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Sunday, April 06, 2003

Tax Court Rules Strip Club Owner May Deduct Tips To Dancers

This year�s leading contender for the opinion most likely to be gratuitously placed in textbooks comes from the case of JERRY S. PAYNE, an attorney who ended up with controlling interest in a strip club as payment for defending the previous owner, Gerhard Helmle, on drug charges. Helme stayed on as manager, and now, 15 years later, one issue in this case is whether Payne was correct not to claim income from certain �withdrawal authorizations� (WAs) of cash he signed and indicated as being for promotional purposes. Due to acquisition of the club being self-employment income, as well as some large previous payments from the club, Payne had zero basis in the club and the IRS wanted to characterize the WAs as constructive dividends to be taxed as capital gains. Payne argued that the WAs were for the legitimate expenses of allowing Helme to give tips on an irregular basis to the �quality dancers� at both his club and other(!) clubs. (Yes, I know my headline is wrong, because this issue involves the characterization of payments rather than deductions. But the concept is similar, the reasoning is the same, and �deduct� is funnier.)

It�s hard to know who to root for in this case. One sleazy side uses the law to take money from people threatened with prison and gives it to whores. On the other side is Payne.

Payne appeared pro se and the only evidence he offered was his own testimony on his behalf. He argued that the need to tip the �quality dancers� had become urgent in light of the litigation over the club�s failure to obtain a permit to be an SOB. (Sexually Oriented Business) (Apparently you need a permit to be an SOB in Texas. I think this is a good idea. I have noticed that there are far too many SOBs in Texas, and it is a good idea restrict their number by requiring permits. I doubt you could get rid of all the SOBs in Texas, but it is only fair to make people pay for being SOBs.) He said that tips to dancers at other clubs were necessary to entice them to come to his club. Payne claimed that the sole purpose of the WAs was to restrict the amounts of cash that Helme would be permitted to use for tips. Presumably, without such restrictions, Helme would go wild showing unrestrained generosity toward his employees. And other clubs� employees.

The IRS seemed to rest its case on lack of substantiation and burden of proof. Tax Court reports the IRS, ��argues that petitioner�s trial testimony was �self serving, inconsistent, conflicting, and generally not credible�, and that petitioner failed to produce credible evidence that the cash and food distributed pursuant to the WAs were used for any business purpose.� Tax Court seemed to accept that the WAs were substantiation, and believed Payne more than the IRS.

At first I thought Tax Court had decided this case wrong. Could Tax Court possibly have failed to notice the potential elements of personal pleasure and recreation inherent in tipping strippers? And the explanation for tipping other club�s strippers is worthy of Bill Clinton. Does Tax Court really think it was the strippers who were being �enticed�? And the fact that the strip club�s returns were not in evidence is troubling. If these tips to the �quality dancers� were business expenses, were they included on W-2s or 1099s?

But as I think more about giving money to strippers, I can not see how this case could be decided the other way. I once attended a gaming convention where Steve Jackson of Steve Jackson Games told a story about being audited by the IRS. When they came across his deduction for his personal computer, the auditors slyly asked him if he played games on his computer. Jackson reported that he looked the IRS agents in the eyes and said, �Of course I play games on my computer. I�m in the game business. I have to keep up with the competition.� This explanation makes perfect sense, even though Jackson did not publish computer games. Computer games were still competition to his games, and trends in computer and non-computer games influence each other greatly. (It turns out the IRS was more reasonable than the Secret Service, who accused him of using his computers for cyber terrorism.)

As professionals in the strip club business, it is perfectly legitimate for Payne and Helme to evaluate their employees� performances and to sample what the competition has to offer. And you can not deny legitimate business expenses just because the businessmen enjoy their jobs.

Motto: Do what you love.

For Tax Professionals Only: The boring parts of the case.

* Tax Court ruled Payne did receive constructive dividends for a few WAs that did not corroborate his testimony, because they indicated he spent the money for his benefit or that he �spent� or �took� the money.

* There is an interesting one-page discussion describing the burden of proof as a rarely-used tie-breaker.

* The transfer of the club�s operation from one company to the other was a tax-free reorganization, did not result in �boot�, and was not done in anticipation of an impending sale. Not withstanding that the club was sold three months after the transfer and there is evidence that the transfer may have been made in part to make the property more salable, there was no evidence that the sale was impending at the time of the transfer.

* IRS�s disallowance of Payne�s Schedule C deductions for parking fees and for bad debts was sustained for lack of substantiation. Tax Court used Payne�s testimony that the went to the Houston courthouse frequently against him, stating that it therefore constituted a regular place of business and that commuting expenses could therefore not be deducted.

* An underpayment penalty against Payne was sustained with respect to the deficiencies arising out of the disallowances of his Schedule C deductions.

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