Harris v. Commissioner

Sales Manager Dimmed on $250k Energy Deduction Scheme

A lighting sales manager's aggressive attempt to eliminate his tax liability using purchased energy efficiency allocations has been extinguished by the Tax Court. The manager, who claimed to be the 'designer' of energy-efficient systems in government buildings, faced over $49,000 in tax deficiencies and penalties for the 2016 and 2017 tax years. Judge Weiler rejected all of the taxpayer's claims, finding he was an employee, not a qualifying designer under Section 179D, and upheld the IRS's penalties.

Buying the Deduction: The Allocations and the Study

As a sales manager at Lighting Unlimited, Harris's scheme began with legitimate business operations. Lighting Unlimited secured contracts for several projects involving Arizona government entities, including schools and administrative buildings. To leverage potential tax benefits from these projects, Lighting Unlimited hired ICS Tax, LLC, to conduct an energy efficiency study. The study focused on two projects: the Arizona Department of Environmental Quality building and the Arizona Department of Administration building.

According to the ICS Tax study, Lighting Unlimited could have claimed a Section 179D deduction of $849,998. Section 179D provides a deduction for the cost of energy-efficient commercial building property. The study included certifications from a professional engineer, Austin Hermsen, who calculated specific deduction amounts for each building: $534,000 for the Arizona Department of Environmental Quality building and $315,998 for the Arizona Department of Administration building.

Here's where the plan took a sharp turn. Attached to the ICS study were "Allocation of 179D Energy Efficient Commercial Building Deduction Forms." These forms purported to allocate portions of the Section 179D deduction to Harris as the "designer" of the energy-efficient systems. The forms indicated the projects were completed in December 2017, and they allocated $177,982 and $105,322 to Harris for the Department of Environmental Quality and Department of Administration buildings, respectively. Crucially, Harris paid approximately $17,000 in 2018 to obtain these allocation forms. The allocation forms were signed by Harris as the designer and by a representative from Neil Urban Planning and Construction Services as the authorized governmental representative, both on June 28, 2018.

On his 2016 and 2017 tax returns, Harris reported significant losses on Schedule C, Profit or Loss From Business. For 2016, he designated himself as a proprietor engaged in "Lighting Design," reported zero income, and claimed $74,000 in "other expenses," which he identified as the Section 179D deduction. A similar pattern appeared in 2017, where he designated his business as "Certified Light Designer," reported zero income, claimed $44,606 in depreciation and Section 179 deductions, and listed $108,500 in "other expenses" related to the Section 179D deduction.

Employee vs. Business Owner: The Schedule C Fight

Harris's aggressive tax positions extended to his classification of himself as a business owner, a move the IRS contested. In both 2016 and 2017, Harris filed Schedule C forms, Profit or Loss From Business, designating himself as a proprietor engaged in "Lighting Design" and "Certified Light Designer," respectively. He reported zero income and substantial expenses related to the Section 179D deduction. The IRS challenged these filings, arguing that Harris was an employee of Lighting Unlimited, not an independent business owner, rendering the Schedule C deductions improper.

The court first addressed the preliminary matter of the $17,000 expense deduction Harris claimed for his portion of the ICS study. Harris testified he paid this in July 2018, but he attempted to deduct it in 2017. The court noted that Harris was a cash-basis taxpayer. Treasury Regulation § 1.461-1(a)(1) states that a cash-basis taxpayer deducts expenses for the year of payment. Therefore, the court disallowed the deduction because the payment occurred in 2018, not 2017. Furthermore, Harris provided insufficient evidence, beyond his own testimony, to prove the expense was an ordinary and necessary business expense. The court pointed out that his employment contract with Lighting Unlimited stipulated reimbursement for traditional employee expenses, suggesting this expense should have been reimbursed. To deduct unreimbursed employee expenses as an ordinary and necessary business expense under Section 162, the expenses must be necessary. The court cited Lucas v. Commissioner, 79 T.C. 1, 6 (1982), explaining that if an employer is meant to cover certain employee costs, it is not necessary for the employee to pay them.

