There is a line in the first verse of Eminem’s 1996 largely overlooked song, “Infinite,” where he raps, “Yo, my pen and paper cause a chain reaction.” His debut album of the same name bombed, but the lyric was prophetic: The songwriter later signed with Dr. Dre and the rest is musical history.
Your pen and paper can indeed cause a chain reaction: That is because having something written down carries weight. And not just metaphorical weight, but in real life.
The Tax Court has long reinforced that written evidence is required to support taxpayer claims. The court, in April’s opinion in Williams v. Commissioner, found that while the taxpayers were credible when testifying, they couldn’t substantiate their claims with evidence. As a result, many of their deductions were denied.
The Tax Court reached a similar conclusion this month when Nikta Fatemeh Abdolrahim and Melvin Collins, a married couple with consolidated cases for the years 2009 through 2012, were unable to offer written evidence to support their claims. The court found the taxpayers credible but noted, "[a]s we have stated many times before, this Court is not bound to accept a taxpayer’s self-serving, unverified, and undocumented testimony.” Shea v. Commissioner, 112 T.C. 183, 189 (1999) (citing Tokarski v. Commissioner, 87 T.C. at 77).
The couple lived in a four-bedroom home—referred to as the Grafton property—owned by Abdolrahim in Shrewsbury, Mass. Abdolrahim performed about 40% of her work from home in 2009 and 2010. Collins also conducted his business from home, specifically working from space that Abdolrahim rented to him and his company.
The IRS issued notices of deficiency for the years 2009 and 2012, alleging that the taxpayers overstated deductions and underreported income. A portion of the deductions and income was tied to the basement of the Grafton property.
On the 2009 Schedule E, the couple reported rental income of $3,600 and expenses of $10,696. The rental income represented rents paid by Collins for his business; the associated costs, however, represented 25% of the total expenditures for the Grafton property. The taxpayers, who filed jointly, also reported their home address as the Grafton property.
Their 2010 joint tax return reflected similar a loss on Schedule E.
Collins also failed to timely file returns for 2011 and 2012. Those returns were never processed, but records produced after the taxpayers filed their petition made claims consistent with the 2009 and 2010 returns for the rentals.
As with most cases that end up at Tax Court, the IRS sent the taxpayers a notice of deficiency. The notice included, among other things, disallowances for several deductions and an increase in taxable income related to the rental expenses. The taxpayers disputed the changes, and the matter eventually went to court.
Tax code Section 262(a) generally prohibits tax deductions for personal, living, or family expenses. And under sections 280A(a) and (b), a taxpayer can’t deduct expenses associated with a personal residence, other than those like interest and taxes that are specifically allowed, without regard to their connection with a trade or business or income-producing activity. The use of the residence is personal when, for any part of a day, the taxpayer or the taxpayer’s qualifying relatives uses the space for personal purposes unless, under the facts and circumstances, a fair rent is charged for the use. Under section 267(c)(4), a taxpayer’s spouse is a qualifying relative.
During the years at issue, Collins and Abdolrahim were married. Collins used space in the basement of the Grafton property that Abdolrahim rented to him or his business, not only for his company but also for his private use (including storage). Under those facts, his personal use of the basement is attributable to Abdolrahim.
Additionally, the court found that there is no evidence of the fair rental value of the space Collins rented in the basement. As a result, the taxpayers failed to meet their burden of establishing that they meet the relevant exception to the section 280A(a) general rule, and the Schedule E deductions for rental real estate for 2009 and 2010 were disallowed.
As for other unreimbursed employee business expenses? The court found no clear distinction between Collins’ living expenses and the expenses he allegedly incurred in connection with his business. The result? No deduction.
These findings could just be viewed partly as a cautionary tale. As a result of the 2017 tax law, for the tax years 2018 through 2025, you can no longer deduct home office expenses if you are an employee. Those unreimbursed employee business expenses aren’t even available on a Schedule A anymore.
But that doesn’t mean that documentation isn’t important—especially as it applies to rentals and self-rentals. Having a written lease which clearly indicates a rental term and the basis for a fair rent is essential to substantiate deductions on Schedule E.
It can also mean much more. For example, tucked away in the third virus relief package (Public Law 116-136) is the following restriction on allowable uses of funds in the Paycheck Protection Program (PPP), which has made hundreds of billions of dollars of government-backed forgivable loans available to small businesses.
- "(i) IN GENERAL.—During the covered period, an eligible recipient may, in addition to the allowable uses of a loan made under this subsection, use the proceeds of the covered loan for— ….’ (V) rent (including rent under a lease agreement);"
In other words, for purposes of the PPP, rentals must be supported by a lease agreement. The Small Business Administration makes clear, in its guidance, that the lease agreement should be in writing. A similar requirement exists for Economic Injury Disaster Loans. Do you see a pattern?
We often remind taxpayers that an essential part of owning and operating a business is holding yourself out as a business. But it is important to reiterate what that means, including following the rules AND getting the paperwork right.
A written lease agreement—putting your pen to paper—can cause the best kind of chain reaction. It can be used not only to justify tax deductions, but also to substantiate costs for loans (not only special loans like the PPP but existing loans like EIDL and conventional bank loans). And on the lessor side, it can offer proof of income.
Eminem boasts at the end of Infinite that he’s learned his lesson. He raps, “Now I’m tryin’ to repent from it… I’m tempted.” Hopefully, you are, too.
The lesson here? Always get it in writing. Always.
The case is Collins v. Commissioner, T.C., No. 9649-14, 4/23/20.
This is a weekly column from Kelly Phillips Erb, the TaxGirl. Erb offers commentary on the latest in tax news, tax law, and tax policy. Look for Erb’s column every week from Bloomberg Tax and follow her on Twitter at @taxgirl.