The number of self-employed workers is on the rise. Recent employment data indicates 11%, or over 17 million U.S. workers, are self-employed. This increase can be attributed in part to the rise of the gig economy, as individuals seek out flexibility in work they enjoy on a schedule they set. Self-employed workers often find maintaining business records arduous, and complying with the tax requirements for business deductions can be particularly challenging.
Recent U.S. Tax Court cases emphasize the difficulty that taxpayers face if they do not have records to substantiate business expenses. This article highlights the importance of properly documenting business expenses and provides advice on tax recordkeeping in the digital age.
RECENT TAX COURT CASES
The Tax Court is often asked to decide whether taxpayers’ claimed business expense are deductible. Whether the expenses are deductible often hinges on whether they are properly substantiated, under the general requirements for substantiation or, where applicable, the heightened substantiation requirements of Sec. 274(d) (discussed more below). Below are several recent cases highlighting key issues regarding substantiation and how the Tax Court determines whether the substantiation requirements have been met.
In Eze, T.C. Memo. 2022-83, the taxpayer’s returns included two Schedules C, Profit or Loss From Business (Sole Proprietorship), for his IT consulting and construction businesses. The taxpayer claimed he paid many of his expenses in cash directly to service providers and therefore did not have sufficient evidence that the expenses incurred were his own. The court held the expenses were in some cases not credible and/or were implausible from the records or testimony presented. Nearly all of the taxpayer’s business expenses, including all his claimed vehicle expenses, were disallowed due to a lack of substantiation.
In Wolpert, T.C. Memo. 2022-70, the taxpayer was a civic engagement consultant with significant travel and vehicle expenses. The vehicle expenses were disallowed due to inadequate substantiation and a lack of contemporaneous records. His travel expenses were also disallowed for insufficient corroborative evidence of criteria including travel dates, specific destinations, and business purposes for the trips.
In Elbasha, T.C. Memo. 2022-1, the taxpayer worked as a doctor in rural Georgia and claimed business expenses including for travel to a business meeting in Cairo, Egypt. The IRS disallowed the travel deduction and some other business expenses on the taxpayer’s Schedules C because the expenses’ business purposes were not established and/or they lacked substantiation. The Tax Court agreed with the IRS and held that charts the taxpayer provided were inadequate to substantiate his expenses without further documentation of the amounts incurred and their purpose.
While the IRS prevailed in the majority of 2022 Tax Court business expense substantiation cases, the rulings in Patitz, T.C. Memo. 2022-99, and Butterfield, T.C. Summ. 2022-16, were partial victories for the taxpayers. The taxpayers in Patitz were able to adequately substantiate unreimbursed business travel expenses as employees for the 2015 and 2016 tax years. The court found the taxpayers’ testimony credible and that their electronic logbooks documenting mileage were sufficient contemporaneous records to allow for a deduction. In Butterfield, the taxpayers also scored a partial victory, with the court finding they had substantiated part of their meals and lodging deductions, while disallowing other expenses for lack of substantiation.
As can be seen from these cases, detailed and contemporaneously produced records of business expenses are generally a critical element of business expense substantiation. Any failure to produce sufficient records to substantiate the expenses underlying a deduction counts heavily against the taxpayer and may result in a disallowance of the claimed expenses. While a court may not always require documentary evidence and may accept what it believes to be the credible testimony of a taxpayer when determining whether a business expense is allowable, taxpayers cannot rely on the leniency of a court with regard to business expenses, particularly with respect to Sec. 274(d) expenses.
Taxpayers bear the burden of proving they are entitled to claimed business deductions. They also bear the burden of substantiating the amount and purpose of all claimed business deductions. In addition, Sec. 274(d) and Temp. Regs. Sec. 1.274-5T(c)(2) prescribe heightened substantiation requirements for certain business expenses, including expenses for traveling and expenses with respect to any listed property under Sec. 280F(d)(4). Under Sec. 274(d), the taxpayer must substantiate these types of expenses by “adequate records” or by sufficient evidence corroborating the taxpayer’s own statement.
An “adequate record” for purposes of Sec. 274(d) must include:
- The amount of the expense;
- The time and place the expense was incurred;
- The business purpose of the expense; and
- The business relationship related to the expense.
The Tax Court frequently considers whether a taxpayer has provided adequate records as defined by Sec. 274(d) for substantiation of travel expenses. Examples of adequate records for substantiation of these expenses include an account book, diary, log, statement of expense, trip sheet, or similar record, as well as corroborating documentary evidence that together establish each required element of the expense.
Listed property as defined under Sec. 280(d)(4) includes “any passenger automobile.” For automobile and other vehicle expenses to be deductible under the adequate-records requirement, the taxpayer must substantiate the expenses by maintaining records indicating the amount of the expense, the mileage for each business use and the total mileage for all business use during the year, the date of each business use, and the business purpose for each use (Temp. Regs. Sec. 1.274-5T(b)(6)).
The Cohan rule, named for Cohan, 39 F.2d 540 (2d Cir. 1930), allows a court to approximate a deduction amount if the taxpayer is unable to fully substantiate the underlying expense. The Tax Court generally will not employ the rule, however, unless the taxpayer presents sufficient evidence to provide a basis for the estimate. Also, the rule cannot be applied to deductions subject to the Sec. 274(d) heightened substantiation requirements. The Tax Court applied the Cohan rule in several of the cases cited above.
BUSINESS RECORDS HELD INSUFFICIENT
The courts evaluate business records and disallow deductions with insufficient documentation. This may occur, for example, when calendar entries are not made contemporaneously, taxpayers fail to provide evidence that their travel relates to particular locations or business purposes, or the mileage claimed does not appear consistent.
The court may disallow expenses for reasons including:
- Lack of substantiation;
- Concerns about the authenticity of receipts provided;
- Failure to provide contemporaneous documentation; or
- The expenses are not related to a trade or business.
AVOIDING THE DISALLOWANCE OF EXPENSES
Recent business expense substantiation cases highlight the danger of a poor or essentially nonexistent recordkeeping system. However, many options are available to business owners to assist in creating a functional recordkeeping system that documents expenses with relative ease.
Business owners must make the following determinations regarding expense substantiation:
- Do they want to use electronic means to streamline their recordkeeping?
- Do they need their accounting system to integrate with other platforms (for example, apps, as described below)?
CPAs can aid business owners in making these determinations by asking additional focused questions on their operations and preferences (see the sidebar, “Key Questions to Ask Business Owners”).
APP OPTIONS ABOUND
The substantiation cases also demonstrate how documenting business expenses can be particularly challenging when they are commingled with personal expenditures. With 97% of Americans owning a cellphone, and 85% owning a smartphone, the most convenient option for many business owners is to track expenses digitally through a smartphone app. This is particularly true for business owners who do not regularly conduct business in an office setting.
Options to consider when selecting a business expense documentation app include cost. Many apps are free with optional add-ons, while others offer monthly subscription pricing. Some examples of apps that have consistently received good reviews include:
- QuickBooks Accounting;
- SimplyWise receipt scanner;
- FreshBooks; and
The chart “Business Expense Apps,” below, presents relevant features for these five business expense tracking apps. The chart compares their features, with a focus on business travel and expense substantiation. Self-employed individuals may review the website of each app to further understand any additional features available, which can include invoicing, financial statement reporting dashboards, and time tracking. Business owners can consider which option best fits their needs and price range.