In a recent case, the United States Tax Court addressed an increasingly hot topic: the deductibility of business expenses. More specifically, the Tax Court addressed the substantiation requirement (i.e. the extent of support that a taxpayer must provide to support a business expense deduction).
Summary of Facts:
Taxpayer was employed as a mortgage banker by a company called Quick Loan Funding and Homefield Financial Inc. He was paid wages reported on Forms W-2, Wage and Tax Statement, of $ 127,319.47 and $ 79,052.24, respec-tively.
Taxpayer included three Schedules C with his individual tax return for three separate businesses in 2007. First, tax-payer reported gross receipts of $ 2,309 and claimed deductions for car and truck expenses of $ 10,242 in connection with his business as a mortgage banker. Respondent disallowed this expense. Second, taxpayer reported no gross re-ceipts or sales but claimed total expenses of $ 69,893 ($11,922 of which was for car and truck expenses) in connection with an advertising business. Respondent disallowed all of the ZE Advertising Co. claimed expenses. Finally, taxpayer reported gross receipts of $ 43,218, claimed costs of goods sold of $ 22,587, and claimed miscellaneous advertising expenses of $ 25,560 in connection with a search engine optimization business. The IRS disallowed all deductions.
The Tax Court upheld the IRS' disallowance of taxpayer's claimed business expenses. Consequently, taxpayer was liable for taxes on the claimed deductions. Furthermore, taxpayer was liable for accuracy-related penalties for improperly claiming unsubstantiated business expense deductions.
Deductibility of Business Expenses
I.R.C. § 162(a) allows a deduction for "ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." In this respect, a business expense is "ordinary" if it is normal, usual, or customary within the taxpayer's particular trade, business, or industry. Commissioner v. Heininger, 320 U.S. 467, 471 (1943); Deputy v. du Pont, 308 U.S. 488, 495 (1940). Similarly, a business expense is "necessary" if it is appropriate and helpful for the development of the business. Id.
When is an Expense a "Business Expense"?
In Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987), the United States Supreme Court held that to be considered to be carrying on a trade or business within the meaning of section 162, "the taxpayer must be involved in the activity with continuity and regularity and . . . the taxpayer's primary purpose for engaging in the activity must be for income or profit." In determining whether a taxpayer's involvement with the alleged business was sufficiently continuous and regular, it is not controlling that the taxpayer intended to operate a business, because a business may not exist or yet have commenced without a single customer. There is no business in active operation where there are no customers and no evidence of any sales efforts that could lead to customers. Goodwin v. Commissioner, 75 T.C. 424, 433 (1980), affd. 691 F.2d 490 (3d Cir. 1982); Wolfgram v. Commissioner, T.C. Memo. 2010-69.
In Baacel Roumi v. Commissioner, the taxpayer failed to establish that his claimed advertising business was in fact an ongoing business for profit as required by Section 162(a). Taxpayer presented no evidence that the business was in operation in 2007. Indeed, taxpayer testified at trial that his advertising business was "in development" in 2007. Moreover, the advertising company's taxpayer identification number was not established until January 2008. Furthermore, taxpayer did not present evidence that the business had ever generated revenue or that he had claimed expense deductions relating to it in prior tax years. On this basis, the Tax Court held that the taxpayer failed to persuasively explain why an active business generated no gross receipts or sales yet managed to generate $ 69,893 in expenses.
IRS is Presumptively Correct
The Court began by emphasizing the well-established principle that a determination by the IRS is presumptively correct and that taxpayers bear the burden of rebutting such presumption. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). This pro-IRS standard is rooted in the theory that tax deductions are a "matter of legislative grace" in the sense that the government is not required to allow deductions as an offset to taxable income. Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). The logic and fairness of this theory can be debated, but the fact is that, as a result, the law has placed the burden on taxpayers to establish entitlement to any claimed deduction. In the context of business expense deductions, this means that disallowance of claimed business expenses will be presumed correct in most cases. [To be clear, there are certain circumstances where the burden of proof as to factual matters shifts to the IRS. See I.R.C. § 7941(a). However, the taxpayer in this case neither alleged that Section 7491(a) applied nor established compliance with the Internal Revenue Code's substantiation and recordkeeping requirements. See I.R.C. § 6001; I.R.C. § 7491(a)(2)(A) & (B); Treas. Reg. § 1.6001-1(a). Accordingly, the burden of proof was on the taxpayer to substantiate the his business expenses.]
