Small Business Taxes & ManagementTM--Copyright 2020, A/N Group, Inc.
Documentation is the key. While we don't know how taxpayers fare in dealing with the IRS in an audit, we can use court cases as a proxy. You might think that the cases usually involve a question of tax law. In cases where a deduction is disallowed, a very high percentage of the time the issue is substantiation of the expense. And, if the expenditure isn't substantiated, whether or not the amount would be deductible generally becomes a moot point.
In past articles we've discussed the documents you need to substantiate a deduction. Many taxpayers think they can fool an agent by creating a diary, making up invoices, etc. It's not nearly as easy as you might think. This article explores actual situations where the taxpayer was caught with either conflicting documents, forged instruments, claiming personal expenses as business deductions, etc.
Traps to Avoid--Moves you can Make
When was that paper made? Workers who receive tips are supposed to keep a contemporaneous record. That means a record created at or near the time of the occurrence. (Contemporaneous records are required in other situations such as an auto log.) During the audit a waitress claimed she had a tip record, but couldn't find it. The IRS decided on it's own amount for her tip income based on statistics. She decided to fight the IRS in court. Before the trial began she produced the tip record, but the IRS and the taxpayer proceeded with the trial. The IRS claimed the tip record was not contemporaneous, but was constructed recently. Because the trial was some five years after the year at issue, the paper used for the tip record should have been that old. The IRS called a representative of the company that made the pad the taxpayer used to record the tips. He testified that the pad in question was not sold by the company until three years after the taxpayer claimed to have made the record. While it's unusual for the IRS to go that far, it's not unheard of.
The idea behind a contemporaneous record is that a diary kept at or near the time (e.g., created the same day or the same week) is much more likely to be accurate than one created several months later. And certainly better than one made years later. The IRS and the courts take this very seriously. Even without dating the paper, ink, etc. most IRS agents with some experience and most judges can tell when a diary was constructed virtually all at once. If the handwriting isn't a tipoff, there are sure to be inconsistencies. See below.
Another point. Keeping a contemporaneous record is generally to your advantage. Without it you may be cheating yourself. Tax preparers often hear "I'm sure I spent more but I just can't remember".
Audit lottery. Years ago more than a few taxpayers played the "audit lottery". The idea was take the deduction. If it's disallowed you'll owe the tax and not much else so you it's worth the gamble. That's changed. There's a 20 percent accuracy-related penalty for lack of documentation (and other reasons). The penalty is imposed if the amount of the understatement of tax for the year exceeds the greater of 10 percent of the tax required to be shown on the return or $5,000. As usual, it's more complicated than that. What's important is that between additional taxes, penalty and interest, your bill could be expensive. And it's likely to come a couple of years after filing.
Getting it right. One of the best reasons for preparing that log at or near the time the car usage, out-of-town trip, etc. is that's there's a good chance you'll make a mistake. In one case the taxpayer claimed he drove 330 miles from New York City to Portland, Maine; then back the next day. Unfortunately, the Tax Court was thorough and checked all the T&E documentation and found he also took a deduction for an airline trip (substantiated by a ticket) for the same day. The court not only disallowed his 660 miles for the trip, after two more questionable items it found his entire car log not credible and disallowed all his auto mileage. In another case the judge throw out a consultant's mileage when his diary showed him to be having lunch with a client in town on the same day he claimed he was 420 miles away. These are not unusual examples.
Sometimes questionable actions are, in fact, true. You work out of the Boston office and live in town. A client on vacation in Maine requests a meeting on a Saturday on Portland. That's very unusual, especially during your slow months. Keep some extra documentation. In addition to the name of the client and what was discussed, keep additional documentation such as EZ-pass log for tolls, cell phone bill showing location of calls, parking stubs, name of anyone else at meeting, etc.
