IRS and the Disallowance of Unsubstantiated Expenses
The focus of our practice is on civil and criminal tax controversy, and we are often asked to defend taxpayers under IRS examination. One of the areas focused on by the IRS are the expenses claimed by taxpayers against their income. Taxpayers need to understand that they have to carry the burden of showing they are entitled to a deduction claimed on their tax return.
Whether taxpayers live in Stamford, Connecticut, New York city or elsewhere, a significant hurdle faced by taxpayers with tax issues involves providing enough documentation to substantiate claimed expenses, deductions, and various other tax attributes. Some recent tax court decisions provide examples of how lack of substantiation can impact a taxpayer’s liabilities to the IRS.
On November 22, 2016, the U.S. Tax Court issued T.C. Memo. 2016-212 highlighting this very issue. There, a taxpayer was denied certain unsubstantiated business deductions and penalties were imposed. The IRS used a bank deposits analysis to reconstruct the taxpayer’s income because she did not keep any informal or formal books of account to record her businesses’ income and expenses, nor did she employ a bookkeeper or accountant. She had made numerous deposits into multiple bank accounts that were not attributable to her work as an employee, and she was unable to prove that most of the deposits she received as reimbursements from church, store and merchant refunds, and as repayment of loan principal from others were attributable to nontaxable sources. Further, the taxpayer was not entitled to deduct vehicle expenses in excess of amounts allowed by the IRS because she failed to substantiate them. The mileage spreadsheets she used were not prepared at or near the time of the trips and were therefore, inadequate proof of trip records. She provided no evidence to corroborate her mileage spreadsheets, and therefore failed to meet the strict substantiation requirements of Internal Revenue Code Sec. 274(d).
The taxpayer was also not entitled to deduct unsubstantiated charitable contributions in excess of the amounts allowed by the IRS as she had paid a third party travel agent for the expenses associated with the trip rather than directly to a church for a trip to Africa. She again did not provide a contemporaneous written acknowledgment from the donee organization that would satisfy the requirements of Internal Revenue Code Sec. 170(f)(8)(A). The taxpayer was liable for an accuracy-related penalty based on negligence for failing to keep adequate books and records and for not exercising reasonable care in determining her proper tax liabilities.
Similarly, on November 23, 2016, the U.S. Tax Court issued T.C. Memo 2016-213 in which an artist was denied unsubstantiated travel and passenger automobile expense deductions. The artist, who created acrylic paintings and travelled with his artist ex-wife and her adult daughter to a foreign country for an art class, was not entitled to deduct his claimed travel and automobile expenses on Schedule C as he failed to substantiate the amount and timing of the expenditures. Further, he failed to substantiate the amounts of most of the automobile expenses with either a logbook or other records, such as the miles driven, the dates of travel, or the business purpose of the trips. And, although he claimed a travel expense deduction of a specific amount on his Schedule C, he claimed a greater (and therefore inconsistent) travel expense deduction at trial. Moreover, the taxpayer provided no supporting evidence other than his vague and general testimony as to the claimed expenditures for air travel, car rental, car insurance, fuel or art supplies purportedly used during the trip. The Tax Court held that the taxpayer’s claimed deductions for travel expenses failed for want of substantiation as to the amount and timing of the expenditures.
On November 23, 2016 the U.S. Tax Court also issued T.C. Memo 2016-214 holding that an individual was not entitled to dependency exemption deductions under Internal Revenue Code 151(a) and (c) for his stepson as the taxpayer failed to demonstrate that his stepson was his qualifying child or qualifying relative for the tax year at issue. The taxpayer did not offer any testimony or other evidence concerning the abode of his stepson, the amount of support (if any) provided by or to his stepson, or his stepson’s gross income for the tax year at issue.
The taxpayer was also not entitled to deduct expenses related to hotel room rentals in excess of what the IRS allowed as the taxpayer failed to substantiate the additional expenses, nor was he entitled to a deduction for vehicle expenses and meals and entertainment expenses under Internal Revenue Code 274(d) as he again failed to substantiate the expenses. The taxpayer operated a multilevel network marketing business, and in order to promote his business, taxpayer rented hotel space and conducted weekly meetings, training, and presentations. With respect to the claimed expenses related to hotel room rentals, the taxpayer produced invoices without his name nor the name of his business listed on the invoice, with no explanation on the invoice as to the business purpose of the rental. And, with respect to the taxpayer’s claimed deductions for meals and entertainment expenses, the taxpayer offered into evidence a handwritten ledger which listed vendor names, dates, and amounts. The Tax Court found the ledger to be insufficient as there were no explanations regarding the business purpose of the meals or petitioner’s business relationship to the person(s) with whom he allegedly dined.
If you have any questions about an IRS examination please contact us at (203) 285-8545.