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TAX TALK: Business Expense Deductions Require Documentation

Hal Zemel, CPA, J.D., LL.M. 09.19.2016 | TAX TALK

The IRS generally requires you to substantiate your business deductions. If the IRS audits your tax return, they can examine your books and records to determine if you claimed the correct deductions. If you have incomplete or missing records, your business may lose out on valuable deductions. Here are two recent U.S. Tax Court cases that help illustrate the rules for documenting deductions.

Case 1: Insufficient records

In the first case, the court found that a taxpayer with a consulting business provided no specific facts and no documentation to substantiate more than $52,000 in advertising expenses and $12,000 in travel expenses for the two years in question. His only allegation concerning the advertising expenses were that they related to “horses purchased for business use and the losses”; he attached documents purporting to establish the horses' pedigree.

The taxpayer’s only factual allegation concerning the travel expenses were that “his business was over 1050 miles round trip and he incurred much expense in caring for his business.” Travel expenses are subject to heightened substantiation requirements. The taxpayer must substantiate, by adequate records or sufficient evidence, the amount, time and place, business purpose, and the business relationship of the expense.

The taxpayer’s evidence was not enough. The court stated: ”The taxpayer bears the burden of proving that claimed business expenses were actually incurred and were ordinary and necessary.“ In addition, businesses must keep and produce” records sufficient to enable the IRS to determine the correct tax liability.“ (TC Memo 2016-158)

Case 2: Documents destroyed

In another case, a taxpayer was denied many of the deductions claimed for his company. He traveled frequently for the business, which developed machine parts. In addition to travel, meals and entertainment, he also claimed printing and consulting deductions.

The taxpayer recorded expenses in a spiral notebook and day planner and kept his records in a leased storage unit. While on a business trip to China, his documents were destroyed after the city where the storage unit was located acquired it by eminent domain.

The IRS allows taxpayers to claim expenses and substantiate them through secondary evidence when the taxpayer loses the substantiating documents through circumstances beyond his/her  control (for example, in a fire or flood). The court allowed 40% of the taxpayer’s travel, meals, and entertainment expenses, but denied the remainder as well as the consulting and printing expenses. The reason? The court noted that a taxpayer did not undertake sufficient efforts to reasonably reconstruct the lost records through secondary evidence. The taxpayer didn’t present any testimony from the individuals he paid to substantiate the deductions. (TC Memo 2016-135)

Be prepared

Keep detailed, accurate records to protect your business deductions. Record details about expenses as soon as possible after they’re incurred (for example, the date, place, business purpose, etc.). Keep more than just proof of payment. Also keep other documents, such as receipts, credit card slips and invoices. If you’re unsure of what you need, check me at HZemel@BerdonLLP.com or your Berdon advisor.

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