I was recently asked what I thought taxpayers should take from the recent scramble to apply for the Small Business Administration’s Paycheck Protection Program. Without hesitation, I replied, “keep good records.”
Record keeping has always been an important part of tax compliance. That’s because taxpayers aren’t always required to submit documentation along with tax returns—especially when filing electronically—to the IRS. Taxpayers are supposed to retain evidence to support deductions for business and travel, charitable donations, medical expenses, and more for at least as long as the statute of limitations (typically three years from filing for most tax returns).
But more often than not, life gets in the way. And instead of neatly scanned receipts, our records can look more like mountains of crumpled papers. If you—like me—don’t scan and file as soon as the mail comes in, it’s worth taking the time to periodically organize your records.
Why does it matter? Because, as business owners and independent contractors have recently been reminded, line items on a tax return don’t tell the entire story. Having easily accessible and organized records at your fingertips can save time. As a California couple recently learned in Tax Court, it can also save dollars.
Henry Williams and Sonja Johnson filed their taxes jointly. In 2007, Williams formed a holding company to acquire an insurance business. He eventually did buy a company in 2010. Over the years, Williams spent quite a bit of money to market and operate his business, and he reported his expenses on a Schedule C of his individual tax return.
On examination, the IRS sent the couple a notice of deficiency. The notice included, among other things, disallowances for several deductions and an increase in taxable income related to retirement account withdrawals. The taxpayers disputed the changes, and the matter eventually went to court.
By rule, at Tax Court, taxpayers generally bear the burden of proving that they are entitled to any deductions claimed. And by statute, taxpayers must maintain sufficient records to support their tax liability.
That didn’t happen here.
For example, Section 274(d) requires taxpayers to substantiate travel, entertainment, gift, and listed property (including passenger automobiles) expenses with adequate records or sufficient evidence. By statute, that support must confirm the time, place, and amount of the expense, as well as the business purpose (additional requirements may apply depending on the type of expense).
Typically, taxpayers are encouraged to keep a contemporaneous diary or log, together with supporting evidence like annotated receipts or bills. Merely recalling the nature of the expense isn’t enough.
In this case, the taxpayers were not able to provide adequate records to support all of their deductions. For example, they claimed a depreciation deduction for office equipment and a car. But they didn’t provide evidence to substantiate the deduction, including how much was attributable to the car and how much was due to the office equipment. Even though the Tax Court found the testimony regarding the depreciation credible, the taxpayers failed to substantiate it, and thus the deduction was denied.
Similarly, the taxpayers submitted airline itineraries and a conference schedule to support travel expense deductions. However, those documents did not confirm the business purposes of the trips or the amounts claimed on the return. Since they failed to satisfy Section 274(d), the court found that the taxpayers were not entitled to the deduction.
The court likewise sustained denials of various deductions for meals and entertainment, interest, and insurance expenses. In each case, the court agreed that the evidence produced by the taxpayers was not enough to confirm all or part of the amounts claimed on the returns.
The lack of evidence didn’t stop at deductions. The taxpayers agreed that they had made early withdrawals from their retirement accounts in 2010 and 2011. Typically, those withdrawals are subject, under Section 72(t), to an additional tax of 10% for taxpayers under the age of 59 and a half (sometimes referred to as an early withdrawal penalty). The taxpayers were under that age when they made the withdrawals. However, they claimed that the withdrawal penalty didn’t apply because they met an exception under Section 72(t)(2)(A). Specifically, they argued that the amounts were used to pay for qualified higher education expenses.
The taxpayers were able to show that they did pay some qualified education expenses in 2010. However, the record did not support additional qualified education expenses for that year, or any such costs for 2011. The court found that the taxpayers were liable for the additional tax for those amounts that were not substantiated.
The result? While the taxpayers were able to provide support for some of their tax deductions and other tax-favored breaks, they lacked evidence for others. In cases where taxpayers cannot provide adequate proof for their claims, those claims are denied.
That’s a good lesson to keep in mind in the current economic climate. Tax breaks like the employee retention credit (ERC) and loan forgiveness programs like the Paycheck Protection Program may require substantiation of tax and other financial records at the outset to qualify for relief. But more importantly, they may require confirmation of financial burdens (or improvements) for forgiveness or credit. Maintaining sufficient, contemporaneous records means that taxpayers won’t have to struggle to offer proof later.
Record keeping isn’t one of the more sensational facets of tax law, but it’s one of the most important. The best plans, the greatest tax-favored schemes, the most significant advantages in the law—they all mean nothing if, at the end of the day, you can’t support those positions.
This is a weekly column from Kelly Phillips Erb, the TaxGirl. Erb offers commentary on the latest in tax news, tax law, and tax policy. Look for Erb’s column every week from Bloomberg Tax and follow her on Twitter at @taxgirl.
To read more articles log in.