Private sale of vehicle. Fred bought a collectible car from a private seller in another state. He paid $40,000 for the 50-year old vehicle. When he registered the car he thought he'd save some money on the sales tax and claimed the car was worth only $5,000. At an 8% sales tax rate he saved $2,800. As a collectible he insured the car for $40,000. Less than a full month passed before the car was totaled in a freak accident. Because the owner had a suspicious claim some years back, the insurance company wanted proof of the value. The insurance company asked for the value claimed for sales tax purposes. Unfortunately, that was only $5,000. The owner was out $35,000. When he claimed a casualty loss on his tax return the IRS asked for documentation because the loss wasn't covered by insurance. When the truth came out the IRS disallowed the casualty loss because the owner couldn't prove the $40,000 basis without claiming he committed sales tax fraud. Currently, casualty losses aren't deductible on your personal return. But claiming a low amount on one document could have other consequences. The IRS may claim a low basis when the item is sold (making your gain larger) or could allow depreciation based on the lower value. Note. Many states don't take kindly to sales tax fraud. Some are very quick to prosecute.
Loan documentation. Sue wanted a line of credit of $150,000 for her business. Both Sue and her husband were self-employed (in different businesses). There was no way the bank would approve the loan based on the income shown on their tax return. So they went to a CPA (not their tax preparer) who prepared financial statements based on their accounting records. The financials showed income more than three times that shown on the tax returns. The bank approved the loan. The taxpayers were subsequently audited by the IRS. The IRS believed they had underreported their income. The Service reconstructed their income and assessed a deficiency. When the agent uncovered the loan, he issued a summons for the loan documentation. At trial the taxpayers argued the IRS reconstruction was inaccurate. Upon seeing the amount of income the taxpayers claimed in the loan application, the court sided with the IRS.
Of course it could go the other way. The lender could (and often does) request a transcript of your filed tax return. If the lender finds a lower income number on the tax return, your application will most likely be rejected. And, should you get a loan and default, misrepresenting your income on a loan application is fraud.
Multiple bank accounts. Some people have only one bank account. Some have a plethora. If you've got a business, you've got a least one account, perhaps several, for the business. Add a rental property or two, an account you hold with your elderly parents, and that special savings account for the vacation home and it can quickly add up. It's not unusual for an entreprenuer to have more than seven accounts. Should you be audited the IRS will most likely ask for information on all the accounts. That can include accounts held jointly with your children and others. And any transfers in can be deemed income unless you can show to the contrary. For example, the business needs some quick cash so you take $2,500 out of that rental property account and deposit in your business account. Without adequate documentation the IRS could label that as unreported income. Next month when the business is flush you transfer the money back into the vacation home account. Another $2,500 in income. You just created $5,000 of taxable income.
All is not lost. If the transfers are documented, you shouldn't have a problem. Don't take the $2,500 in cash. Consider transferring the money to the other account using one of the transfer services or writing a check to the business. Record the deposit on the books as a loan. If you use a check, keep the time in transit to a minimum. And keep such transfers to a minimum. You may be able to document everything, but it raises suspicions and will take your or your accountants time to sort it out. Keep all your bank records. Yes, you may be able to get them later from the bank, but there may be a charge. Download the statements and make a backup. Your tax advisor will have other suggestions.
Multiple projects. It's not unusual to have one or more rental properties as well as your principal residence and perhaps a vacation home and all that may be in addition to a business property. You should be able to identify clearly the property benefiting from any expenditures. Simply keeping a receipt from the lumber yard or contractor may not be sufficient. For example, you home is in Madison and you've got a rental property in Chatham only 15 miles away. You claim that the $5,000 in construction materials is for the repair of your Chatham rental when in fact it's for the new deck on your home. You show the agent the invoice, but he calls the lumber yard and gets the delivery record. You'll have a hard time explaining that. But what if there's no delivery record? Can you show the materials were actually used for the rental? Make sure the contractor, supplier, etc. identifies the address where the materials are delivered or the work done. Clearly the larger the dollars, the more diligent you should be about the records. Can't get good documentation? Take pictures. In more than one case pictures have secured a deduction where no conventional documentation was available. Make sure the picture is date stamped and you can fully identify the site from the surroundings. Got a list of smaller amounts for various properties? Identify the properties on the invoice or register tape. That's probably all you can do.
Make sure you identify the rental property clearly if you have more than one property. It could be very important when the property is sold since it could affect the gain or loss.
Business vs. Personal. The IRS is always looking to change a claimed business expense into a personal one. Often there's no need to worry. Fred has a business selling specialty surgical instruments. There's no possible personal use for the instruments. But many business owners are in a business because it's something they enjoy. Chances are the owner of that marine supply store has a boat. Avoiding a problem here can be tough.