Required Level of Substantiation
Pursuant to I.R.C. § 6001, taxpayers are required to identify each deduction available and show that they have met all requirements associated with each deduction. As part of this duty, taxpayers are required to keep books or records that substantiate all claimed deductions. See also Roberts v. Commissioner, 62 T.C. 834, 836-837 (U.S. Tax Ct. 1974).
To be clear, if a taxpayer cannot fully substantiate a claimed deduction, a court may estimate the allowable amount of such deduction. See Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930). However, any uncertainty will be construed against a taxpayer whose failure to substantiate is of his own making. This means that courts do not sympathize with taxpayers who could have kept receipts and other records but failed to do so. Moreover, in order to estimate a deduction, there must be some basis upon which an estimate can be made. See Vanicek v. Commissioner, 85 T.C. 731, 742-743 (U.S. Tax Ct. 1985). See also Williams v. U.S., 245 F.2d 559, 560-561 (5th Cir. 1957) (stating that without a basis for estimating a deduction any allowance would amount to "unguided largesse"); Villarreal v. Commissioner, T.C. Memo. 1998-420 (holding that a court may estimate amounts, but only if such estimation has a reasonable evidentiary basis).
If a taxpayer is unable to substantiate claimed business expense deductions there will almost invariably be an insuffi-cient basis for a court to uphold any portion of the deduction. Thus, while judicial authority technically exists for up-holding unsubstantiated deductions, the authority is largely self-defeating insofar as it requires some sort of substantia-tion on which an estimate can be based. As a result, application of this doctrine has traditionally been limited to cases in which taxpayer records have been lost or destroyed due to circumstances beyond his or her control. E.g., Malinow-ski v. Commissioner, 71 T.C. 1120, 1125 (U.S. Tax Ct. 1979). In those cases. a taxpayer will generally be allowed to substantiate the deductions by a reasonable reconstruction of the expenses. E.g., Evan v. Commissioner, T.C. Memo. 2004-180. Although the Court may estimate amounts, any estimations must have a reasonable evidentiary basis. Villarreal v. Commissioner, T.C. Memo. 1998-420.
Note, however, that taxpayers bear a heavy burden even in cases where records have been lost or destroyed. For in-stance, in this case, the taxpayer asserted that a house fire destroyed the records and documents relating to the claimed business expense deductions. The Tax Court, nevertheless, declined to relieve him of his substantiation burden. In-stead, the Tax Court noted that the taxpayer had an opportunity to reconstruct the relevant records to meet his substantiation burden, but failed to do so. The take away from this aspect of the holding is that lost or destroyed business expense records should be reconstructed sooner rather than later. By sooner, I mean that taxpayers would be well-advised to document the circumstances giving rise to the loss or destruction of such records and reconstruct them as soon as is practically possible. Ideally, the reconstructive efforts should occur before any challenge or other determination by the IRS. Otherwise, it begins to look like the records were manufactured solely in anticipation of an audit or litigation.
Heightened Substantiation Requirements in Certain Circumstances
In certain circumstances, taxpayers must satisfy heightened substantiation requirements to be permitted a deduction under Section 162. See, e.g., I.R.C. § 274(d). The heightened substantiation requirements of Section 274(d) apply to: (1) travel expense ( e.g., mileage, gas, meals and lodging while away from home) (2) any item in the nature of enter-tainment, amusement, or recreation (e.g., meals); (3) any expense for gifts; and (4) the use of "listed property," as de-fined in I.R.C. § 280F(d)(4), which includes any "passenger automobile". To deduct such expenses, the taxpayer must substantiate by adequate records or sufficient evidence to corroborate the taxpayer's own statement of the amount, the time, the place, and the business purpose of the claimed car or truck expense. I.R.C. § 274(d).
