Meeting the Demands of IRC Section 274(d): substantiating trade or business expenses.
A comparison of cases from the NTA's two most recent annual reports revealed an increase in the number of such cases, but they also showed a significant decrease in the number of cases in which the taxpayer prevailed (Exhibit 1). The NTA's 2012 report identified 115 decisions addressing the deduction of trade or business expenses. In those cases, taxpayers seldom convinced the courts to allow a deduction; the IRS prevailed in 69% of the decisions and the courts decided against taxpayers because of a failure to substantiate deductions with proper documentation.
EXHIBIT 1 Court Decisions Addressing Trade or Business Expenses 2012 Report 2011 Report Number of Cases 115 107 IRS Prevailed 69% 53% Substantiation Issue 63% 74% Pro Se Cases 62% 71% Source: 2011 and 2012 National Taxpayer Advocate reports
Using information from the 2012 NTA report and 2012 Tax Court decisions, the discussion below examines one category of trade or business expenses where substantiation is frequently an issue--those subject to Internal Revenue Code (IRC) section 274(d). This section is a challenge to apply because it contains demanding documentation requirements. Taxpayers and their advisors should follow this analysis of recent court decisions to determine the key factors necessary to secure deductions and should consider the strategies provided in the ensuing sections for avoiding problems related to IRC section 274(d).
Under IRC section 6001, taxpayers are required to maintain records that document income and deductions in order to determine their tax liability. Adequate documentation provides a basis for the deduction of all ordinary and necessary expenses incurred in carrying on a trade or business (IRC section 162); thus, the tax law provides a motivation for taxpayers to maintain records so that all allowable expenses are deducted, resulting in the lowest possible tax liability. Evidence from the 2012 NTA report indicates that taxpayers struggle to maintain recordkeeping procedures that adequately document trade or business expenses.
Failure to document expenses can lead to the disallowance of deductions; however, when documentation is insufficient, the IRS and the courts have been willing to estimate deductible expenses and allow some deduction under the "Cohan Rule," established in Cohan v. Comm 'r (39 F.2d 540 [Second Circuit, 1930)). Tax advisors can rely on Cohan to assist taxpayers in estimating deductions in instances where legitimate deductions were incurred but documentation was lacking. But reliance on the Cohan Rule is not an attractive option; the taxpayer's failure to maintain adequate documentation allows the IRS and the courts to penalize the taxpayer by conservatively estimating deductions when the amount is disputed.
For taxable years beginning after January 1, 1986, Congress partially superseded Cohan by enacting IRC section 274(d), which prohibits the deduction of certain business expenses unless strict sub-stantiation requirements are met. IRC section 274(d) applies to the following:
* Travel expenses, meals, and lodging
* Entertainment, amusement, or recreation expenses
* Deductions related to items designated as "listed property" under IRC section 280F(d)(4)(A); listed property originally included automobiles, cell phones, computer equipment, and property used for entertainment, recreation, or amusement. (Under Public Law 111-240, cell phones are no longer listed property for tax years beginning after December 31, 2009.)
To substantiate a deduction under IRC section 274, a taxpayer must have records that document--
* the amount of the expense;
* the time and place of the expense;
* the business purpose of the expense;
* the business relationship between the taxpayer and other parties involved for entertainment, amusement, or recreation expenses and gifts; and
* the amount of business use and total use for listed property (Treasury Regulations section 1.274-5T[b][i][B]).
Treasury Regulations section 1.274-5T(c)(2)(i) describes adequate documentation as an account book, diary, log, statement of expense, trip sheets, or similar record, and documentary evidence which, in combination, are sufficient to establish each element of an expenditure or use."
IRC section 274(d) enumerates the information that taxpayers must maintain to secure a deduction. The regulations quoted above provide a variety of methods by which the information can be documented. In the court opinions described below, the documentation methods utilized by taxpayers are evaluated against these guidelines.
Recent Appellate Court Decisions
Many of the decisions in the 2012 NTA report that addressed the issue of substantiating deductions were Tax Court cases (available from http://www.ustaxcourt.gov). The NTA report also identified seven appellate court decisions (initially tried in the Tax Court) that addressed substantiation issues under IRC sections 162 or 274(d). Exhibit 2 summarizes the key findings of these decisions, discussed below.
