Taxes: Beware of the Perils of Poor Recordkeeping
“The taxpayer must prove he or she is entitled to the deductions claimed…Taxpayers are required to maintain records sufficient to establish the amounts of allowable deductions and to enable the (IRS) to determine the correct tax liability.” – The U.S. Tax Court
The importance of keeping thorough and accurate records can’t be emphasized enough. If you have incomplete or no records and get audited by the IRS, it can cost you valuable deductions.
Two new Tax Court cases illustrate the potential pitfalls facing some taxpayers.
Case #1: Adan Sucilla operated Sucilla Farm Labor Contractor, a sole proprietorship providing farm labor services in California. He claimed deductions for various business expenses in 2007 and 2008 including travel and entertainment, car and truck expenses, repairs, maintenance, supplies, taxes and insurance. But Sucilla didn’t keep separate
The IRS agent who examined the returns for these two years found that all the business income was reported accurately, but some expenses were not substantiated because Sucilla had either lost or misplaced the receipts.
For 2007, out of a total of $2,262,421 in expenses, the IRS found $165,386 was unsubstantiated. For 2008, out of a total of $1,287,945 in expenses, $35,920 was unsubstantiated.
However, the IRS allowed deductions totaling $38,635 and $18,585 for 2007 and 2008, respectively, for previously unclaimed but allowable expenses.
Tax outcome: Citing a lack of information concerning the deductions claimed on the tax returns, the Tax Court agreed with the IRS. Other than the deductions conceded, the court stated, the taxpayer “failed to provide receipts, logs, books or any other kind of documentation to substantiate the deductions.”
The Court added that the “Cohan rule,” which allows estimates of expenses without complete documentation, does not apply to certain expenses (see right-hand box).
One consolation: Because Sucilla acted with reasonable cause and in good faith, the Court ruled that he was not liable for any accuracy-related penalties for substantially understating income. (Sucilla, TC Memo 2011-197)
The substantial understatement penalty imposed under Section 6662 of the Internal Revenue Code is one of the most commonly assessed federal income tax penalties. It can also be one of the most expensive. The penalty equals 20 percent of any tax underpayment caused by a substantial understatement of income tax liability on a federal return.
However, there is an important penalty exception when the taxpayer:
* Had reasonable cause for taking the tax position that caused the substantial understatement and
* Acted in good faith.
One of the ways to demonstrate reasonable cause and good faith is to give a competent independent tax professional all the relevant information and then rely on his or her advice and tax preparation efforts.
Case #2: Maria Elleen Sherrer operated a business in Florida that provided accounting and tax services. For the two tax years in question, she filed Schedule C as a self-employed taxpayer, claiming deductions for a wide range of expenses related to travel and entertainment, vehicles, advertising, repairs, insurance, supplies, rent and utilities.
On her one tax return, Sherrer showed a total income from her business of $43,000, with deductions of $35,063, for a net profit of $7,937. Her next year’s tax return revealed income of $58,500, and deductions of $44,125 — for a net profit of $14,375. The IRS disallowed deductions of $9,904 one year and $15,779 for the next year.
The tax law requires documentation to prove business expense deductions and imposes particularly stringent requirements on travel and entertainment expenses and “listed property” such as computers and automobiles.
Sherrer only offered “generalized and somewhat vague testimony” to support her claims, according to the Court. For documentation, she provided canceled checks, bank account statements, receipts and invoices. However, the court stated, the records were not well organized and the way she presented her case made it difficult to reconcile the claims with her tax return entries. Also, Sherrer failed to describe the business relationship of certain individuals who received payments from the practice.
Tax outcome: After reviewing all the information, the Tax Court generally sided with the IRS. To add insult to injury, it imposed substantial underpayment penalties because Sherrer didn’t demonstrate that she had acted with reasonable cause and in good faith with respect to the tax underpayments (Sherrer, TC Memo 2011-198).
The moral of these two stories is pretty simple: Don’t leave the important matter of documentation to chance. With guidance from your tax adviser, you can prepare tax return records that will stand up to close scrutiny from the IRS.
There is no one way to keep records. In fact, the IRS states on its Web site that “you may choose any recordkeeping system suited to your business that clearly shows your income and expenses.” However, in a few cases, the law does require certain records and imposes requirements. For example, with respect to travel, entertainment, gift and listed property expenses, a taxpayer must generally substantiate with records:
1. The amount of the expense.
2. The time and place the expense was incurred.
3. The business purpose.
4. In the case of a business entertainment or gift expense, the business relationship.
5. For listed property, a taxpayer must establish the amount of business use and the amount of total use.
For more information about tax recordkeeping, consult with your tax adviser.