Lessons from Tax Court: Bad Records, Bad Outcomes

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Federal tax law allows deductions for many items, such as legitimate business expenses and charitable donations. But, if you claim deductions on your tax return, you also must maintain adequate records to support them. If your tax return is audited, missing or incomplete records could lead to additional taxes, interest and penalties, as these three recent U.S. Tax Court cases demonstrate.

Alan Brookes, et ux. v. Commissioner (TC Memo 2017-146)

In this decision, the taxpayers were a married couple who filed a joint tax return. They operated the husband’s financial services and consulting business, along with the wife’s art business, through an S corporation. The S corporation’s losses were passed through to the couple’s personal tax return.

The IRS audited the couple’s tax returns for the 2010 through 2012 tax years, and disallowed many of the business’s deductions, increasing the taxpayers’ taxable income for the three years in question. For example, deductions the taxpayers claimed for travel, meals, entertainment and auto expenses were disallowed because the taxpayers had failed to:

    • Keep contemporaneous records,
    • Categorize the expenses, and
    • Separate business expenses from personal expenses.

However, the IRS allowed partial deductions for advertising, rent, gallery fees and supplies related to the wife’s art business, because the taxpayers had kept receipts from one of the tax years that showed purchase dates and amounts paid. Other deductions were allowed based on the wife’s oral testimony in conjunction with some sketchy recordkeeping.

The IRS also allowed partial deductions for amounts paid for massage therapy to treat the wife’s severe scoliosis, because the S corporation operated a medical expense reimbursement plan. However, deductions the taxpayers claimed for other medical expenses were disallowed due to inadequate recordkeeping.

The Tax Court concluded that the IRS had acted properly when it disallowed many deductions and also agreed that the taxpayers owed the 20% penalty for negligence on the additional tax assessed. The court opined that the taxpayers had failed to produce adequate records to support the disallowed expenses or demonstrate reasonable cause or good faith in claiming the disallowed expenses. Ultimately, the Tax Court sided with the IRS, charging the taxpayers with additional federal income tax of roughly $122,000 and a 20% negligence penalty of more than $24,000.

2. Stephen Drah v. Commissioner (TC Memo 2017-149)

In another recent Tax Court case, the taxpayer worked as an independent contractor for FedEx. Specifically, the taxpayer’s wholly owned C corporation contracted to provide services to FedEx and then paid wages to the taxpayer. On his individual return, the taxpayer claimed deductions for contract labor expenses, as well as vehicle depreciation, repair and maintenance.

The IRS audited the taxpayer’s tax return for the 2011 tax year and determined that the taxpayer had generally failed to substantiate the amount and business purpose of many expense deductions. Other business expense deductions — including those related to a vehicle leased by the corporation — were properly deductible by the corporation (and presumably were) but not by the taxpayer on his personal return.

The Tax Court concluded that the taxpayer owed additional income tax of roughly $12,000, plus nearly $4,000 in penalties for failure to file his personal return on time, failure to pay personal federal income tax and failure to make estimated tax payments.

3. Mark R. Ohde v. Commissioner (TC Memo 2017-137)

Another recent Tax Court decision involved married taxpayers who claimed charitable contribution deductions totaling more than $146,000 on their joint 2011 federal income tax return for donations of clothing, media, furniture and other household items. The taxpayers claimed to have donated more than 20,000 items to Goodwill.

The IRS audited the couple’s tax return and disallowed $145,000 of the claimed charitable contribution deductions. Why? The taxpayers had failed to properly substantiate noncash contributions that were purportedly worth more than $250. The receipts supplied by Goodwill didn’t describe the specific items contributed or indicate the number of items of any particular type. Instead, they simply stated that the thousands of items delivered fell into the categories of clothing, shoes, media, furniture and household items. In addition, donations that were purportedly worth more than $5,000 weren’t supported by qualified appraisals.

The Tax Court concluded that the IRS had acted properly in disallowing $145,000 of charitable deductions and assessing the 20% negligence penalty (based on the taxpayers’ inadequate recordkeeping). The Tax Court noted, “The term ‘negligence’ includes any failure to make a reasonable attempt to comply with the tax laws, and ‘disregard’ includes any careless, reckless, or intentional disregard” of the tax laws. The court concluded that recordkeeping failures can amount to negligence.

Bad Records, Bad Outcome

These cases show that inadequate support for tax deductions — such as lack of receipts and other documentation, the use of confusing and inconsistent accounting techniques, and vague testimony — can have expensive tax consequences. In addition to owing additional tax, taxpayers who claim unsubstantiated deductions may also be assessed interest and penalties on their unpaid taxes.

The Internal Revenue Code, the IRS, and the courts don’t distinguish between completely bogus deductions and deductions for legitimate, but unsupported, expenses. In either case, you can get into the same amount of trouble. Will your recordkeeping practices survive IRS scrutiny? Contact your tax advisor to fortify your recordkeeping procedures and help support your valuable tax write-offs.