It's more common that the business makes expenditures that could be personal in nature. For example, the business purchases items that could be used for personal purposes as well as business. For example, your purchase a big-screen TV for your waiting room. Or 20 rolls of hand towels for the shop restroom. Consider having the TV delivered to your office rather than simply picking it up. Can you show 20 rolls of hand towels per week is reasonable use? The IRS may not question such a purchase unless the usage is unexpected. On the other hand, you can expect a question if the type of expenditure is unusual for the business. For example, consider a three-man advertising firm. The purchase of a $350 chainsaw is sure to perk an agent's interest. Talk to your accountant or tax advisor if you're susceptible to these problems. The more likely the expenditure could be for personal rather than business purposes, the more you want to be able to show the use. In some cases a verbal explanation to an agent is all that's needed; in other cases you may want to keep a diary, take photos, etc.
Right business. You may have two or more business operations. For example, you do custom logging through an S corporation and have a hay farm you operate as a sole proprietorship. Make sure the expenses end up on the right business. If Madison Logging Inc. buys the tires for the log skidder and Fred's Farm pays for them, they're not deductible on either entity. You may be able to correct the error on audit, but you may not fare well if you've got a number of such inaccuracies. In addition, two or three years down the road you might not remember who the expenditure was for or have any way of showing the correct entity.
You're the sole shareholder of four S corporations. That may not bring as much scrutiny as a situation where you're a 80 percent owner in an S corporation and also do business through a wholly owned LLC.
Straining credibility. Sometimes it's virtually impossible to document a deduction. The home office is one example. The space must be used solely and exclusively as an office. That may be easy to prove for the 10 by 10 converted bedroom at the end of the hall that represents 15% of the house. But don't, as some taxpayers have done, claim you use 70% of the home for business. Even if you use the kitchen table for 10 hours a day, that's not exclusive. First, it'll probably trigger an audit. Second, if you go to court, you'll never convince a judge. Another example is car usage. One taxpayer tried to claim her car was used 100 percent for business. But she had no other vehicle and lived in the suburbs.
Don't assume the judge won't understand your business or situation. It's not unusual for the court to go through considerable effort to understand the mechanics of a business, transaction, etc. Often the court finds testimony conflicting with documentation, industry practice, etc. That will go against you.
Keep a diary. If the IRS or court believes the diary is comtemporaneous, it can carry more weight than you might think, particularly if it's detailed. For example, even though the other party bought lunch you record the date, time, people at the meeting, issues discussed. That could back up the reason for the airline ticket and hotel stay. Spent time at a rental property. Recording the work performed, who did the work, date and time, etc. can substantiate where the materials or items purchased were used and may secure you a deduction for work or a purchase where you don't have the invoice or it's unclear. A diary or log can be even more important if the transactions, meetings etc. are suspicious. For example, you claim to be have met with a client at 9:00 in the morning and another 200 miles away at 2:00 in the afternoon. If the diary lists the 9 am meeting as a short discussion followed by the signing of documents, the afternoon meeting doesn't sound as suspicious.
There are times when a good log is essential. Spent a week working on the vacation home you rent out? The IRS could claim that's personal time and could affect your deductions. A detailed log of the work performed can support the time as work time and not be personal use. Own a business, S corporation, or LLC and only work there part time? If you don't materially participate in the business, you won't be able to deduct any losses against ordinary income. Log entries can substantiate the time spent. Sometimes it's clear you meet the time threshold (the restaurant is your only business), but if there could be a question, keeping a log makes sense. Spend a considerable amount of time working on your rental properties? You may be able to take the 20 percent qualified business income deduction if you can show your time. Claim to be a real estate professional? You'll need to show at least 750 hours working at real estate. If so you can deduct losses against ordinary income without restrictions. The courts have disallowed the deduction for a number of cases where there was no long.
Have homes or work in more than one state? You may find two states trying to tax you as a resident. That can prove expensive. This is a complicated issue, but a good log or diary could protect you. Talk to your tax advisor.
Selling a business? One taxpayer was selling her business and commented to the buyer "of course I make a lot more than I show on the tax return" and proceeded to provide details. The negotiations for the sale took a nasty turn and the buyer decided to blow the whistle on the seller. That triggered a fraud audit. While the rules are complicated, a whistle blower can get a reward from the IRS. So be careful what you say to who.
