Glass Warehouse tried to claim a $118,302 deduction for subcontractor expenses in 2019. The problem? They couldn’t show what services they actually paid for. Their backup plan—a professional-advice defense for a 2018 penalty—also fell flat.
Holding
The Tax Court said no to the $118,302 deduction for 2019. Also approved a penalty for the 2018 understatement of taxes. The final bill will be calculated at a later date. Standard procedure.
Why It Matters
Proof of services controls the deduction. General testimony about shareholder-officers’ management duties did not establish the additional subcontractor services supporting the disputed expense.
The holding is narrower than the parties’ compensation dispute. The Court did not decide that the payments were disguised dividends. It also did not decide compensatory intent, and the parties agreed that the reasonableness of compensation was not at issue.
Shareholder reporting does not establish a corporate deduction. Reporting the payments as income on an owner’s return does not prove that the corporation meets its own deduction requirements.
Hiring a CPA does not establish a penalty defense. A taxpayer needs evidence of the information supplied, advice received, and actual good-faith reliance. The preparer’s name on a return does not supply that record.
Key Facts
Glass Warehouse was a closely held C corp that sold glass shower doors and enclosures via retail. Gross receipts for 2019 were approximately $4.1m. The two shareholder-officers (Ryan Thatcher and Nidal Hanna) held 80% and 20% respectively and both worked full time.
On paper the company says it paid $71,250 in officer compensation in 2019. The W-2s show $166,674 in total wages to the two officers. They're not separate payments so don't add them together.
The company attempted to deduct $173,974 for subcontractors. The IRS disallowed $118,302 of that. In court the company only referenced the $109,819 that the owners had reported as other income. The remaining $8,483 was neither explained nor substantiated.
No Form 1099s were issued to the officers in respect of those alleged subcontractor payments. The accounting manager was only able to comment on their normal management work, not on any additional services. The officers themselves didn't give any testimony.
For 2018, the tax issues were resolved except for the penalty. The company was liable for $107,775, not the $92,775 it reported. The 2019 penalty was dropped. So the deduction dispute and the penalty dispute were for different years.
Statutory or Regulatory Framework
Section 162 permits ordinary and necessary business expenses, including reasonable compensation for services actually rendered. Sections 6001 and the related recordkeeping regulations require evidence supporting the expense’s nature, amount, and purpose.
Ninth Circuit precedent applies two requirements to compensation deductions: a reasonable amount and compensatory intent, meaning an intent to pay for services. The parties removed reasonableness from dispute, and the Court resolved the deduction on substantiation instead.
Section 6662 imposes a 20% accuracy-related penalty. For a C corporation, section 6662(d)(1)(B) defines a substantial understatement by reference to the lesser of $10 million or the greater of $10,000 and 10% of the required tax.
Section 6664(c) provides a reasonable-cause and good-faith exception. Reliance on professional advice depends on the adviser’s competence, the accuracy and completeness of information supplied, and the taxpayer’s actual good-faith reliance.
Section 7491(c)’s penalty burden of production applies to individuals, not corporations. Section 6751(b)’s supervisory-approval requirement remains relevant to the corporate penalty.
Arguments
Taxpayer argued:
The accounting manager’s testimony, accounting records, and a payee statement substantiated the subcontractor expenses.
The shareholder-officers’ reporting of $109,819 as other income, and their payment of employment taxes, supported the corporation’s deduction.
Bookkeeping entries referring to reclassification of shareholder distributions reflected errors rather than an intent to disguise dividends.
The company reasonably relied on a qualified professional tax adviser and should not owe the 2018 penalty.
Government argued:
The company had not substantiated the disputed subcontractor services.
Some bookkeeping entries and payment characteristics supported treating the payments as shareholder distributions rather than compensation.
The 2018 understatement supported an accuracy-related penalty, either for a substantial understatement or, alternatively, negligence or disregard of rules.
Court’s Reasoning
The company retained the burden of proof. It did not meet the substantiation conditions needed to shift that burden. The promised evidence did not substitute for the evidence actually introduced at trial.
Daily management duties did not substantiate the claimed additional work. The accounting manager described duties consistent with the officers’ existing employment. She knew of no separate subcontractor agreements and identified no additional services supporting the disputed payments.
The company failed to provide reliable expense records. It supplied no supporting contracts, invoices, payroll records, Forms 1099, or other reliable documents establishing the purported services. The Court did not hold that a missing Form 1099 alone defeats a deduction.
The officers’ returns did not control the company’s treatment. A corporation generally constitutes a separate taxpayer from its shareholders. Their personal tax reporting did not prove the corporation’s entitlement to the expense deduction.
The Court did not decide the disguised-dividend question. It discussed the parties’ competing theories and bookkeeping entries but expressly declined to rely on those entries or determine the payments’ proper characterization. Lack of substantiation independently resolved the deduction.
The settled 2018 tax figures established a substantial understatement. The $15,000 difference between required and reported tax exceeded both $10,000 and 10% of the required tax. The Court therefore did not need to decide the alternative negligence ground.
The reliance defense lacked evidence. No witness established what information the company gave its preparer, what advice the preparer supplied, or how the company relied on that advice. Statements in briefs and counsel’s comments did not prove those facts.
Penalty Approval
The IRS introduced a civil penalty approval form signed by the immediate supervisor before issuance of the notice. The company did not dispute compliance at trial or on brief. The Court accepted the approval under section 6751(b) and cited the Ninth Circuit’s Laidlaw’s Harley Davidson decision, which addresses approval before assessment or before the supervisor loses discretion to approve it.
The opinion does not establish a universal requirement that supervisory approval precede the first communication with every corporate taxpayer. Its approval analysis follows the applicable Ninth Circuit authority and the record before the Court.
Result
The Court denied the disputed $118,302 deduction for 2019 and upheld the section 6662(a) substantial-understatement penalty for 2018, with final amounts to follow under Rule 155.
The Takeaway
If you run a closely held company and want to pay owners extra, you need to show what services they actually performed. If you want to blame your tax adviser, you need proof you actually relied on their advice. The Court didn’t ban extra pay or call these payments dividends. It just wanted evidence.