EXHIBIT 2 Appellate Court Decisions Addressing Trade or Business Expenses Business Receipts and Receipts Purpose Business Pro Se Purpose Lacking Lacking Lacking Cases Number of Cases 2 2 3 5 (Total = 7) Relevant IRC 162 162 and 162 and 274 -- Sections 274 Source: 2012 National Taxpayer Advocate reports
These decisions represented five appellate court jurisdictions (the Second, Third, Ninth, Tenth, and Eleventh circuits), and the IRS prevailed in all of them. In two decisions, the taxpayer had few, if any, receipts to document the amount of expenses, and the court was unwilling to rely on verbal testimony and estimate the deduction (Langille v. Comm 'r, 2011-2 USTC para. 50,731 [CA-111; Adler v. Comm 'r, 2011-2 USTC para. 50,603 [CA-3D. In two other decisions, the taxpayer could document expenses with receipts, but failed to secure a deduction because of failure to document a business purpose (Plotkin v. Comm 'r, 2012-2 USTC para. 50,688 [CA-11]; Van Der Lee v. Comm 'r, 2012-2 USTC para. 50,638 [CA-2]). In the final three decisions, the taxpayer could not show a business purpose and lacked receipts or provided receipts that were illegible (Schoppe v. Comm 'r, 2013-1 USTC [CA-10]; Fein v. Comm 'r, 2012-2 para. 50,707 [CA-2]: Martin v. Comm'r, 2011-1 para. 50,447 [CA-9]).
In summary, most ot the taxpayers appealing their Tax Court decision put themselves in a precarious position by not devoting enough time and effort to obtain basic documentation, such as receipts, thus failing to meet even the most lenient documentation requirements. A receipt or record of amount spent is relatively easy to obtain and can be acquired from outside sources, such as banks. credit card companies, and retailers. By accessing these sources, taxpayers can enter an IRS audit or litigation with documentation that substantiates the amount of the expense and the date incurred.
Taxpayers seeking a deduction for expenses subject to IRC section 274(d) failed because they did not substantiate a business purpose. An examination of Tax Court decisions illustrates that establishing a business purpose is the key obstacle taxpayers face in deducting these expenses.
2012 Tax Court Decisions
The U.S. Tax Court was established to mediate tax issues between taxpayers and the IRS. The opinions of this court provide useful interpretations of tax law for taxpayers and advisors. A text search of 2012 Tax Court opinions revealed 53 decisions in which IRC section 274 was addressed (summarized in Exhibit 3). Taxpayers' success in litigating IRC section 274 issues has been abysmal, whether they hired representation or chose to serve as their own counsel.
EXHIBIT 3 2012 U.S. Tax Court Decisions Citing IRC Section 274(d) Total Tax Court Tax Court Tax Court Regular Memorandum Summary Number of 53 0 31 22 Cases Cases Where 0 0 0-1 Split 0-4 Split Taxpayer Decision Decisions Prevailed Pro Se 39 0 19 (61%) 20 (91%) Cases (%) (74%)
Tax Court Memorandum decisions. The taxpayer successfully prevailed in only one Tax Court Memorandum case (Rodriguez v. Comm 'r, T.C. Memo 2012286). In this split decision, the taxpayers were not allowed to deduct auto expenses because the only documentation provided was expense receipts; however, deduction of travel expenses was permitted because the taxpayers provided receipts, along with a schedule of dates and business purposes, for each trip. This decision is one of many that reveal that the documentation of a business purpose is a determining factor in securing deductions subject to IRC section 274(d). Information from these decisions might be useful to taxpayers who wish to pursue this avenue of relief. No Tax Court Summary opinions resulted in the taxpayer prevailing, although taxpayers received some relief in four split decisions.
Cibotti v. Comm 'r (T.C. Summary Opinion 2012-21) presents an example of a typical taxpayer experience. Dean Cibotti deducted gift and vehicle expenses incurred in his business as a mortgage broker; he claimed the gifts were used as an incentive for clients to purchase mortgage loans, thereby establishing a business purpose. To the extent that the dollar amount of these gifts could be documented through bank records, the court allowed Cibotti a deduction. But the court disallowed over 80% of the deduction claimed because he could not document the amount spent.
For his vehicle expenses, Cibotti deducted the standard amount per mile permitted by the IRS. He did not maintain a log, but established a pattern of trips; some of these occurred each weekday and others occurred once per week. He also deducted mileage for meetings with clients, which he substantiated using personal documents (his calendar and route maps) that were also corroborated by an outside source. The court allowed deductions for mileage where Cibotti could document that an expense was incurred and establish a business purpose. Cibotti made an admirable effort to document that mileage incurred was related to his business, but almost two-thirds of this deduction was disallowed because he failed to show a business purpose.
Failure to document a business purpose was mentioned by the court as a reason for disallowing deductions in more than 56% of these Tax Court Summary decisions; thus, the lack of some contemporaneous record of business purpose was detrimental to taxpayers when subject to IRS audit In 82% of these Tax Court Summary decisions, the taxpayer claimed a deduction for vehicle expenses. The documentation problems most frequently encountered by taxpayers were a failure to maintain a log with business mileage and a failure to show a business purpose for the trip. Unless Congress repeals IRC section 274(d), taxpayers must find a remedy to these problems or risk losing the deduction of a significant amount of business expenses.
