Claiming Tax Deduction for Your Yacht? You’d Better Have Proof

From yacht maintenance to vacations in Puerto Rico, taxpayers are pushing their luck with what they’re claiming as business expense deductions.

If they can’t prove that those expensive meals, luxury purchases, or exotic vacations are tied to their businesses, their deductions may be denied by the IRS. If they take their case to the U.S. Tax Court, in search of a sympathetic ear they might still not find relief.

Business expense deductions are expected to be reasonably related to a taxpayer’s business and should be evidenced by copies of receipts, practitioners told Bloomberg Tax. There are a few exceptions that may apply to other forms of documentation when receipts are unavailable.

Most business deductions aren’t challenged or litigated but the ones that are usually lack substantiation, said Kathy Keneally, partner at Jones Day in New York and former assistant attorney general at the U.S. Department of Justice Tax Division.

One reason might be that taxpayers are claiming deductions they think are valid business expenses, said Keneally. In some cases, return preparers encourage taxpayers to take deductions without making sure they can be substantiated, Keneally said. This might be due to ignorance, desire to show clients large deductions, or simply fraud, she said.

Taxpayers often just guess in determining what to deduct as a business expense, said Gersham Goldstein, former partner at Stoel Rives LLP in Portland, Ore. They don’t consider the potential consequences, such as being audited, he said.

No Receipts, No Refunds

Lack of receipts is a primary reason many business expense cases reach the Tax Court. The most commonly disputed business expense deductions are related to food, home office, entertainment, and travel, according to Tax Court data collected by Bloomberg Tax.

Parties argued about business expenses in 16 out of 49 issued opinions in the second quarter of 2018, according to the data. In most of these cases, taxpayers lacked proper documentation and were denied the deductions.

Others, however, seemed to take more creative license with what might qualify as a business expense, according to the Bloomberg data.

For example, a married couple who owned rental properties in Kentucky claimed many business-related deductions that the court rejected. Among them was a trip to Puerto Rico that the court said “seems entirely unrelated to their rental properties in Kentucky.” Paul and Cynthia Martin also attempted to claim deductions on “electrical expenses, a refrigerator, a heating and air conditioning service plan, a full size bed, a garage door, a maid, and amortization.”

“The documentation they did provide consists of a smattering of receipts and credit card statements,” the U.S. Tax Court ruled in July.

‘Ordinary and Necessary’ Expenses

Tax code Section 162 allows deductions for all “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”

An ordinary expense is one that is commonly used in a taxpayer’s business, according to the IRS Taxpayer Advocate Service. A necessary expense is one that is helpful for the development of the business.

The Tax Court ruled in August that Damon Becnel, a property developer, couldn’t claim unsubstantiated deductions for expenses associated with his yacht, the Britney Jean. He said the yacht was used to market his properties. The Tax Court found the yacht to be an “entertainment facility” and said Becnel failed to prove the expenses were “ordinary and necessary” for his business.

Other business owners’ claimed deductions were more closely related to their businesses but still failed to convince the court.

Mohammad Najafpir, the owner of a smog inspection station, attempted to write off more than $31,000 in home office expenses related to storing his business invoices in his garage from 2009 to 2011.

The tax code generally prohibits deductions for the use of a taxpayer’s home, except for storage of inventory or product samples offered for sale, according to Section 280A(a) of the Internal Revenue Code.

Storing the invoices didn’t qualify for the exception, although state law required Najafpir to keep them, according to a July ruling.

The Cohan Rule

Taxpayers who couldn’t or didn’t keep receipts for business expenses might still have an option, said Peter Connors, a tax partner at Orrick, Herrington & Sutcliffe LLP in New York.

The Tax Court usually has a lower standard of substantiation than the IRS, said Keneally. Claimed deductions can be supported by a taxpayer’s testimony or less formal records than the IRS would require.

“If it is just a question of documentation, there is a rule, called the Cohan rule, that the Tax Court will often apply to allow deductions where records don’t exist,” said Connors.

The rule was established in 1930 after a court allowed well-known entertainer and composer George M. Cohan—who wrote “Give My Regards to Broadway"—to deduct business expenses without receipts.

The IRS must allow a business owner to deduct business expenses despite not having every receipt to back them up, according to the Cohan rule. The IRS, for example, didn’t accept a composition notebook in place of receipts for one of Keneally’s client. The Tax Court, however, did accept the notebook, following the client’s sworn testimony explaining her record-keeping methods.

The Cohan Rule may not be used to deduct travel expenses, entertainment, gifts, and certain “listed properties” without substantiation.

George S. Lakner, a psychiatrist and owner of a medical consulting business, and his wife Martha G. Smith, property manager, claimed deductions for grocery shopping, trips to Macy’s, Home Depot, and Bed, Bath and Beyond without identifying which business the expenses applied to.

The court’s August decision cited the Cohan rule as an alternative to providing receipts but still disallowed the deduction for failure to provide “sufficient evidence corroborating his own statements, the amount, time and place, and business purpose for each expenditure.”