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November 28, 2023

Cashing In On Your Deductions


Have you ever had a large check or bill payment you were racing to make at the end of the year?
Ever wondered what happens if the check or bill cleared the following day, and it crossed the tax year?
A recent tax court case gives us clarity.

In TC Memo 2023-47, an Oklahoma taxpayer appeared before the tax court. Back in 1995, when the bison roamed the plains of Oklahoma, the taxpayers of this case purchased a nursing home. They borrowed several million from a mortgage company.

The TLDR for the case?

The taxpayers had a check payment that crossed tax years and claimed their deduction in the wrong year. Be careful when you claim an expense that crosses tax years, because these folks literally aged out of their deduction. See Rev Rul 80-335 for more details.

But more facts below –

The Federal Housing and Urban Department (HUD) insured the loan, albeit with several stipulations. In 2003, the nursing home ended up defaulting on its loan, HUD foreclosed on the nursing home and sold it for a loss. Eventually, they sued and settled with the taxpayers (7 years later) and other owners for $1.75 million.

Of that $1.75 million, the taxpayers were obligated to pay $875,000, which they took a deduction for on their tax return, in addition to their legal fees.

The couple then claimed a deduction on Form 4797, as a sale of business property, which theoretically makes the case that it is a Sec. 162 expense – meaning it’s an ordinary and necessary business expense for the taxpayer’s trade or business. The taxpayers were trying to establish the premise that the loss deduction was proximately related to their now-foreclosed nursing home business.

The cashier’s check they made was dated December 27th, 2012, and 2012 was the tax year in which they claimed the deduction.
Their attorney attempted to deliver the check but was informed that the government could not accept the check until the settlement was fully approved. The settlement did not finalize until March 2013. (You probably know where this is going already).
The IRS disallowed the deduction stating two points: (1) that the check would not be deductible until 2013 and (2) that it shouldn’t qualify as a deduction under § 162(f), which states that punitive damages are non-deductible.

The taxpayers argued that under Oklahoma law, the timing of the deduction would qualify as a tender of payment which, in their eyes, makes the amount deductible in 2012.

The court begins their starting point with the timing issue because you can’t go any further if your deduction is in the wrong year. And individuals are normally cash method taxpayers. And cash method taxpayers, generally, can only take a deduction for the year the expenditure is paid, not incurred.
In regard to check payments crossing tax years, there is a specific rule that states a payment by check is deductible when delivered, and with no proof of delivery, it is considered deductible when actually received (see Treas. Reg. § 1.461-1(a)(1)). If you have proof of time of mailing, i.e., mailed December 30th but not received until January 2nd of the following year, then the deduction can be taken using the December 30th date.

The court finds since the check was not truly delivered until March 22nd, 2013, when the check was cashed after the settlement was approved. (Judge Holmes muses if they ever had a true obligation until the settlement was 100% resolved) The court, in response to the taxpayer argument, stated this case is both a federal case and matter, so no need to look at state law.

This means there is no deduction, and the buck stops before even progressing to the § 162 analysis. It is possible that if the check had been made by year end, that the expense would have been deductible.

But that’s the ultimate kicker.

It was not done before year-end, therefore, not deductible for 2012 .

The court looked at a few cases in their analysis, one of which was Guy v Commissioner, TC Memo 2013-103.

In TC Memo 2013-103, the taxpayer was a professor that was disputing the disallowance of legal fees that were paid to keep his line of work that allowed him grants at his university. He made a few different checks out to the attorneys. One was made on Dec 29th 2006 and was not deposited by the attorney until late January of 2007. The other was made out in 2006 and deposited in 2006. The payment that crossed over tax years was the only payment that was deductible as Dr. Guy was looking to deduct all these payments in 2007. As stated in § 1.461-1(a)(3), a deduction that should have been made in a prior year is only allowable for that prior year. While this is the reverse case for our Oklahomans, the rules still apply.

The court additionally analyzes to see if they are on the hook for § 6662(a) penalties and if they acted in good faith with their deduction and do eek out a win on that front.

What can we learn here?

One lesson is, if you’re a cash method taxpayer, take a peek at Rev Rul 80-335.

IRS Revenue Ruling 80-335 describes a ‘pay by phone’ payment situation for a taxpayer who has another individual write checks for them and then list the transactions made. The revenue ruling determines that under § 1.461-1(a)(1), that the payment is deductible in the taxable year paid. And so long as there is proof of delivery, like the list of transactions provided by the agent, then the deduction can fall into the earlier year instead of when it is deposited by the payee.

While this wouldn’t have helped these taxpayers, it could help out taxpayers who are trying to accurately deduct a check payment at the end of the year, in the year they are made AND delivered.

Just make sure you have proof of delivery! Additionally, check out Guy v Commissioner, TC Memo 2013-103, and Reynolds v Commissioner, TC Memo 2000-20 for more situations similar to this!