The IRS also disallowed Harris's depreciation and Section 179 expense deduction claimed on Schedule C for 2017, arguing he did not conduct a trade or business during that year. The court agreed. Section 162(a) allows a taxpayer to deduct ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. However, personal expenses are generally not deductible, per Section 262(a). Furthermore, to determine eligibility for a depreciation and Section 179 expense deduction, the court had to determine whether Harris’s activities constituted a trade or business under Sections 179(b)(3) and 167(a)(1). The court found that Harris failed to present evidence at trial showing he incurred expenses related to or otherwise undertook any trade or business for the relevant tax period. Since Harris stipulated that he was an employee during the tax period and testified that his claimed Schedule C deduction related to his role as an employee, the court sustained the IRS’s disallowance of the depreciation and Section 179 expense deduction.

The Core Issue: Who is a Section 179D 'Designer'?

After concluding that Harris failed to prove he operated a trade or business, the court turned to the central dispute: whether Harris qualified as a "designer" eligible to claim a Section 179D deduction. Section 179D provides an immediate deduction for expenses related to energy-efficient improvements to commercial building property, instead of requiring capitalization and depreciation under Sections 167 and 263. Specifically, Section 179D(d)(4) addresses situations where energy-efficient commercial building property (EECBP) is installed on or in property owned by a federal, state, or local government. In these cases, the Secretary is directed to issue regulations allowing the deduction to be allocated to the "person primarily responsible for designing the property," instead of the government owner, which cannot use the deduction. To date, no such regulations have been issued. This "designer" is then treated as the taxpayer for purposes of claiming the Section 179D deduction.

The court emphasized that Harris bore the burden of proving he met the definition of a "designer" under Section 179D(d)(4). The Tax Court relied heavily on its prior analysis in Johnson v. Commissioner, 160 T.C. 18 (2023), which established the legal standard for determining who qualifies as a designer. In Johnson, the court concluded that the taxpayer was a designer because he analyzed the original sequence of operations, inspected the existing systems to determine how they were actually operating, and modified the sequence of operations to better operate the systems. The Johnson court found that the taxpayer had "created the technical specifications for the installation of the EECBP at issue."

However, the Tax Court found Harris's situation distinguishable from Johnson. The court noted that Harris provided only self-serving testimony and failed to provide sufficient evidence demonstrating that he created any technical specifications or design elements for the energy-efficient improvements. The court stated that, based on the limited evidence, it could not conclude that Harris functioned as a designer. Therefore, the court held that Harris was not a "designer" as intended under Section 179D(d)(4), and sustained the IRS's disallowance of the deduction. The court's decision underscores that merely selling or managing a project, without demonstrably creating the technical specifications, does not qualify a taxpayer for the Section 179D deduction as a 'designer'.

Penalties, EITC, and the Cost of Aggressive Positions

Having determined that Harris was not a "designer" as intended under Section 179D(d)(4), and sustained the IRS's disallowance of the deduction, the court then addressed the fallout from these aggressive tax positions.

The IRS had assessed accuracy-related penalties under Section 6662(a), which imposes a penalty equal to 20% of the underpayment of tax attributable to, among other things, negligence or a substantial understatement of income tax. An understatement is "substantial" if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. The court sustained these penalties for both 2016 and 2017. It found that Harris's understatements were indeed substantial and that he failed to demonstrate reasonable cause for claiming the improper deductions.

Furthermore, the disallowance of the $74,000 Section 179D deduction for 2016 increased Harris's adjusted gross income (AGI), disqualifying him for the Earned Income Tax Credit (EITC). The Earned Income Tax Credit, under Section 32, is a refundable tax credit for low-to-moderate income working individuals and families. Because Harris's true income exceeded the statutory threshold for EITC eligibility, the court upheld the IRS's denial of the credit.

The IRS had also sought to impose a two-year ban on Harris's EITC eligibility for 2017 and 2018, as permitted by Section 32(k)(1)(B)(ii). This section allows the IRS to disallow the EITC for two years if it is determined that the taxpayer's claim was due to reckless or intentional disregard of the rules and regulations. However, because 2017 and 2018 had already passed by the time of the court's ruling, the issue of the two-year EITC ban was moot.

This case serves as a cautionary tale for taxpayers considering aggressive tax strategies. The Tax Court's ruling underscores the importance of strictly adhering to substantiation requirements when claiming deductions, particularly for Section 179D allocations. It also highlights the risks associated with attempting to reclassify employee work as a business venture to claim deductions and credits for which they are not eligible.