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Palin's New Clothes Augur Tax Troubles

Posted: 10/22/08 09:47 PM ET

Revelation of the Republican National Committee (RNC) spending $150,000 to clothe vice presidential nominee Sarah Palin augurs tax troubles for both. The principal tax issue is whether the clothing constitutes a deductible business expense or a personal consumption benefit. As a deductible business expense, the clothing would not affect Ms. Palin's taxable income. However, if the clothing is a nondeductible personal consumption benefit, her taxable income increases by the $150,000 spent.

Unluckily for Ms. Palin, the clothing appears to constitute nondeductible personal consumption. Clothing is a deductible business expense only if two separate requirements are both satisfied. First, the clothing must be required at work. Second, the clothing must not be usable for ordinary wear. Thus, if clothing is usable for ordinary wear, it is not a deductible business expense, even if also required for work. The special uniforms of firefighters and professional deep sea divers, for example, qualify as deductible business expenses. Their uniforms are both required for their work and not usable for ordinary wear.

Ms. Palin can argue that her designer outfits are required by her work as vice presidential nominee. However, it is likely that such expensive clothing will be considered usable for ordinary wear, even if she prefers jeans and T-shirts when not on duty.

In the leading judicial precedent on this question, Pevsner v. Commissioner, the manager of a designer clothing boutique was required to purchase and wear Yves Saint Laurent clothing on her job. The manager did not wear the designer clothing off the job because it was inconsistent with her simple private lifestyle. Nevertheless, the Fifth Circuit Court of Appeals concluded that the clothing was usable for ordinary wear, regardless of what the manager intended, and therefore the cost could not be deducted as a business expense. In other words, the court concluded, the individual's personal lifestyle is irrelevant. The only question is whether clothing could be adapted for ordinary use, not whether it is so used by the taxpayer in question.

Suppose that Ms. Palin contributes the clothing to charity once the campaign ends. Will that solve her income tax predicament? Probably not. While Ms. Palin has to report as income the amount spent for the clothing when new, she can deduct as a charitable contribution only the fair market value of the clothing when used. In this regard, an IRS publication ominously states, "Used clothing and other personal items are usually worth far less than the price you paid for them." Thus, the amount of any deduction for her used clothing promises to be far less than the amount of income reported by her from receiving the new clothing.

Even worse for Ms. Palin, there are payroll tax, as well as income tax, implications. Because she receives the clothing in connection with her work as vice presidential nominee, it is compensation subject to payroll taxes.

A charitable contribution of the clothing will not affect payroll tax liability at all. If you earn $100 that you donate to charity, you may have offsetting income and deduction items for income tax purposes but payroll taxes are still owed on the $100 earned. Thus, a charitable contribution of the clothing may reduce her income tax but not the payroll tax.

Ms. Palin's personal payroll tax burden depends on whether she is an independent contractor or an employee. If an independent contractor, she must pay the entire amount. If an employee, she pays only half of the payroll tax and her employers, presumably the RNC and the McCain campaign, pay the other half.

At this point, Ms. Palin gets lucky. Her classification as independent contractor or employee depends, not on the label adopted by the parties, but rather on the degree of control exercised over her work. Ms. Palin appears completely programmed and to have little autonomy. What she says and where she appears is reportedly under the total control of the RNC and the McCain campaign. Therefore, she can argue that she is an employee and owes only half the payroll tax. However, good news for her is bad news for her presumed employers, the RNC and the McCain campaign, who are responsible not only for the employer half of payroll taxes but also for her half if they fail to withhold it.

P.S. The RNC now claims that Ms. Palin owes no additional taxes because the clothing was just on loan. I could be wrong but I would bet that the clothing was given to her without the condition that it be returned. If there was a loan, where's the written evidence? Usually, lenders don't loan $150,000 without documentation.