You might also want to think twice about telling customers "I can take off the sales tax if you pay cash". If it turns out the customer is an IRS or state revenue agent, he or she might want to get a job promotion instead of saving $40 in sales tax. An IRS agent knows if you're cheating the state out of sales tax, you're probably cheating the IRS out of income tax.
Witnesses. Tax cases don't bear a close resemblance to a TV court proceeding. There are often only a few witnesses, if that. But don't be surprised if the IRS comes up with some surprises. It often talks to company vendors, suppliers, employees, bank employees, etc.
Expert witnesses. Now's not the time to go cheap. Expert witnesses may be your biggest asset in a case. Appraisers are the most frequently used expert witnesses and it's not unusual to see their testimony torn apart by the court. For appraisers, the larger the value of the property being valued, the more you should do to secure the best appraiser.
Fraud. Generally, the IRS is presumed correct. If it disallows a deduction, the taxpayer has to prove he's entitled to it. If the IRS shows unreported income, the taxpayer has to show it doesn't exist. But the tables are turned in the case of fraud. The IRS has to prove it by clear and convincing evidence. There are a number of "badges of fraud". If the IRS can show the court a number of these badges are present, that can be convincing evidence. One of the badges is poor recordkeeping--another good reason for good documentation. Another badge is dealing in cash when that would be unusual for the industry. The corner deli may get most (if not all) of it's receipts in cash. But a contractor who has a mostly cash business would be suspect. Using a check cashing service to convert customer checks to cash instead of making a bank deposit is a red flag. In some cases the lack of prenumbered invoices has been cited. Talk to your tax advisor about these issues.
Fraudulent instruments. Taking a deduction for an expenditure that's not deductible (e.g., a traffic ticket, depreciating land, deducting a capital expenditure as a repair) rarely results in more than an accuracy-related penalty. An occasional deduction of a personal expenditure as a business expense often will fall in the same category as will undocumented business deductions. A significant number could be an indication of fraud.
On the other hand, if you generate or doctor an invoice for say, cost of goods sold, that's fraud, and there can be serious consequences. The IRS has interviewed vendors and suppliers if it suspects a false document. No documentation for an expense? You're better off throwing yourself on the mercy of the IRS or the court.
Travel and entertainment, auto usage. This is an involved topic and beyond the scope of this article. The documentation requirements here are specific and stringent. Moreover, if you're audited, this is one of the first places the IRS or state will look. Contemporaneous recordkeeping is essential.
Cohan Rule. Named after George M. Cohan, this rule gives the court or IRS leeway to allow some deductions despite a lack of documentation. But the court has to have some basis for estimating the amount and it does so only where it's clear the taxpayer incurred the expenses. Often the court's estimate is based on the documentation you do have. For example, you lost two months worth of the receipts for work done on the equipment in your plant. The court may estimate the amount based on the expenses you can document. But you're certainly at the mercy of the court and will almost surely not secure as good a deduction as if you had adequate records. Finally, the court cannot use the Cohan rule on travel and entertainment expenses, meals and lodging away from home, and auto and other listed property use. And, of course, that's the area you'll probably need it most.
Sales tax. An audit here can often make a visit from the IRS feel like a family cookout. The states get a substantial portion of revenue from sales tax and get real serious on cheating. Documentation here can be more critical than any other area of taxes. If you have a restaurant, convenience store or many other types of retail sales or services, many state auditors will do a sample audit if your records are inadequate. Some courts have upheld sample audits based on one days' or one weeks' sales. For example, the state is auditing your restaurant. They auditor spends the day watching the cash register and finds your sales for the day were $1,400. You're open seven days a week, 360 days for the year. To find the annual sales he multiplies $1,400 by 360 days. He may use that number for three years of an audit. A statistician can challenge that approach on many grounds, but you'll have a hard time because you have poor records. There's a possibility you'll come out ahead, but for a number of reasons it's unlikely.
State considerations. Two points here. First, instead of the IRS selecting you for audit, it could be the state. They work under similar rules. And, whether you're audited by the IRS or a state, they communicate so you'll have to file an amended return with the other agency reporting the results of the audit. Second, if you do business in more than one state you've got to keep records so that you know where the sales were located. This can get complicated. Best to heed your accountant's advice.
Copyright 2020 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 08/21/20