Tax Memorandum

This is a tax memorandum that was done for my Corporate Taxation class, along with my partner, Matthew Morgan.

To:                   Dr. Lawrence Kowalski, Tax Professor

From:              Emily and Matthew Morgan, Tax Associates
Subject:           Travel and Entertainment Expense Deduction
Date:                December 3, 2010

I. Facts Presented

            The Internal Revenue Service (IRS) audited Winter Corporation’s current year tax return and disallowed the $10,000 of travel and entertainment expenses incurred by Charles, an officer-shareholder, as a result of inadequate documentation. The IRS claims the expenditure was a constructive dividend paid to Charles; however, he argued that he derived no personal benefit from the expenditure.
II. Issues Presented

            Can this $10,000 expenditure be deducted as travel and entertainment expenses?  Or rather, does it qualify as a constructive dividend and if so, what are the tax consequences? 

III. Conclusion

            Without adequate documentation, the IRS will continue to assert the $10,000 travel and entertainment expenditure Charles to be classified as a constructive dividend.  He must report this amount as income, rather than a deduction.

IV. Discussion

According to Internal Revenue Code section 274(d):

“No deduction or credit shall be allowed under section 162 or 212 for any traveling expense, for any item with respect to an activity which is of a type generally considered to constitute entertainment, amusement, or recreation, or with respect to a facility used in connect with such an activity, unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating the taxpayer’s own statement (A) the amount of such expense or other item, (B) the time and place of the travel, entertainment, amusement, recreation, or use of the facility or property, or the date and description of the gift, (C) the business purpose of the expense or other item, and (D) the business relationship to the taxpayer of persons entertained, using the facility or property, or receiving the gift.”

The requirements to deduct a travel and entertainment expense include substantial adequate documentation.  Without this, the IRS will continue assert this $10,000 expenditure as a constructive dividend to Charles, even though he maintained it is business-related and claims no personal benefit.  Oral testimony is not enough—written substantial documentation is necessary.

The limitation of requiring substantiation of travel and entertainment expense deductions supersedes Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930).  In this court decision, if the taxpayer incurred travel and entertainment expenses, but could not readily determine exactly how much to deduct, then the taxpayer could make a close approximation. However, according to Treasury Regulation 1-274, “Section 274(d) contemplates that no deduction or credit shall be allowed to a taxpayer on the basis of such approximations or unsupported testimony of the taxpayer.”  Therefore, we may not deduct the travel and entertainment expenditure and Charles must pay ordinary income on the constructive dividend.

According to Gotcher v. United States, 5^th Circuit Court of Appeals, “The test for constructive dividends in such circumstances is two-fold; not only must the expenses be non-deductible to the corporation, but they must also represent some economic gain or benefit to the owner-taxpayer.” [U. S. v. Gotcher [68-2 ustc ¶9546], 401 F. 2d 118, 121-124 (5th Cir. 1968)].  Taxpayer must show to the court or IRS that they were not the primary beneficiary of the expenditure. The IRS ruled the expenditure as non-deductible, thus meeting requirement one.  They further stated it was a constructive dividend to Charles because he received an economic gain from the $10,000 expense to his name.  Although Charles contends he derived no personal economic gain or benefit, without proper documentation to substantiate how he spent the money and so forth, the IRS will contend that the expenditure is a constructive dividend.

To further support this stance on constructive dividends, court case Wortham Machinery Company v. United States states that, “a constructive dividend is paid when a corporation confers an economic benefit on a stockholder without expectation of repayment” (Wortham Machinery Company v. United States, 10 Cir., 521 F. 2d 160, 164).   If Charles creates a $10,000 travel and entertainment expenditure on the corporate account, without any substantial evidence of what he did, he is assumed to have derived some sort of economic benefit.

For next year, we strongly recommend creating a policy for all employees to follow regarding travel and entertainment expenses.  This will help alleviate the chance of this problem happening again.   Substantial documentation will provide to the IRS with the necessary information to prove the travel and entertainment expenditure qualifies as a 162(a) deduction. However, without adequate documentation proving it was within the scope and reach of IRC 162(a), the IRS will continue to disallow a deduction similar to this.