The recent Tax Court Memorandum decision in Adrienne Mennemeyer v. Commissioner of Internal Revenue, T.C. Memo. 2025-80, offers valuable insights for tax professionals regarding the taxability of settlement proceeds, the deductibility of business expenses, and the imposition of penalties for failure to timely file. This case underscores the critical importance of meticulous record-keeping and clear documentation in substantiating claims before the Internal Revenue Service (IRS) and the Tax Court.

Background of the Case

The petitioner, Adrienne Mennemeyer, was formerly employed by PNC Investments LLC (PNC). Her employment concluded on December 12, 2013, after which PNC filed a U5 document with the Financial Industry Regulatory Authority (FINRA) alleging dishonesty, which significantly hindered Ms. Mennemeyer’s ability to secure further employment in the securities industry.

In response, on December 3, 2015, Ms. Mennemeyer initiated a FINRA Arbitration. Her claims included defamation, wrongful termination, unfair competition, tortious interference with business expectancy, and expungement. Notably, her claims did not encompass health concerns, beyond acknowledging emotional and psychological harm resulting from PNC’s actions. The FINRA Arbitration resulted in an award of $300,000 in compensatory damages and $1,500,000 in punitive damages, with the award explicitly stating that its recommendations were based on "the defamatory nature of the information" in the U5.

PNC subsequently filed a petition to vacate the arbitration award in the U.S. District Court, leading to a settlement agreement between Ms. Mennemeyer and PNC in April 2018. Under this Confidential Settlement Agreement and General Release (Settlement Agreement), PNC agreed to pay $1,510,000. Of this sum, Ms. Mennemeyer received $997,466, and her attorneys were paid $512,534. The Settlement Agreement included a general release pertinent to Ms. Mennemeyer’s "employment and/or termination of employment with PNC" and claims arising from the FINRA Arbitration, but made no mention of health concerns or physical injuries. Ms. Mennemeyer asserted that the settlement was partly for health concerns and that she was forced to waive future health-related lawsuits, but no contemporaneous records supported these claims.

Following her departure from the securities industry, Ms. Mennemeyer established Olive Tree Enterprises LLC (Olive Tree), a single-member disregarded entity operating as an antique mall in Wentzville, Missouri. In 2018, Olive Tree generated revenue by selling Ms. Mennemeyer’s own goods, renting space to vendors, and selling consigned goods, retaining 10% of consignment proceeds. She also acquired and improved used goods, often with cash, and admitted to poor tracking of these expenditures. In late 2018, Ms. Mennemeyer purchased a Chevrolet Suburban for $54,481 for Olive Tree’s business use, such as hauling merchandise and delivering furniture. Although she maintained a separate personal vehicle, the Suburban was used for business purposes. She did not keep logs or contemporaneous records for vehicle use. Her romantic partner and certified public accountant, John Burns, prepared Olive Tree’s books and records, including calculating cost of goods sold (COGS) from bank statements and a general ledger.

Ms. Mennemeyer’s 2018 federal income tax return was due on April 15, 2019, but she filed it on October 15, 2019. She claimed an extension was mailed via Form 4868, but Mr. Burns did not personally witness the mailing, nor could he find receipts to prove it. The tax return reported $498,733 of the PNC award as taxable income, based on advice from her tax attorney. Olive Tree’s Schedule C reported gross receipts of $194,942, COGS of $234,344, and expenses of $177,426, resulting in a loss of $216,828.

The IRS initiated an examination of Ms. Mennemeyer’s 2018 return and, on March 15, 2023, issued a Notice of Deficiency (NOD) determining a significant deficiency of $588,906 and an addition to tax of $164,389 under section 6651(a)(1). The deficiency was largely driven by the full inclusion of the PNC settlement proceeds, increasing Ms. Mennemeyer’s taxable income from $274,175 to $1,858,000. The NOD also disallowed numerous business expense deductions for Olive Tree. Post-trial, Ms. Mennemeyer conceded $18,000 in unreported wage income and a $5,045 taxes and licenses adjustment, while the IRS conceded a $58,816 wage deduction. The parties stipulated to $48,429 in COGS, leaving approximately $185,915 in COGS still in dispute.

Issues Presented and Taxpayer’s Request for Relief

The case presented four primary issues for the Tax Court’s decision:

Whether the limitation period for assessment expired prior to the issuance of the NOD.
Whether Ms. Mennemeyer had unreported income from the arbitration settlement.
Whether certain purported business expenses were deductible as ordinary and necessary business expenses.
Whether Ms. Mennemeyer was liable for an addition to tax under section 6651(a)(1) for failure to timely file her return. The IRS conceded that Ms. Mennemeyer was not liable for a section 6662(a) penalty.

