Tax Deductions Associated With “Other Income”

Published Categorized as Tax Deductions
Tax Deductions Associated With “other Income”
Tax Deductions Associated With “other Income”

The IRS was recently given a significant increase in its budget. Its request for more money was premised on the need to hire more IRS revenue agents to audit more non-compliant tax returns.

While the IRS has in fact reduced its headcount significantly, it has also benefitted from recent tax law changes. Some of these changes to our tax laws have significantly reduced the IRS’s audit workload. Admittedly, other tax law changes have increased the IRS’s return processing workload, but this workload generally does not include work performed by IRS revenue agents or involve increased audits.

The elimination of miscellaneous itemized deductions by the Tax Cuts & Jobs Act of 2017 is a prime example. Miscellaneous itemized deductions represented a significant opportunity for taxpayer non-compliance. The IRS employs thousands of tax examiners, tax compliance officers, and revenue agents whose sole job is to audit these expenses.

These employees were not let go. They still work for the IRS. They are still conducting audits–and they will be doing so alongside the new IRS agents hired with the increased budget.

If these auditors are not having to deal with miscellaneous itemized deductions, they will be looking for other adjustments. They will be applying other theories for disallowing tax deductions. The question as to whether expenses are related to a “trade or business” is a good example.

The recent Monroe v. Commissioner, T.C. Summary Opinion 2021-24, provides an example of a fact pattern that is likely to trigger these adjustments.

Facts & Procedural History

The taxpayer was employed as a car salesman for a local car dealership. He was paid wages as an employee of the local car dealership. The car dealership reported the wages to the taxpayer on a Form W-2, Wage & Tax Statement.

The taxpayer also received performance incentive payments from the car dealership for cars he sold. The dealership made the payments by depositing funds directly onto a prepaid card issued to the taxpayer. The dealership reported these payments to the taxpayer on Forms 1099-MISC, Miscellaneous Income. The taxpayer reported the performance incentive payments and related expenses on Schedule C, Profit & Loss From Business, on his tax returns.

The IRS audited the taxpayer’s income tax returns. It concluded that the expenses were not deductible on Schedule C. Rather, the IRS concluded that the expenses were to be reported on Schedule A, Itemized Deductions, as miscellaneous itemized deductions. The taxpayer filed a petition in the U.S. Tax Court to challenge the IRS’s determination.

Miscellaneous Itemized Deductions

Taxpayers can deduct unreimbursed employee expenses paid for carrying on a trade or business of being an employee. These employee expenses are generally miscellaneous itemized deductions. This means that they are reported on Schedule A and limited to amounts in excess of 2% of the taxpayer’s Adjusted Gross-Income (“AGI”). AGI is basically the total income received by the taxpayer during the tax year.

Expenses incurred to earn a profit that are not related to a trade or business are also usually treated as miscellaneous itemized deductions.

These rules changed in 2017. This case involves the tax years 2014 and 2015, which pre-date the Tax Cuts & Jobs Act (“TCJA”). The TCJA denies deductions for miscellaneous itemized deductions such as those in this case if the expenses are incurred after 2017 (it also disallowed deductions for entertainment expenses). Had the case involved post-2017 expenses, the distinction between Schedule C and Schedule A expenses means the difference between expenses being deductible or not deductible.

Trade or Business or Other Income

The taxpayer took the position that his performance incentive payments were a separate trade or business from his employment. He did this by reporting the payments on his Schedule C. He also reported his expenses on Schedule C.

The IRS took the position that the performance incentive payments were not received for trade or business. If correct, the result is that the payments are “other income” and are to be reported on the first page of the tax returns.

The court had to decide whether the expenses were related to a separate trade or business, related to the taxpayer’s employment, or were not related to a trade or business.

The court describes the taxpayer’s activities as follows:

In order to facilitate his overall car sales, Mr. Monroe engaged in certain marketing activities. Those activities involved offering incentives to: (1) potential customers who test drove a Shawnee vehicle for which Mr. Monroe was the designated salesman, (2) customers who purchased a Shawnee vehicle for which Mr. Monroe was the salesman, and (3) persons who referred customers to Mr. Monroe. The various incentives included a free round of golf for two people, lunch, dinner, a $100 gift card, or tickets to a Kansas City Chiefs football game.

Based on this, the court concludes that the taxpayer’s activity was not a trade or business and not related to a trade or business. The performance incentive payments were simply other income.

The result is that the performance incentive payments were not subject to self-employment taxes (which reduces the taxpayer’s tax), but the related expenses would be miscellaneous itemized expenses (which post-2017 would not be deductible and therefore would increase his tax).

The Takeaway

This fact pattern is common. Employees often have income from sources other than wages. This type of “other income” can either be reported as “other income” or as income from a trade or business.

This presents a quandary for taxpayers when they file their tax returns. Does the taxpayer report the income as “other income” and avoid self-employment taxes but lose out on any deductions, or do they report the income on Schedule C as a trade or business and deduct the related expenses on the same schedule?

This is a situation where advanced tax planning is warranted. For example, a better option might be to incorporate the business and possibly make an S corporation election for the business. This may put the taxpayer in a better position to assert that there is a trade or business and, at the same time, limit the amount of self-employment taxes. This is one of several options for addressing this quandary.

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