In Mondell0 v. Commissioner, T.C. Summary Opinion 2011-97 (7.25.11), a part-time web developer ran his business as a sole proprietorship. He worked hard on his craft, as most sole proprietors do. Unlike most sole proprietors, however, Mondello saw fit to “accrue” a $50,000 deduction to himself for services rendered but not yet paid.
If you find this confusing, you’re not alone. Sole proprietorships — unlike S corporations, C corporations, or multi-member partnerships — are not given any independent tax significance apart from their owner. In other words, from a tax perspective, you are your sole proprietorship, and your sole proprietorship is you. It would then follow that paying a salary from your sole proprietorship to yourself is as meaningless a gesture as lending $40 bucks from your right hand to your left foot.
For Mondello, however, the $50,000 accrual resulted in a decrease in taxable income without an offsetting income pickup, as the sole proprietorship was on the accrual method and he reported his income on the cash method. The deduction also reduced Mondell’s income subject to self-employment tax and resulted in a reduction in adjusted gross income that allowed for an increased medical expense deduction.
As one might imagine, the IRS disagreed with Mondello’s position and denied the deduction. The Tax Court sided with the IRS, noting:
Under the accrual method a taxpayer is not entitled to deduct an expense “if there is no legal obligation during the taxable year to make such payment.” The word “liability” means “The quality or state of being legally obligated or accountable; legal responsibility to another or to society, enforceable by civil remedy or criminal punishment”. Should petitioner have “refused” or become unable to pay himself, there would have been no legal consequence. He would not seek forced collection from himself, nor would he be able to sue himself in a court of law to obtain a judgment against himself for any amounts he “owed” to himself, even if he were so inclined. There was no legal obligation during the taxable year, or any other year for that matter, for petitioner to pay himself anything.