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What we can learn from a fallen Tax Court judge

Joe Kristan is a founding member of Roth & Company P.C.

Taxcourt-entrance-300x225You might think a Tax Court judge, of all people, would know not to commit tax crimes -- and would know how to get away with it if she did. That's why tax professionals are agog that former Tax Court Judge Diane Kroupa has pleaded guilty to tax evasion. 

It's almost disappointing how pedestrian her tax crimes are. No offshore cash stashes, no mysterious shell corporations. Along with her husband, with whom she filed joint returns, Judge Kroupa took personal expenses as business deductions.

You can't do that. There is a lot of magical thinking about the power of a business tax return to allow you to deduct personal expenses. You could argue that the multilevel marketing industry thrives on this thinking. But it only works if the IRS doesn't notice it. Judge Kroupa learned what happens when they do.

When you have an unincorporated, wholly owned business, you report the tax consequences on Schedule C, Profit or Loss From Business. Any resulting income -- or loss -- is reported on your Form 1040.

The temptation arises to call everything you spend a business expense. After all, any income you have on the Schedule C starts out with a 15.3 percent self-employment tax. If you have a six-figure joint income, the regular tax on top of that starts out at 25 percent -- and that doesn't even include state taxes, which hit 8.98 percent in Iowa and 7.85 percent in Judge Kroupa's Minnesota.

Deductions gone wild. It's good to take deductions, as long as you know where to stop. It's easy to identify real business expenses -- say, a law license, or office supplies. But then you get into gray areas -- and suddenly gray is the new orange.

Judge Kroupa's husband, Robert Fackler, had a political consulting business that he reported on Schedule C on the couple's joint returns. The couple had a rather expansive view of what constituted "business" expenses, as laid out in the plea agreement:

KROUPA and Fackler fraudulently claimed the following personal expenses as Schedule C business expenses associated with the operation of Grassroots Consulting:

a. Various personal expenses associated with the Easton Residence including rent, utilities, Internet/cable service, garbage removal, and household cleaning;

b. Various personal expenses associated with the Plymouth Residence including household cleaning, bathroom remodeling, new windows, interior design fees, home repair, decorating, house painting, landscaping, plumbing repairs, washer/dryer, dishwasher, garbage removal, and Internet/cable service;

c. Personal expenses incurred for use of furniture to “stage” the Plymouth Residence when the defendants attempted to sell the house;

d. Limousine and taxi fees for travel by KROUPA for Tax Court business; and

e. Other personal expenses ...

The "other personal expenses" included Pilates classes, spa fees, jewelry and clothes. Oh, and vacations to Hawaii, Greece, China, Mexico, and Thailand. And music lessons, family photos, groceries ...

Encouraging the others. The IRS likes to publicize cases like this as a form of instruction -- sort of like the horrible car wreck movies they used to show in drivers-ed classes. But what are we to learn from the wreckage of a once-distinguished career? I can suggest a few things:

  • Not everything is deductible. Sometimes a busy entrepreneur will say, "I'm always on duty, so all my expenses are business expenses." It doesn't really work that way, despite books that invite the gullible to "deduct everything." 
  • A vacation doesn't become a business expense just because you have a business. There are times you can mix business with pleasure. If you are traveling for a business conference to Hawaii, you can also turn the trip into a vacation. But that doesn't make business expenses of your family's airfare to Oahu, or of your hotel expenses after the conference ends. And don't even think of appointing everyone in your family to your "board of directors" and calling the whole family vacation a deductible "directors' meeting." As I said, the IRS wasn't born yesterday.
  • The IRS looks for this stuff. There's nothing in this case that the IRS hasn't seen hundreds of times. The income tax is over 100 years old, giving the IRS plenty of time to figure out how to look for this sort of cheating. IRS business return examination programs have standard procedures to look for personal expenses run through the business, and they are pretty good at finding them.

By all means, deduct all of your real business expenses. A few expenses might be close calls. But not the trips to the day spa. 

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