Court’s Legal Analysis and Application to Facts

Burden of Proof and Witness Credibility

The Tax Court reiterated the fundamental principle that determinations in a notice of deficiency carry a presumption of correctness, placing the burden on the taxpayer to prove them erroneous. Taxpayers also bear the burden of proving entitlement to any claimed deduction and must maintain sufficient records. The Court found Ms. Mennemeyer’s testimony generally credible, but Mr. Burns’s testimony was deemed self-serving and lacking in candor, particularly regarding the origin of Ms. Mennemeyer’s health concerns and the Form 4868.

Statute of Limitations for Assessment

Under section 6501(a), the Commissioner generally must assess income tax within three years of the return’s filing date. However, section 6501(c)(4) permits the Commissioner and taxpayer to extend this period through a written agreement. If a taxpayer makes a prima facie showing that the statute of limitations bars an assessment, the Commissioner must demonstrate a valid written consent was executed, and the NOD was mailed before the extended period expired. A consent is considered valid on its face if it identifies the taxpayers, bears their signatures, identifies the year, and is dated before the existing limitations period expires. Once the IRS introduces a facially valid consent, the taxpayer bears the burden of proving its invalidity.

In this case, Ms. Mennemeyer had signed Form 872, Consent to Extend the Time to Assess Tax, which extended the assessment period through October 15, 2023. The NOD was issued on March 15, 2023. The Court found that the Commissioner established all necessary elements for the extension, concluding that the Form 872 was facially valid and signed by both parties. Ms. Mennemeyer failed to establish the consent’s invalidity. Therefore, the Court concluded that the limitation period had not expired when the NOD was issued.

Taxability of Settlement Proceeds Under Section 104(a)

Section 61(a) broadly defines gross income to include all income from whatever source derived, encompassing income from settlement agreements. Section 104(a)(2) provides an exclusion from gross income for "the amount of any damages . . . received . . . on account of personal physical injuries or physical sickness," but explicitly excludes emotional distress. To qualify for exclusion, there must be a direct causal link between the action giving rise to damages and the physical injury or sickness. Congress’s 1996 amendment to section 104(a)(2) specifically limited the exclusion to physical personal injuries.

When damages derive from a settlement, the nature of the underlying claim dictates excludability. The Court first examines the express terms of the agreement; if ambiguous, it then looks to the payor’s intent.

The Settlement Agreement in question broadly released claims, but specifically related to Ms. Mennemeyer’s "employment and/or termination of employment with PNC" and the FINRA Arbitration. The agreement did not mention personal injuries, nor did it suggest the settlement was for physical injuries. While Ms. Mennemeyer testified that PNC was concerned about a future health-related lawsuit, the Court gave this little weight as it was merely her belief unsupported by the record.

The Court found the Settlement Agreement unambiguous. Even if it were ambiguous, the surrounding facts and circumstances indicated PNC compensated Ms. Mennemeyer for defamation and economic damages, not personal physical injuries or sickness. Her claims in the FINRA Arbitration focused exclusively on defamation and the economic impact of job loss, with no claims for health concerns beyond emotional/psychological harm, which is excluded. The Arbitration Award itself was explicitly "based on the defamatory nature of the information" in the U5. Consequently, the Court ruled that Ms. Mennemeyer must include the full settlement amount in gross income because it was not received on account of personal physical injuries or physical sickness.

Deductibility of Attorney’s Fees

When a litigant’s recovery constitutes taxable income, the portion paid to the attorney is generally includable in the litigant’s gross income. However, section 62(a)(20) permits an above-the-line deduction for attorney fees and court costs paid in connection with any action involving a claim of "unlawful discrimination". Section 62(e) broadly defines unlawful discrimination to include acts under federal, state, or local law that regulate "any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law".

The IRS did not dispute Ms. Mennemeyer’s alternative position regarding the deductibility of attorney’s fees, effectively waiving the argument. The Court found that Ms. Mennemeyer’s claims against PNC, which related to her employment relationship and lost wages, fell squarely within the broad category defined in section 62(e)(18)(ii). Therefore, the parties were instructed to consider the section 62(a)(20) deduction for attorney’s fees when recalculating the deficiency under Rule 155.

Business Expenses of Olive Tree Enterprises

Deductions are a matter of legislative grace, requiring the taxpayer to clearly demonstrate entitlement and substantiate the amount and purpose of the expense. Section 6001 mandates taxpayers maintain adequate records. Section 162(a) allows deductions for "ordinary and necessary" business expenses. An "ordinary" expense is common and acceptable in the business, while a "necessary" expense is appropriate and helpful. The Cohan rule allows the Court to estimate deductible expenses if there’s an evidentiary basis, but the burden for inexactitude rests heavily on the taxpayer. Crucially, the Cohan rule cannot be applied to deductions subject to the strict substantiation requirements of section 274(d).

