Substantiating business expenses is a common problem for many businesses going through an audit with either the Internal Revenue Service (IRS) or their State Department of Revenue. You are probably like most business people. You don’t get up in the morning excited about keeping your tax records.
But if you want to be in business and not suffer when the IRS audits your tax returns, you need to keep tax records. This takes a little time and requires some knowledge.
Substantiating business expenses (Internal Revenue Code (IRC) Section 274)
Under Sec. 274(d), for certain expenses, taxpayers are required to be able to provide specific detailed information to substantiate the expenses. This is an all-or-nothing proposition. Without proper substantiation, no deduction is allowed expense, even if the IRS believes that a legitimate expenditure was made.
Four classes of expenses for which specific substantiation is required
- Travel expenses (including meals and lodging while away from home);
- Any item with respect to an activity that is of a type generally considered to constitute entertainment, amusement, or recreation, or with respect to a facility used in connection with such an activity;
- Business gifts (which are limited to $25); and
- Expenses with respect to any listed property (vehicles, computers or other property that could lend itself to personal use).
Certain vehicles that cannot be used for more than a de minimis amount of personal use are exempted from the substantiation requirements. However, it is important for businesses to discuss trucks, vans, and SUVs with a qualified tax professional to determine if the vehicles are exempt.
Taxpayer must substantiate “by adequate records or by sufficient evidence corroborating the taxpayer’s own statement”
- The amount of the expense or other item;
- The time and place of the travel, entertainment, amusement, recreation, or use of the facility or property, or the date and description of the gift;
- The business purpose of the expense or other item; and
- The business relationship to the taxpayer of persons entertained, using the facility or property, or receiving the gift.
IRS and the courts look for contemporaneous records with the details listed above and, lacking it, they may disallow the entire deduction.
How can the IRS disallow everything?
The Tax Court has ruled that:
- The IRS is presumed correct in denying all deductions without proper documentation.
- The taxpayer has the burden of overcoming this presumption and proving that the IRS is wrong.
- The IRS may estimate certain deductible expenses if the taxpayer provides sufficient evidence for estimates; however, in deciding the deductible amounts, the court must bear heavily against the taxpayer (the Cohan rule).
- The IRS may not apply Cohan estimates to travel; meals and entertainment; or listed property, such as a passenger vehicle. The court must disallow these deductions in full if they fail the strict substantiation requirements of Section 274(d) as to amount; time and place; business purpose; and, in the case of meals and entertainment, business relationship.
Why keep detailed receipts?
Numerous tax court decisions demonstrate the importance of keeping detailed contemporaneous records for business vehicles that can be used for personal purposes and observing other Sec. 274(d) substantiation requirements. Taxpayers need to understand what type of documentation is required to take a deduction on a tax return. As indicated above, the courts and the IRS will not allow any deduction without this documentation.
For questions or assistance with your business expenses and filing your return, contact Alerding CPA Group at 317-569-4181 or www.alerdingcpagroup.com.