Taxes: beware the perils of poor recordkeeping
Nov 1, 2011
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.
One recent Tax Court case illustrates the potential pitfalls facing some taxpayers.
Facts of the case: Adan Sucilla operated 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 books for his business operation. Instead, he relied on bank statements, subcontractor checks, and receipts to account for the expenses. Sucilla did, however, hire an accountant to prepare his federal tax returns for the years in question.
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. The Cohan rule is described below.
One consolation: Because Sucilla acted with reasonable cause and in good faith, the court ruled that he was not liable for accuracy-related penalties for substantially understating income (Sucilla, TC Memo 2011-197).
The substantial understatement penalty 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.
The moral of this case is pretty simple: Don't leave the important matter of documentation to chance. With guidance from your tax advisor, 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 website 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, gifts, and listed property expenses, a taxpayer must generally substantiate with records:
- The amount of the expense.
- The time and place the expense was incurred.
- The business purpose.
- In the case of a business entertainment or gift expense, the business relationship.
- For listed property, a taxpayer must establish the amount of business use and the amount of total use.
For more information about tax recordkeeping, please contact us.
A tax fall-back position
When all else fails, the "Cohan rule" might bail taxpayers out of a tax recordkeeping jam.
In a landmark case decided more than 80 years ago, the Second Circuit Court of Appeals allowed legendary Broadway showman George M. Cohan to deduct various expenses he could not substantiate. The court reasoned that he had provided credible evidence that some expenses had been incurred, so it permitted deductions on a limited basis (Cohan, 39 F.2d 540, 2d Cir., 1930).
As the Tax Court explained in the Sucilla case, "In these instances, the court is permitted to make as close an approximation of the allowable expense as it can, bearing heavily against the taxpayer whose inexactitude is of his or her own making." (In some cases, the Cohan rule is allowed when records are lost for reasons beyond a taxpayer's control, such as a fire or natural disaster.)
When making estimates under the Cohan rule, the court added that there must be some basis upon which they are made or an allowance "would amount to unguided largesse."
Travel and entertainment expenses are not allowed. Since the original Cohan case, the courts have determined that the strict substantiation requirements for travel and entertainment expenses and listed property override the application of the Cohan rule. Therefore, courts cannot estimate them without documentation.
Caution: The Cohan rule should be viewed only as a last resort. The best approach is to keep detailed records required to substantiate deductions.
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