Every year, hundreds of taxpayers battle the federal government in regional district courts and US Tax Court, an independent judicial authority created by Congress for taxpayers challenging IRS notices of deficiency. Bottom Line Personal asked accountants Edward Mendlowitz, CPA, and Maryann T. Reyes, CPA, to highlight cases that might help you avoid problems and save money…
Case study: Donald Swanson, a retired taxpayer in Anchorage, Alaska, was an avid fisherman for more than 30 years. He occasionally acted as a charter halibut fishing guide under the business Happy Jack Charters. During the three years at issue in the case (2014 through 2016), he went on 11 charter-fishing trips in his 22-foot Boulton Sea skiff as well as several personal fishing trips. Swanson reported annual incomes of $1,500, $2,345 and $3,709, respectively. He reported net losses over the three-year period totaling $131,105 for upkeep of the skiff and a seaplane.
IRS position: He was not entitled to business expense deductions because he was not running a for-profit business.
US Tax Court ruling: Mr. Swanson’s charter activity was a hobby, and so his business-related deductions were denied. The court found he failed multiple IRS tests for running a business. Examples: He didn’t maintain business records…he had no commercial fishing license or insurance…he had no business plan… and he made no attempt to improve profitability or take steps to control expenses and increase income.
Lesson: The IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years. Otherwise, it may be classified as a hobby, which means that you will need to prove a valid profit motive if you want to take deductions. For more information, see the nine factors the IRS typically uses to determine profit motive at Law.Cornell.edu/cfr/text/26/1.183-2.
Donald E. Swanson v. Commissioner, No. 21701-18, T.C. Memo. 2023-81
Case study: When Dennis and Suzanne Gomas retired from their Florida-based online pet food business, My Pets Pride, in 2016, they turned it over to Susanne Anderson, Mrs. Gomas’s daughter and Mr. Gomas’s stepdaughter. Over the next two years, Anderson engaged in an elaborate scam, using fictious invoices and fake legal documents to convince the Gomases that their former employees had committed fraud and Mr. Gomas was facing arrest. In 2017, the couple withdrew heavily from their retirement accounts, more than $1.1 million, and handed it over to Anderson so she could help coordinate his defense against the fake criminal case. Unaware of Anderson’s betrayal, Mr. and Mrs. Gomas dutifully paid income tax on the distributions. Anderson was convicted of theft and fraud charges. She was sentenced to 25 years in prison. Mr. and Mrs. Gomas filed an amended individual income tax return for the 2017 tax year, seeking a refund of the income tax they had paid, which totaled $412,259. They argued that the distributions should not be included in their taxable income because they had not personally benefited from those funds and the money was stolen.
IRS position: No refund was due because the 2017 IRA distributions Mr. and Mrs. Gomas took were taxable income, regardless of what they did with the money once it left their IRAs.
US District Court ruling: The judge noted that there are circumstances in which an IRA distribution would be taxed to someone other than the IRA beneficiary. Example: If Anderson had forged Gomas’s signature to take distributions from his retirement account. But Gomas had authorized the liquidation of stock in his IRA, requested the distribution and had the money wired to his personal bank account. He voluntarily exercised control over that bank account, including the payments to his stepdaughter. At trial, the couple argued that, at the very least, they were entitled to deduct the lost funds as ordinary and necessary business expenses because they believed Anderson was using the money to pay for legal services to resolve fictitious legal charges. The Court rejected that theory because no actual business expenses were ever incurred.
Lesson: If you are scammed, the IRS and the courts lack the authority to excuse payment of taxes on the stolen funds. Historically, you would have been able to take a deduction on your personal income taxes for theft-related losses, but Congress suspended the theft-loss deduction for the years 2018 to 2025.
Dennis Gomas et al. v. United States, U.S. District Court for the Middle District of Florida, No. 8:22-CV-01271
Case study: Robert Lucas was a California software engineer who had diabetes, which he managed effectively with insulin injections and other medications. Partway through 2017, he was laid off from his job. To cover the cost of his diabetes care, he took a distribution of $19,365 from his traditional 401(k) plan. He did not report the distribution on his tax return because he misunderstood his online research, thinking that it did not constitute taxable income due to his medical condition. And although he was under 59½, he also argued that he was not liable for the 10% early distribution penalty because his diabetes constituted a medical disability, an exemption allowed by the IRS.
IRS position: Lucas was issued a notice of deficiency for his 2017 tax year of $4,899 based on the inclusion of the retirement plan distribution in his 2017 gross income and the early withdrawal penalty.
US Tax Court ruling: The notice of deficiency was upheld. Nothing in the Internal Revenue Code, Treasury Regulations or case law supported Lucas’s interpretation that his 401(k) distribution was nontaxable income. As for the early distribution penalty, the IRS defines “disabled” as being unable to engage in substantial gainful activity that had been customarily engaged in prior to the disability. Mr. Lucas had been diagnosed with diabetes in 2015 but continued to work after that, including part of the year that he took the distribution.
Lesson: The IRS does waive the 10% early-withdrawal penalty in some health-related incidents beyond qualifying disabilities. Example: The COVID pandemic forced many people with health issues to tap their traditional retirement accounts early. In some cases, they avoided the penalty (but not tax on the distribution) because their medical expenses were not reimbursed by health insurance. You can find more than 20 other exceptions to the early-withdrawal penalty at
IRS.gov and search for “Exceptions to tax on early distributions.”
Robert B. Lucas v. Commissioner, T.C. Memo. 2023-9
Case study: Thomas Richey and Maureen Cleary owned a multimillion-dollar waterfront home with docks and access to the open ocean, as well as a 40-foot boat, in Stone Harbor, New Jersey. In March 2017, winter storm Stella caused significant damage to the vacation home and the boat. On their joint income tax return that year, the couple declared casualty loss deductions of $640,000 for their house and $180,000 for the boat.
IRS position: The deductions were denied. The couple failed to substantiate the cost of the damages and did not prove that the storm caused physical damage to their vacation home and boat.
US Tax Court ruling: The notice of deficiency was upheld. Richey never provided photos or expert testimony that the damage to the retaining wall or the home’s foundation was storm damage rather than damage from erosion and wear-and-tear. His valuation of the damage was inadequate—he estimated the loss in the home’s value by comparing it to other homes in the area using the Multiple Listing Service (MLS) real estate database. And he did not file an insurance claim, which is essential for a loss deduction if the taxpayer has insurance. As for the boat, the couple presented the court with a photo of it before the storm but no photos of the after-storm damage or receipts for repairs.
Lesson: Destructive weather events are increasing in frequency around the US. If you go through a disaster such as a fire, flood, storm or hurricane, you must not only establish actual damage but also prove the amount of the loss either by fair market appraisals before and after the event or by using the cost of repairing the damage. Deductions for the repairs cannot be an excuse to make home improvements and increase the home’s value but must be necessary to restore the property to its condition immediately before the casualty.
Important: This case occurred before the Tax Cuts and Jobs Act that Congress passed effective January 1, 2018, and that is scheduled to end after 2025. It stipulates that you cannot deduct casualty losses for personal use property from your income taxes unless the damages were caused by a federally recognized disaster as categorized by the Federal Emergency Management Agency (FEMA).
Thomas K. Richey and Maureen P. Cleary v. Commissioner, T.C. Memo. 2023-43