Cost of Goods Sold (COGS)

Ms. Mennemeyer reported $234,344 in COGS on her Schedule C. The IRS disallowed the entire amount due to lack of substantiation. The general ledger provided by Ms. Mennemeyer accounted for less than half of the reported COGS, and most entries were linked to bank records not provided to the Court. While the parties stipulated to $48,429 in COGS post-trial, approximately $185,915 remained in dispute. Ms. Mennemeyer acknowledged she did not maintain records for cash purchases. The Court found that she failed to provide sufficient evidence for an estimate under Cohan, noting the significant mismatch between invoices and the general ledger rendered the ledger unreliable. Thus, the Court found that Ms. Mennemeyer failed to adequately substantiate the remaining disputed COGS.

Motor Vehicle Purchase (Suburban)

Ms. Mennemeyer purchased a Chevrolet Suburban for $54,481 for Olive Tree’s business use. She claimed a section 179 deduction but argued for section 168(k) depreciation on brief. To substantiate a depreciation deduction, a taxpayer must establish business use and depreciable basis. Section 179 allows for immediate expensing of qualified property, but only for the business portion, and no deduction if business use is less than 50%. Section 168(k) provides bonus depreciation for qualified property with a recovery period of 20 years or less, provided business use exceeds 50%.

Section 274(d) imposes heightened substantiation requirements for "listed property," which includes "any passenger automobile" and "any other property used as a means of transportation". A "passenger automobile" is generally rated at 6,000 pounds gross vehicle weight or less. While the Suburban weighed over 6,000 pounds, excluding it from the "passenger automobile" definition, the Court found it was still "listed property" under the "any other property used as a means of transportation" catchall, as it was purchased to transport goods.

Although the Court found Ms. Mennemeyer’s testimony regarding the Suburban’s business purpose credible, she failed to meet the strict substantiation requirements of section 274(d) by not providing sufficient contemporaneous evidence that the vehicle was predominantly used for business. Ms. Mennemeyer had no logs or contemporaneous records related to its use. Therefore, the Commissioner’s disallowance of the deduction for the Suburban’s purchase price was sustained.

Car and Truck Expenses

Ms. Mennemeyer admitted that she did not maintain mileage or cost records for other vehicle expenses. The Cohan rule, which allows for estimation of expenses, is inapplicable to listed property, including property used as a means of transportation, due to the strict substantiation rules of section 274(d). In the absence of any documentary evidence, the Court found that Ms. Mennemeyer failed to adequately substantiate the claimed car and truck expense deduction for 2018.

Addition to Tax for Failure to Timely File

Individual income tax returns for 2018 were due on April 15, 2019. An automatic six-month extension is granted if a complete Form 4868 is submitted by the due date with a proper estimate of tax. Section 6651(a)(1) imposes an addition to tax for failure to timely file, unless the failure was due to reasonable cause and not willful neglect. The taxpayer bears the burden of proving reasonable cause.

Ms. Mennemeyer filed her 2018 return on October 15, 2019. She claimed an employee at Mr. Burns’s office mailed Form 4868 on February 28, 2019, supported by a purported copy with a handwritten notation. However, Mr. Burns did not witness the mailing nor could he find proof of mailing. Critically, there was no evidence the IRS received the Form 4868. The Court emphasized that by not mailing the document via registered or certified mail, Ms. Mennemeyer assumed the risk of nondelivery.

The IRS met its burden of production by demonstrating no receipt of the extension. Ms. Mennemeyer’s evidence was insufficient to persuade the Court that the IRS’s determination was incorrect. Consequently, Ms. Mennemeyer failed to carry her burden of proof and was held liable for the addition to tax under section 6651(a)(1).

Conclusion

The Tax Court in Mennemeyer v. Commissioner ultimately sustained the Commissioner’s deficiency and addition to tax determinations, as limited by the parties’ concessions and the Court’s findings. This case serves as a stark reminder for tax professionals and their clients of several key takeaways:

Substantiation is Paramount: The strict substantiation rules, particularly for listed property under section 274(d), are unforgiving. Even credible testimony regarding business use is insufficient without contemporaneous records.
Settlement Characterization: The taxability of settlement proceeds hinges on the "on account of" nature of the underlying claims, not merely the taxpayer’s belief or the payor’s unproven motives. Absent explicit language or compelling evidence of physical injury, proceeds are likely taxable.
Attorney’s Fees Deduction: Claims related to employment relationships, particularly those involving lost wages or discrimination, can qualify for an above-the-line deduction for attorney’s fees under section 62(a)(20).
Timely Filing: The burden of proving an extension was timely filed and received by the IRS rests squarely on the taxpayer. The risk of non-delivery for ordinary mail falls on the taxpayer.

Tax professionals should counsel clients on the critical need for detailed and contemporaneous record-keeping for all business expenses, especially for listed property, and ensure proper procedures for filing extensions are rigorously followed.

Prepared with assistance from NotebookLM.