Earlier this week, United States Tax Court Judge Richard T. Morrison ruled, in the case of Emmanuel A. Santos v. Commissioner, T.C. Memo 2016-100 (May 17, 2016), that the government will not pay the cost of a taxpayer obtaining a law degree.
This is a pro se case. While the record was not very clear, the taxpayer, Emmanuel A. Santos, claimed he earned a degree in accounting from Indiana University in 1988. Thereafter, he began a career as a tax return preparer. In 1996, he obtained a master’s degree in taxation. Eventually, Mr. Santos expanded his tax return preparer practice to include accounting and financial planning services.
Mr. Santos attended a law school in California, graduating in 2011. He was admitted to the California Bar Association and the United States Tax Court in 2014. In 2015, Mr. Santos and his father started Santos & Santos Law Offices LLP, a law firm offering attorney, tax planning, accounting and financial planning services.
On his 2010 federal income tax return, Mr. Santos deducted, in addition to various expenses, including laundry costs, $20,275 for law school tuition and fees. On audit, many of these deductions were denied.
After likely losing at the IRS Office of Appeals, Mr. Santos headed to the United States Tax Court. The sole issue in dispute was whether the deduction of $20,275 for law school tuition and fees was allowable under Code § 162 as an ordinary and necessary business expense.
When Educational Expenses Are Considered Deductible (and When They Are Nondeductible)
Treas. Reg. § 1.162-5(a) is clear—educational expenses that either: (i) maintain or improve skills required by the taxpayer in his or her current employment; or (ii) are required by the taxpayer’s employer (or applicable law) as a condition to continued employment or rate of compensation, are deductible. On the other hand, certain types of educational expenses are expressly nondeductible, including expenses for education that qualify the taxpayer for a new trade or business. Treas. Reg. § 1.162-5(b)(1) provides examples of these nondeductible educational expenses. One of the examples set forth in the regulations specifically references a taxpayer practicing accounting who pursues a law degree. The costs of attending law school are nondeductible because the course of study qualifies the taxpayer for a new trade or business. The law degree is not required to continue practicing accounting.
Previous Tax Court Holdings
Judge Morrison cited numerous cases where the courts have held, consistent with the Treasury Regulations, a law degree qualifies a taxpayer for a new trade or business, and thus the cost of the degree is a nondeductible educational expense. This is true, even if the degree improves the taxpayer’s accounting and tax skills, and the taxpayer remains practicing accounting (i.e., never practices law). See e.g., Taubman v. Commissioner, 60 T.C. 814 (1973).
Despite the clear language of the Treasury Regulations and the numerous cases supporting the government’s position, Mr. Santos brought his case to the United States Tax Court. He appears to have argued that the holdings in the cases where the court relied upon the Treasury Regulations are incorrect because the regulations are invalid. Mr. Santos’s argument, at first blush, appeared intriguing to me. By gosh, I recently won an Oregon Tax Court case invalidating a long-existing administrative rule (which is akin to Treasury Regulations).
Shortly after Treasury promulgated Treasury Regulation § 1.162-5, the United States Tax Court ruled that it was valid. The Ninth Circuit Court of Appeals affirmed the tax court’s conclusion. See Weiszmann v. Commissioner, 52 T.C. 1106 (1969), aff’d 443 F.2d 29 (9th Cir. 1971).
Giving It the Old College Try
Mr. Santos argued that the court in Weiszmann employed the wrong standard to examine the validity of the regulation at issue. Unfortunately for him, the tax court quickly dismissed the argument without much discussion. Then, Mr. Santos asserted that Treasury failed to adequately respond to public comments before finalizing the regulations at issue, thus making the regulations invalid. Unfortunately, Mr. Santos did not raise that issue until after the trial had concluded. Consequently, the trial court record contained no evidence upon which the tax court could even evaluate his assertion. While his argument was creative and certainly intriguing, it never gained any traction. If he had offered evidence on the issue at trial, the tax court’s opinion would have been a much more interesting read. Who knows if any evidence exists to support his assertion of invalidity – Mr. Santos lost!
