Bad Books Lose Bad in Tax Court (Reed v. Commissioner)

Reed v Commissioner is an unfortunate story of those who decide that systems, books, and records are not important. And that spreadsheets do not do well in the face of IRS and court scrutiny.

Scott Reed was a real estate consultant who did historic rehab deals in Arkansas and Alabama. He ran multiple businesses and had multiple real estate development deals. He had a rental property, a wood flipping business (probably not what you see in your head), and a farmland lease.

He also had three historic redevelopment projects. And, because of cash issues, he made several business payments out of personal accounts for all these entities and businesses.

His wife is a physician, and they also had a disregarded LLC called Reed Realty Advisors.

And you can immediately tell this is not going to go well for Reed. Why? Commingling of personal funds, oral handshakes, and cash coming and going in the wrong places.

The judge states in the case that the ‘record-keeping’ has much left to be desired. They effectively showed up with a lot of spreadsheets and hoped that would be enough.

They also never put the constructed or completed books for the consulting company into evidence. Why? Well, this was because their personal accounts were eating business deposits and paying vendors. And when the IRS sees the personal accounts are being used, they like to now examine all of these personal accounts

What Happens If You Don’t Keep Good Books?

If you don’t keep books, the IRS will write your P&L form. And whatever form you already booked, like loan, contribution, or expense, is what you have at trial.

And if you take something that the IRS could potentially combat, you need substantiation for that. And you’ll never get that if you don’t have solid documentation AND solid books.

There is something called the Cohan rule that allows some deductions, but you’ll get more deductions if you can actually substantiate everything properly.

Otherwise, the IRS can knock it all down, and then force you to pay additional fees to wind up in tax court.

Bank Deposits, Missing 1099s, and §6001

§6001 is the whole first half of the case. You have to keep records that let them figure out the tax. You don’t; they reconstruct.

The Reeds also ran a wood-flipping side hustle. It deposited $32,981 in 2014 and $5,200 in 2015. Stipulated. He didn’t report 2015. His reason: I never got a 1099.

But the court (via Sec 61) said not receiving a 1099 does not excuse you from reporting income. Reyes Barrios v. Commissioner, T.C. Memo. 2026-32. §61 does not care about the form.

He also left a 1099-MISC from the property manager on the table. $38,478 was the real rental income number, but he just reported $28,653. Now they might have had a reasonable explanation for this, but they either didn’t want to address it or ignored it in their tax court brief.

And a K-1 from TJ Tower with $21,065 of interest to his disregarded LLC. He said he never personally received it, and therefore shouldn’t be taxed on it. But that’s not how Subchapter K works. United States v. Basye, 410 U.S. 441 (1973). You pick up your distributive share whether the cash hits your account or not. Regardless if your distributions match your K1 or your income.

I’ll focus on this for a second because a lot of people think they are taxed on their distributions. That’s not accurate. You’re not taxed on distributions, but on the K1 reporting of your income.

So if a partnership has $100,000 of net income, and you own 25%, then your K1 will say you have $25,000 of taxable income to deal with.

Sale-Date Basis, Not the Year-End K-1

Alright, on to the next issue. He tried to show that he sold his partnership units at a capital loss… but he had no representation of why he thought this.

Same problem on the K Lofts units he sold. He wanted a capital loss. Pointed at a year-end K-1. The court ran the math on that K-1 and still got a gain.

One of the big issues was the fact he was trying to allocate debt to himself to get additional basis. But, due to the timing of his sale, he couldn’t get that debt basis because it was unclear when there were contributions or distributions on the K1s.

He asked the court to estimate under Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930). They said no. Using Cohan as a substitute for the burden of proof is not how that case works. Coloman v. Commissioner, 540 F.2d 427 (9th Cir. 1976). $108,526 of long-term capital gain stayed.

When the books are bad, Cohan does not save you. It only fills a small hole when you already proved the expense existed.

The $811,000 that the Books Called a Loan

And yes, it keeps getting worse.

2014 and 2015, he moved about $811,000 from personal accounts into Main Street Lofts and K Lofts. The project ledgers called it “Scott Reed Float Loan” and “Scott Reed Short Term/Long Term Loan.” Some of it got repaid.

On the 1040, he deducted it as unreimbursed partnership expenses. $486,796 in 2014. $353,775 in 2015.

He tried his hardest to turn it into a real deduction. §162 business expense. No.

The cash left his personal account, not the consulting company’s. And you don’t deduct an amount you have a right to get back. Orvis v. Commissioner, 788 F.2d 1406 (9th Cir. 1986).

Unreimbursed partnership expense. Still no. And this is a common issue, actually.

A partner does not deduct the partnership’s bills unless the agreement or a regular practice says he has to pay them himself. Klein v. Commissioner, 25 T.C. 1045 (1956).

Also, you have to have your entity operating agreement state that there is an ability to claim unreimbursed partnership expenses. If it does not state that, then you have no recourse for this. Always get someone to analyze this.

Then, he tried to claim this was worthless debt under §166. Still no.
The LLCs still owned real estate. He later swapped K Lofts units for other units. He didn’t chase the co-guarantors.

Commissioner v. National Alfalfa, 417 U.S. 134 (1974) states if you pick the form, you live with it. If those transfers were capital, so no current deduction. If they were loans, he never proved they went bad in those years.

What Still Worked, Because He Could Tell the Story

Alright, while this was a sweep for the IRS, it was more of a gentlemen’s sweep. The Reeds did get some consulting-company deductions. They won on a farmland lease deduction of $50,000 despite it only being a handshake agreement, but actual cash was paid. They also were successful on some engineering expenses too. Those had a clean tie to Reed Realty Advisors, and the project books did not call them loans.

The construction and repair bills at the project sites were disallowed. Those were the LLCs’ costs. Deputy v. Du Pont, 308 U.S. 488 (1940). This doctrine comes back to ‘a taxpayerr cannot deduct another person’s expenses’.

Meaning, if you have another business you run in another entity (that files a tax return), you can’t claim those deductions on a Schedule C when it belongs on a 1065. That’s incorrect in this case.

Lohrke v. Commissioner, 48 T.C. 679 (1967) is the narrow out, and he couldn’t show the projects were broke or that the payments were really to protect his own fee. Derm-practice setup costs run through the real estate consulting Schedule C? Also no. Different business. And they also couldn’t prove this business ever got off the ground and was able to run.

What To Do With This

Look, you need to have a real operating accounting system. Not spreadsheets… and not a personal bank account.

Separate operating account. Real books. You should be able to hand an agent a general ledger that ties to the bank. This is why working with someone to handle your books is top-notch, and you’ll be able to win any kind of aggressive reporting or positions. Why? Because you have the backup needed.

You’ve got to come up with all the proof in these.
You report the K-1 and the 1099 in the same year, even when the form never shows up.
If your 2025 file is still sitting in the personal checking account, that is the year to pull it apart. Not after the notice.

Schedule a discovery call today.