To comply with the adequate records requirement of Section 274(d), taxpayers must maintain records and documentary evidence that in combination are sufficient to establish each element of an expenditure or use. Treas. Reg. § 1.274-5T(c)(1) and (2). In this respect, a contemporaneous log is not required. However, it should be emphasized that corroborative evidence to support a taxpayer's reconstruction business expenditures use must have a "high degree of probative value to elevate such statement and evidence" to the level of credibility of a contemporaneous record. Treas. Reg. § 1.274-5T(c)(1).
Significantly, if Section 274 requires substantiation of an expense, a court may not estimate that expense under the Cohan doctrine. See Lewis v. Commissioner, 560 F. 2d 973, 977 (9th Cir. 1977). Moreover, if an expense is subject to Section 274(d)'s strict substantiation requirements, no deduction is allowable on the basis of any extimate or the taxpayer's uncorroborated testimony. See Sanford v. Commissioner, 50 T.C. 823, 827-828 (U.S. Tax Ct. 1968)
In Baacel Roumi v. Commissioner, the taxpayer claimed to have traveled thousands of business miles without offering any documentation or other evidence to substantiate the time, place, and business purpose of these miles. His claim that the records related to these driving expenses were destroyed in a fire did not relieve him of the substantiation bur-den. Consequently, the Tax Court sustained the IRS' disallowance of the car and truck expense deductions claimed on the ground that he failed to meet the substantiation requirements of Section 162 and Section 274(d). The Tax Court additionally sustained the IRS' disallowance of a deduction for the taxpayer's Mercedes Benz lease payments and gasoline expenditures on the same grounds
I.R.C. § 6662 Accuracy-Related Penalty
Pursuant to Section 6662(a), an accuracy-related penalty of 20% of any income tax underpayment may be imposed. See I.R.C. § 6662(b)(1) and (2). In this respect, the IRS bears the burden of production. I.R.C. § 7491(c). That is, the IRS "must come forward with sufficient evidence indicating that it is appropriate to impose the relevant penalty." See Higbee v. Commissioner, 116 T.C. 438, 446 (U.S. Tax Ct. 2001).
In Baacel Roumi v. Commissioner, the IRS asserted two grounds for imposition of the penalty: (1) negligence; and (2) a substantial understatement of income tax.
The Internal Revenue Code defines "negligence" as "any failure to make a reasonable attempt to comply with the provisions of the Internal Revenue Code." I.R.C. § 6662(c). But the case law defines "negligence" more broadly as "a lack of due care or the failure to do what a reasonable and ordinarily prudent person would do under the circumstances.'" Freytag v. Commissioner, 89 T.C. 849, 887 (U.S. Tax Ct. 1987) (quoting Marcello v. Commissioner, 380 F.2d 499, 506 (5th Cir. 1967). This includes "any failure by the taxpayer to keep adequate books and records or to substantiate items properly." Treas. Reg. § 1.6662-3(b)(1).
A "substantial understatement" of income tax as to an individual is an understatement that exceeds the greater of $5,000 or 10% of the tax required to be shown on the return. I.R.C. § 6662(d)(1)(A).
The taxpayer in Baacel Roumi v. Commissioner claimed that his records were destroyed in a fire. The Tax Court, however, was unsympathetic. According to the Tax Court, the taxpayer had a duty to make reasonable efforts to reconstruct his records or to present other credible evidence to support a reasonable estimate of the claimed business expenses. In the light of the taxpayer's failure to reconstruct his tax records and substantiate his claimed deductions, the Tax Court imposed a 20% accuracy-related penalty in addition to the taxes owed as a result of the understatement.
If you're going to claim tax deductions for business expenses, make sure you can substantiate them. The potential adverse consequences of claiming unsubstantiated business expenses substantially outweigh any tax benefit that will be derived.