Strategies for Compliance
Substantiating business expenses requires an investment of time that could be devoted to other business activities, such as increasing revenues and maintaining quality; however, tax advisors should warn clients of the cost of noncompliance. First, taxpayers seldom prevail in litigating this issue. In 2012, less than 10% of taxpayers litigating an IRC section 274(d) issue in the Tax Court received any relief. Based on 2012 decisions from the Tax Court and the NTA 2012 report, even expert representation cannot improve the probability of success; the success rate of taxpayers who hired counsel and pro se cases was the same.
Second, the cost of noncompliance can result in significant penalties. Echibit 4 reveals average penalties levied by the IRS in 2012 Tax Court cases involving IRC section 274(d) in which the tax deficiency and penalties were disclosed. The total penalties levied typically exceeded 20% of the additional tax. The IRC section 6662 accuracy-related penalty frequently applied because the amount of disallowed deductions resulted in a tax understatement that exceeded 10% of the correct tax liability. For taxpayers who incur substantial expenses subject to IRC section 274(d), devoting time and money to technology that will substantiate these deductions can help them avoid additional taxes and significant penalties.
Tax professionals play a crucial role in helping taxpayers avoid problems by warning them about the strict substantiation requirements of IRC section 274(d). A discussion about adequate documentation should be initiated with any new business. Written communication about the higher standards of IRC section 274(d) should be provided at this time. The importance of substantiating these expenses should be reiterated the first year these expenses appear in a client's records. Taxpayers who heed this warning can avoid the problems illustrated in the court cases discussed earlier.
Incorporating technology into the taxpayer's business procedures is a viable method of addressing the documentation demands of IRC section 274(d). Smartphones provide an avenue for capturing information and producing a contemporaneous record of mileage, expenses, and business purpose. Available applications make recording this information easy. In the court opinions reviewed, the failure to document a business purpose was frequently a problem, and smartphone technology can help remedy this problem.
Frequently, advisors help taxpayers identify expenses that the client might have overlooked or assumed were nondeductible. After identifying these additional deductions, advisors typically help taxpayers estimate these expenses for the current year and suggest procedures to record these expenses in the future. Basic documentation of past expenses should be secured at this time. Receipts can be obtained by accessing the databases of information maintained by banks and credit card companies. Retailers are also building similar databases and can provide purchase histories to customers in need of documentation.
For most trade or business expenses, reasonable estimates of amounts, along with some documentation, are sufficient to substantiate a deduction. Unfortunately, advisor aid is limited when it comes to expenses subject to IRC section 274(d); estimated expenses are not deductible unless substantiation requirements are met. In IRC section 274(d) cases, the taxpayer is prohibited from using estimates and the tax advisor is precluded from using such estimates. The AICPA's Statements on Standards for Tax Services (SSTS) 4, Use of Estimates, provides clear guidance for the tax advisor in these situations.
A Burden for Taxpayers
Since 1998, when the NTA began reporting to Congress, the deduction of trade or business expenses has been one of the most litigated issues. The NTA's 2012 report reveals the difficulty individuals and small businesses experience in substantiating business deductions, and one category of trade or business expenses in particular--those subject to IRC section 274(d), which include travel, entertainment, gifts, and listed property (e.g., computers, vehicles).
Congress has placed higher documentation standards on these expenses. Taxpayers must document the amount, time and place, business purpose, and business relationship of other parties involved for entertainment expenses and gifts. For listed property, the amount of business use versus total use must be established. Court decisions indicate that the omission of any required piece of information is all that is necessary for deductions to be disallowed. The biggest obstacles taxpayers face are substantiating a business purpose and establishing the percentage of business use for listed property.
To help individuals avoid the disallowance of deductions subject to IRC section 274(d), tax advisors must make clients aware of the strict documentation requirements and suggest methods for capturing the required information. Tax advisors should encourage individuals to document this information or risk loss of substantial deductions. Smartphone applications and databases of information are available to assist taxpayers in capturing the information needed to meet the substantiation requirements of IRC section 274(d).
Paul G. Schloemer, PhD, CPA, is a professor of accounting in the Dauch College of Business and Economics, Ashland University, Ashland, Ohio.
EXHIBIT 4 Penalties Assessed by the IRS in 2012 U.S. Tax Court Decisions Citing IRC Section 274(d) Tax Court Memorandum Tax Court Summary Number of Cases 23 19 Average IRS Deficiency $365,549 $19,227 Average Total Penalties $86,200 (24%) $3,938 (20%) (Percent of Total Tax) Average IRC Section 6662 $41,563 $2,992 Understatement Penalty
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|Title Annotation:||compliance & enforcement; internal revenue code|
|Author:||Schloemer, Paul G.|
|Publication:||The CPA Journal|
|Article Type:||Statistical data|
|Date:||Dec 1, 2013|
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