suffered from an illness that prevented him from timely filing his federal income tax return. Additionally, at this time, Mr. Torres could not read and relied on others for his tax obligations.[8] Based on the advice of a bookkeeper, Mr. Torres issued Ms. Ruzendall a Form 1099-MISC for nonemployee compensation in tax year 2016.

On July 18, 2018, Mr. Torres filed a civil lawsuit against M.s Ruzendall, alleging, in part, that he discovered on October 1, 2017, that Ms. Ruzendall had misappropriated funds from the business. Moreover, Mr. Torres failed to timely file the 2016 Form 1120S for the business or his 2016 Form 1040. The Internal Revenue Service issued a notice of deficiency. Subsequently, the business filed an amended Form 1120S, reporting a theft loss in the amount reported on the Form 1099-MISC. Mr. Torres also filed an amended Form 1040 reflecting the flow-through of additional business expenses. The Tax Court held, in part:

During 2016 Ms. Ruzendall was involved with running Water Warehouse. She testified that she ran the business in 2016 and that she paid herself. Petitioner testified that Ms. Ruzendall had “dr[awn] what she felt was her pay” for 2016. Petitioner did not offer evidence that Ms. Ruzendall acted with the intent to defraud. Petitioner has not shown Water Warehouse experienced a theft meeting the elements of embezzlement under California law.

Even if a theft pursuant to California law had occurred, petitioner would not be entitled to a flowthrough loss deduction for 2016. To claim a theft loss deduction, the taxpayer must also establish the amount of the loss and the year in which the loss was sustained. . . .

Petitioner alleged on his amended claim, filed against Ms. Ruzendall, that she took funds from Water Warehouse. The amended complaint does not mention that Ms. Ruzendall was entitled to compensation for services performed on behalf of Water Warehouse. Ms. Ruzendall testified that she took funds without petitioner’s authorization. . . .

Petitioner testified credibly that he was not capable of handling his business because of his illness and not being able to read during 2016 and that he relied upon others. Petitioner’s illness affected his ability to file a timely tax return for 2016. Once petitioner learned of problems regarding his 2016 taxes, he sought a new tax preparer. He also learned to read in 2018. Petitioner has shown reasonable cause, and therefore he is not liable for an addition to tax pursuant to section 6651(a)(1).[9]

Conclusion

In Torres, the Tax Court denied the taxpayer’s deduction under both Sections 162 and 165. It is notable that Mr. Torres’ separate civil action undermined his arguments in Tax Court—(1) Mr. Torres’ allegation that he discovered the misappropriation on October 1, 2017 undercut his argument that the deduction qualified under Section 165(e) for tax year 2016; and (2) Ms. Ruzendall’s admission that she took funds without Mr. Torres’ authorization undercut his argument that the deduction qualified under Section 162. Moreover, while the Tax Court held that Mr. Torres had shown reasonable cause to avoid the addition to tax pursuant to Section 6651(a)(1), it is unclear what the deciding factor was. The inability to read and illness, together, established reasonable cause, and perhaps either factor may have supported the taxpayer’s argument.

[1] See I.R.C. § 162(a).

[2] See Deputy v. du Pont, 308 U.S. 488, 495 (1940).

[3] See Comm’r v. Tellier, 383 U.S. 687, 689 (1966).

[4] I.R.C. § 165(a), (b), and (e).

[5] I.R.C. § 6651(a)(1).

[6] See I.R.C. § 6651(f).

[7] Torres v. Comm’r, T.C.M. (RIA) 2021-066, 2021 WL 2226630, at *1 (T.C. 2021).

[8] Id. at *2-3 (Mr. Torres later learned to read in 2018).

[9] Id. at *3-5.

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