Taxpayers are required to keep adequate records for all business expenses that they wish to claim on their tax return. Deductions are allowed for ordinary and necessary expenses required to carry on their business. These expenses must also be sensible and helpful to the business. Generally speaking, receipts, bank statements, or a copy of a cancelled check may satisfy most support requirements. However, there are cases where additional substantiation will be required as provided under Section 274(d) of the Internal Revenue Code associated with the following:
- Travel – A deduction is allowed for travel expenses related to a trade or business or for the production of income. This also includes meals and lodging while traveling.
- Entertainment – Any expense related to a client or customer activity that would constitute entertainment, amusement, or recreation, or with respect to a facility used for such activity.
- Business Gifts – Gifts to clients or customers which are limited to $25 per recipient.
- Expenses and depreciation related to listed property – listed property is defined as:
- Any passenger automobile
- Property used as a means of transportation (exceptions are provided for certain vehicles)
- Any computer or peripheral equipment (except for computers used exclusively at a regular business establishment)
If selected for review, the type of additional substantiation required for each of the expenses listed above must be contemporaneous and available upon IRS request. Ideally this would include a log or similar record. Specifically, a log should be kept detailing mileage of business travel of a personal or company automobile, for example, reflecting starting and ending mileage for each occurrence on a daily basis.
The following information may be reported on a separate log or the receipt to the related expense:
- The time (date) and place of the travel, entertainment, use of the facility or property, or the date and description of the gift.
- The business purpose of the expense or other item.
- The business relationship to the taxpayer of persons entertained, using the facility or property, or receiving the gift.
A vehicle (i.e., listed property) whose use consists of both business and personal use has additional limitations. Depending on whether or not the vehicle is used 50% or more for qualified business use will dictate the depreciation method, amount of section 179 deduction and bonus depreciation. The substantiation requirements of section 274(d) still remain applicable, no matter what percentage the vehicle is used or which expensing method is chosen.
There is essentially no grey area when it comes to these requirements and even detailed records can be insufficient if the requirements are not met, as is evident in a recent case David H. Garza v. Commissioner, TC Memo 2014-121. In this case, even with a log and detailed information, the taxpayer was denied their deduction because they failed to keep adequate records of each business use. Instead, the taxpayer predominantly kept monthly beginning and ending records of mileage for their automobile.
This being said, there have been instances where the record keeping requirements are not met, and the IRS has still allowed an estimate of the expenses under a principle called the Cohan Rule. This principle is based on an old court case that states a taxpayer be allowed business expenses based on estimates and other evidence if the taxpayer is unable to produce proper documentation. However, in a tax court case, Kenneth G. Schladweiler, TC Memo 2000-351 the court ruled that Cohan estimates are not allowed for items covered by section 274(d) and that “a taxpayer who cannot prove the expense loses the deduction”.
The likelihood a taxpayer or their business may be selected for an audit is difficult to predict. Since these types of deductions tend to add up to substantial amounts, it would be profoundly beneficial to have all information present to prove your deductions are legitimate.