Lack of Proof that Expenses Were Customary, Helpful to Law Practice Scuttles Business Expense Deduction

Receipt An attorney’s attempt to claim that he racked up more than $400,000 in ordinary and necessary expenses in operating a solo law practice failed with the Internal Revenue Service and also did not persuade the US Tax Court. Although the taxpayer had receipts and credit card statements showing how he incurred his claimed expenses, the taxpayer could not explain how most of the expenditures were customary or beneficial to his law firm, leaving the court to uphold an IRS decision disallowing roughly 80% of the expenses the taxpayer claimed.

In 2007, Richard Canatella was the sole proprietor of a law firm named Cotter & Del Carlo. When the taxpayer filed his 2007 taxes the next year, he reported gross receipts of $441,124 and expenses of $423,182. The taxpayer deducted almost $12,000 for travel, meals, and entertainment, and he listed $257,772 of his expense total as “Other expenses.” The IRS disallowed $338,047 of the taxpayer’s total expenses.

Canatella unsurprisingly appealed this determination. The taxpayer argued that each of his claimed expenses was allowable under Section 162(a) of the Tax Code, which allows deductions for ordinary and necessary business expenses. In many cases, the shortcoming for the taxpayer is a lack of documentation. That, however, was not this taxpayer’s problem. Indeed, when queried about his $2,436 in meals and entertainment, he told the Tax Court that if the IRS failed to accept an expense, it was because the agency refused “cancelled checks, bank statements, and documentation that prove … that we’re entitled to the allowance.” The taxpayer’s problem was the “ordinary and necessary” portion of Section 162(a). Unfortunately for Canatella, the court stated, he operated under an erroneous interpretation of Section 162(a) in which anything that he could substantiate with a receipt or a credit card statement was deductible. The court pointed out that, in reality, the statute requires not only documentation but that the expense be ordinary and necessary to the taxpayer’s profession, which in this case was running a law practice. Ordinary generally means “normal, usual, or customary” in the taxpayer’s business. Necessary expenses, meanwhile, typically encompass those that are “appropriate and helpful to the operation of the taxpayer’s trade or business.”

Canatella was unable to demonstrate to the court’s satisfaction that the $338,047 in expenses he racked up were either normal or customary to running a law office, and that they were also appropriate and helpful to the conduct of that business. As a result, the court sided with the IRS, including hitting Canatella with the 20-percent accuracy penalty. The taxpayer attempted to escape the penalty by arguing that he demonstrated the required level of good faith by employing an accountant to prepare his 2007 return. This argument collapsed when the accountant testified that he prepared the return using handwritten information the taxpayer provided to him and that the accountant gave Canatella no tax advice regarding the return.

Business expense deductions are essential to nearly any solo businessperson or small business owner. As important as this deduction is, overstating one’s business deductions can be extremely harmful. For advice and representation about your business’ tax return, contact the experienced tax attorneys at Samuel C. Berger, P.C. and CPAs at S.C. Berger, P.C. They can provide you with the expense deduction assistance you need. To consult our attorneys and CPAs, contact us online or call (201) 587-1500 or (212) 380-8117.

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