The clear take-away from this case is that: educational expenses are generally only deductible if they are incurred to maintain or improve the skills required for current employment or to retain current employment or current compensation. The costs of education required to prepare for a new trade or business are generally nondeductible.
The outcome of these cases is generally dependent upon the facts and circumstances. For example, if Mr. Santos had been a practicing tax lawyer (i.e., had already obtained his J.D. degree, had already passed the bar examination and was practicing as a tax lawyer), the costs of obtaining his LL.M. (taxation) may have been deductible.
Many nuances exist in this area of tax law. Consequently, careful analysis is required.
On December 17, 2013, the US Tax Court issued its opinion in Chaganti v. Commissioner, TC Memo 2013-285. The interesting issue before the court was whether the taxpayer, an attorney, was allowed under Section 162 of the Code to deduct amounts he was personally ordered to pay a trial court and opposing counsel in a case in which he was representing a client.
Mr. Chaganti was initially ordered to pay a “fine” of $262, representing the charges of opposing counsel and his court reporter, for his role in his client’s failure to appear for a deposition. When he did not pay the fine, the court held Mr. Chaganti in contempt and ordered immediate payment (with a daily penalty for late-payment). About a month later, Mr. Chaganti finally paid the fine (without the late payment penalty). Throughout the case, he engaged in behavior the judge labeled as “unnecessarily protracting and contentious.” The court eventually ruled against Mr. Chaganti’s client in the case. The other attorney asked the court for sanctions against Mr. Chaganti (not Mr. Chaganti’s client) as a result of his “bad faith, unreasonable, and vexatious multiplication of the proceedings.” The judge ultimately ordered Mr. Chaganti to pay opposing counsel around $18,000 (to compensate for the additional attorney fees incurred due to his actions) and to pay the court around $2,300 for paying the original penalty late.
Mr. Chaganti paid these amounts on December 28, 2007. He had trouble filing his 2007 tax return on a timely basis (big surprise). More than three years later, after the Service prepared substitute returns, the taxpayer claimed the court-ordered payments constituted deductible business expenses under Section 162 of the Code. The IRS respectfully disagreed. Eventually, the case made its way to the US Tax Court and was presented to Judge Paris. Not surprisingly, the taxpayer represented himself.
The court first addressed the amounts paid to the court. Under Section 162(f) of the Code, “[n]o deduction shall be allowed … for any fine or similar penalty paid to a government for the violation of any law.” This deduction disallowance is not limited to criminal fines or penalties. Judge Paris noted, without lengthy discussion, that the court is a government agency. Thus, the fine is nondeductible.
The remainder of the court-imposed sanctions consisted of payments to opposing counsel (rather than a government agency). Thus, the payments are not governed by Section 162(f). So, the issue is whether the payments constitute ordinary and necessary expenses to be deductible under Section 162(a). For an expense to be ordinary, it must be common and acceptable in the taxpayer’s particular business, and to be necessary, it must be appropriate and helpful in carrying out his business. Judge Paris quickly concluded from the record of the trial court that ordered the sanctions that they were not ordinary and necessary expenses to carry out Mr. Chaganti’s representation of a client. The sanctions were ordered as a result of the taxpayer’s “willful and unreasonable protraction of the litigation.” They are not ordinary in the practice of law; rather, the order of sanctions against an attorney is extraordinary. “[T]he mere fact that petitioner was ordered to pay opposing counsel attorney’s fees … demonstrates that those amounts were not ordinary and necessary to the practice of law.” Mr. Chaganti lost again!
Two take-aways: First, penalties or fines paid to the government or an agency thereof are generally not deductible for income tax purposes. Second, even if the fines or penalties are not paid to the government, unless they are ordinary and necessary, they are not deductible.
Larry J. Brant is a Shareholder in Garvey Schubert Barer, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; New York, New York; Washington, D.C.; and Beijing, China. Mr. Brant practices in the Portland office. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.