For those of you who just entering into the discussion, go back to parts one and two for IRS rulings and court decisions on whether deductions for expenses satisfy the “ordinary and necessary” requirements imposed by Code Section 162. More on such requirements in part three.
Travel and entertainment. Long-standing IRS regulations disallow deductions for travel and entertainment expenses that are “lavish” or “extravagant.” But what’s extravagant for one taxpayer might be an ordinary and necessary expense for another, according to a 1977 decision by the Tax Court.
It dismissed the IRS’s pinched view of extravagant and permitted Mr. Denison, an investment adviser, to claim the cost of transporting potential customers in chauffeur-driven Cadillacs. What proved persuasive? The nature of the adviser’s business, testimony that many of his clients were wealthy Europeans, and the court’s awareness of “the generally obnoxious traffic situation in midtown and lower Manhattan.”
No tax break for “honorary” director. Suppose some friends ask you to serve as a director of their corporation. Be aware that becoming a director can have its perils. Whether you take a director’s seat for money, power, prestige or just to be obliging, you assume certain responsibilities when you accept the position.
Let’s say that you agree to do a favor for a friend and serve as an “honorary” director without pay. Later, you have to come up with the cash to cover the company’s losses. What you might belatedly discover is that the IRS refuses to allow you to deduct your payments.
Consider how badly things turned out for Angus DePinto, an Arizona physician with a full-time practice. Angus agreed to accommodate his longtime friend, James Kelly, the president and majority shareholder of an outfit with the impressive title of United Security Life Insurance Co., and joined its board of directors.
Angus wasn’t very active during his two-year stint on the board. For one thing, he never bothered to ask about United’s financial condition. Nor was he aware that it was losing money.
The physician readily signed minutes of directors’ meetings without reading them—even though some of them said he was present when, in fact, he wasn’t. Moreover, for 15 months Angus wasn’t even aware that James had resigned as president of the company.
When James eventually decided to sell his United stock, he suggested that Angus resign as director. The ever-obliging doctor did that, just days before a new board of directors got control. James proceeded to swap United assets for worthless stock in another company, which the new directors had just organized; they then used the assets to pay off James.
The net result was a loss to United of several hundred thousand dollars. Unfortunately for Angus, but fortunately for the remaining shareholders, they were able to immediately recover the entire amount by bringing suit against him, the only one still around worth suing. Angus had to pay the shareholders because of his negligence in failing to keep himself informed about the company’s affairs and for resigning just before the looting, instead of trying to thwart it.
To ease the financial hurt, Angus took a business-loss deduction for his payment, as well as for some substantial legal fees. But the disallowance of the deduction by the IRS was upheld by the Ninth Circuit Court of Appeals.
The snag was that the losses weren’t incurred in a profit-motivated transaction. As proof, the court cited the doctor’s “total lack of interest in the financial affairs of the company” and the fact that he didn’t expect to receive fees for his director’s chores.
A point worth noting is that the IRS wouldn’t have disputed the deduction had Angus served as a paid director. In one of its administrative rulings, the IRS authorized a deduction for the very type of expenses that the doctor incurred (Ruling 8127085).
For wannabe directors who are waiting for a call from Central Casting, the moral of this case should be clear: Sit on a board of directors only if you mean business. Even then, get the protection afforded you by a directors’ and officers’ liability insurance policy.
What’s next. Part four will discuss more ordinary-and-necessary disputes.
