Perspectives Newsletter – Keeping Good tax Records
Keeping Good Tax Records: A Case Study of What NOT to Do
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.
A new Tax Court case illustrates what happens when adequate records are not kept throughout the year.
Facts of the case: For the tax year at issue, Mohammed A. Rehman was employed for approximately five months at a health insurance benefits company. A Long Island, N.Y., resident, Rehman worked as a marketing outreach representative. He left his job and became a self-employed securities trader and later created a limited liability company for the business.
The IRS disallowed many of the deductions on Rehman’s tax return for expenses he claimed to incur as part of his employment and his self-employment. The tax agency also rejected other deductions.
The expenses and the reasons for disallowance for some expenses are detailed in this chart:
|Deduction||Taxpayer Claim||Tax Law||Tax Court|
|Medical expenses||Rehman suffered from back pain and sought medical treatment. He claimed he paid a doctor $20,000 in cash for back surgery. |
In addition, Rehman claimed approximately $2,500 for bridgework from a dentist.
He did not have records or receipts for the medical/dental care.
|Taxpayers are permitted deductions for expenses paid during the tax year for medical care (for themselves, spouses, or dependents) to the extent they exceed a percentage of adjusted gross income. |
For 2013, you can claim an itemized deduction for qualified medical expenses to the extent they exceed 10 percent of your adjusted gross income (AGI). If either you or your spouse will be 65 or older as of December 31, 2013, a 7.5 percent-of-AGI threshold will apply.
|The court was convinced Rehman received care for back pain. However, it added “there is nothing in the record beyond his own testimony to indicate how much he paid for that treatment or in what year he made any payments. His testimony about amounts allegedly paid is implausible and unconvincing.” Rehman testified he couldn’t produce documentation because the doctor “disappeared.” |
The same testimony was given about dental work … no receipts and the dentist couldn’t be found.
|Charitable contributions||Rehman deducted a charitable donation of $5,500 to an individual resident of India. The IRS disallowed the write-off and the Tax Court agreed.||While taxpayers can deduct contributions to qualified charitableorganizations, donations toindividualsare not allowed.||Since Rehman could not prove that the individual he provided a contribution to was authorized to accept donations on behalf of a charitable organization, he was not entitled to a deduction.|
|Unreimbursed business expenses as an employee||Rehman deducted the expense of traveling to and from clients’ homes while he was an employee. |
He also deducted the cost of traveling to and from restaurants to eat lunch.
|You can deduct “ordinary and necessary” expenses incurred in carrying on a trade or business. |
If you are an employee, you may be able to deduct expenses only if your employer does not reimburse them.
|Some work-related transit expenses are generally not deductible. For instance, expenses for commuting between the taxpayer’s residence and the place of business are generally non-deductible personal expenses. (There are exceptions for deducting commuting costs but Rehman did not prove he qualified.) He also did not show that his employer did not reimburse expenses so he was not entitled to deductions.|
|Meal expenses as an employee||The taxpayer deducted the cost of buying lunch during his workdays as an employee||It is possible to deduct 50 percent of the cost of lunches as meals and entertainment expenses if a taxpayer is eating with a customer or client and the meeting is directly related to the conduct of a taxpayer’s trade or business.||Since Rehman ate alone, he did not meet the requirements to show that the lunches were related to the conduct of his business. Therefore, they were non-deductible personal expenses.|
|Meal and entertainment expenses while self employed||On his Schedule C, Rehman claimed a $2,387 deduction for meals and entertainment and a $7,490 deduction for travel. |
He produced a log that labeled all “lunch” entries as $10. For all entries labeled “Travel” the amount was $14. He testified that each $10 entry was a restaurant bill and each $14 entry was taxi fare from his apartment to the restaurant and back.
|As stated above, it is possible to deduct 50 percent of the cost of lunches as meals and entertainment expenses if a taxpayer is eating with a customer or client and the meeting is directly related to the conduct of a taxpayer’s trade or business. |
A “contemporaneous” log should be kept to record expenses on or near the dates of client and business-related lunches.
|There was no evidence Rehman’s lunches were related to his business, the court stated. Also, a deduction is not allowed for meals and entertainment unless a taxpayer properly substantiates: the expense; time and place; business purpose, and business relationship between the taxpayer and the person(s) entertained. |
The court did not believe the log was kept as the expenses were incurred. “It appears that Rehman prepared the log in one fell swoop long after the dates in question,” the ruling stated.
|Travel/ meal/ entertainment expenses in Las Vegas||On his Schedule C, Rehman claimed some travel, meal and entertainment expenses incurred during three trips to Las Vegas for conferences related to his work. |
He testified he gambled at night.
|You can claim deductions for travel expenses that are reasonable, necessary, and directly attributable to your business. |
If the trip is undertaken for both business and personal reasons, travel expenses are deductible only if the primary purpose of the trip is business.
|Other than Rehman’s testimony, the court noted “there is nothing in the record to show that the primary purpose of the trips was business-related and not personal.” |
Although he showed announcements for conferences in Las Vegas at the time, he did not prove he attended them or that they were ordinary, necessary expenses for his business.
|Office in the home||Rehman claimed a deduction for the cost of utilities in his home, a one-bedroom apartment. He testified that he used the living room — one room of three in his home — exclusively for business purposes.||To deduct any expenses attributable to business use of a home, you must use a portion of the home “exclusively” for business.||“Rehman supplied no information about the layout of his apartment that could make this assertion seem credible, and he was not a credible witness,” the court stated. |
Since he could not show exclusive use, his deductions were denied.
|Supplies||The IRS disallowed $3,763 of supplies deducted by Rehman. He produced a list of expenses showing the date purchases, a description and the amount spent.||A taxpayer can deduct the cost of supplies if the cost is an ordinary and necessary expense directly connected with his or her business.||Rehman’s list did not show that the supplies were related to his business as a securities trader, the court stated. Therefore, he is not entitled to deduct the expenses.|
The above chart only shows some of the deductions that were disallowed in this case. Rehman was also denied some write-offs for advertising, legal costs, educational expenses, books/magazines and business gifts. (Rehman v. Commissioner, T.C. Memo 2013-71)
The moral of this story. Don’t leave the important matter of documentation to chance. Don’t try to re-create expense logs at the end of the year. Don’t think it is not possible that the IRS will ask you to prove your deductions.
However, with organization and guidance from your tax adviser, you can maintain 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, gift and listed property expenses, a taxpayer must generally substantiate records with:
1. The amount of the expense.
2. The time and place the expense was incurred.
3. The business purpose.
4. In the case of a business entertainment or gift expense, the business relationship.
5. For listed property, a taxpayer must establish the amount of business use and the amount of total use.
For more information about tax recordkeeping, consult with your tax adviser. There may be ways to substantiate your deductions that you haven’t thought of, and there may be a way to estimate certain deductions (the “Cohan Rule”) if your records are gone due to, say, a fire, theft or flood.