Tax Court Case Reviews: Lessons Every Taxpayer Should Know

The United States Tax Court issues hundreds of decisions each year. Most receive no public attention. But within those decisions are lessons that apply to millions of taxpayers — lessons about documentation, substantiation, business purpose, and the limits of aggressive tax planning.

Understanding how courts have ruled on common issues is one of the most practical things a taxpayer can do. Not because you are likely to end up in Tax Court — most disputes are resolved long before that — but because the standards courts apply are the same standards the IRS uses in audits.

Here are several landmark and instructive cases, and what they mean for you.

The case: George M. Cohan — the Broadway producer and entertainer — claimed substantial business expense deductions for travel and entertainment. He had no receipts. The IRS disallowed the deductions entirely.

The ruling: The Second Circuit Court of Appeals held that the Tax Court could estimate the allowable deduction based on the evidence available, even without precise documentation. The court reasoned that it was "better to allow some deduction than to allow none at all" when it was clear that some expenses had been incurred.

What it means today: The Cohan rule still exists, but its application has been significantly narrowed by Congress. For travel, entertainment, gifts, and listed property (vehicles, computers), the tax code now requires contemporaneous records — the Cohan rule does not apply. For other business expenses, courts may still estimate, but only when there is credible evidence that the expense was incurred.

The lesson: Keep receipts. The Cohan rule is a last resort, not a strategy.

The case: Thomas Welch, a former employee of a grain company that went bankrupt, paid the company's debts out of his own pocket after starting a new business — hoping to restore his reputation and rebuild his customer relationships. He deducted these payments as ordinary and necessary business expenses.

The ruling: The Supreme Court disallowed the deduction. Justice Cardozo wrote that while the payments may have been "necessary" in the sense of being useful, they were not "ordinary" — they were extraordinary acts that went beyond what a typical businessperson would do.

What it means today: The "ordinary and necessary" standard from Section 162 of the tax code is still the primary test for business expense deductions. An expense must be both common in the industry and helpful for the business. Unusual or extraordinary expenditures — even if genuinely business-related — may not qualify.

The lesson: Business deductions must pass a two-part test. Document not just what you spent, but why it was ordinary for your industry and necessary for your business.

The case: Robert Groetzinger was a full-time gambler who spent 60 to 80 hours per week studying racing forms and placing bets. He had no other employment. The IRS argued his gambling was a hobby, not a business, and disallowed his losses.

The ruling: The Supreme Court held that Groetzinger was engaged in a trade or business. The test: if a taxpayer pursues an activity full-time, in good faith, and with regularity, for the purpose of making a profit, it constitutes a trade or business — even if the activity is gambling.

What it means today: The hobby loss rules under Section 183 disallow losses from activities not engaged in for profit. The IRS presumes an activity is a hobby if it shows a loss in more than three of five consecutive years. Rebutting that presumption requires demonstrating a genuine profit motive — through business-like record-keeping, expertise, time devoted, and history of income in similar activities.

The lesson: If you have a side business that generates losses, document your profit motive meticulously. Keep business records, maintain a separate bank account, and be prepared to demonstrate that you are operating like a business, not pursuing a hobby.

The case: The IRS challenged the compensation paid by a closely held corporation to its CEO, arguing it was unreasonably high and therefore not fully deductible as a business expense.

The ruling: The Seventh Circuit Court of Appeals established the "independent investor" test: compensation is reasonable if an independent investor, reviewing the company's return on equity, would be satisfied with the results. If the company is generating strong returns, high executive compensation is more likely to be reasonable.

What it means today: Reasonable compensation is one of the most litigated issues in closely held corporations. S-corporation owners who pay themselves below-market salaries to minimize payroll taxes face IRS scrutiny. C-corporation owners who pay themselves above-market salaries to reduce corporate income face the same scrutiny from the other direction.

The lesson: Compensation in closely held businesses should be documented, benchmarked against industry standards, and approved by the board. The amount should reflect the value of the services actually performed.

The case: A law firm's partners had lunch together every day at a nearby restaurant to discuss business matters. They deducted the full cost of these lunches as business meals.

The ruling: The Seventh Circuit disallowed most of the deductions. The court held that meals are deductible only when the business discussion is the primary purpose — not merely incidental — and when the meal setting is conducive to business discussion. Daily lunches among partners who would have eaten lunch anyway did not meet this standard.

What it means today: Business meal deductions require a genuine business purpose, a business discussion that takes place during the meal, and documentation of who attended and what was discussed. The Tax Cuts and Jobs Act of 2017 eliminated the deduction for entertainment expenses entirely, leaving meals as the primary remaining category — and making proper documentation more important than ever.

The lesson: Document every business meal with the date, location, amount, business purpose, and names of attendees. A note on the receipt at the time of the meal is worth far more than a reconstructed log created months later.

Across these cases — and hundreds of others like them — a common thread emerges: the taxpayers who prevail are those who can demonstrate, with contemporaneous documentation, that their deductions were legitimate, their business purpose was genuine, and their records were maintained in a business-like manner.

The taxpayers who lose are those who took deductions they could not substantiate, operated without adequate records, or relied on aggressive interpretations that courts ultimately rejected.

Tax Court decisions are public. The IRS reads them. Auditors are trained on them. The standards they establish are the standards applied in every audit.

Understanding those standards — and building your record-keeping practices around them — is not just good tax planning. It is the foundation of a defensible return.

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