A recent United States Tax Court decision, issued on December 12, 2019, demonstrates the potential consequences and penalties that can arise from failing to maintain adequate business records to substantiate claimed income and deductions.

The case of McRae v. Commissioner, T.C. Memo 2019-163, was decided against the taxpayers, Randy and Shelby McRae, leaving them with a tax bill of $84,544 for unreported income and additional accuracy-related penalties for the tax years of 2013–2015.

The McRaes’ tax returns for 2013–2015 were selected by the IRS for audit. Because of inadequate records for their Schedule C (sole proprietorship) business activities, the IRS performed a bank deposit analysis, and determined that income was substantially underreported.

The IRS issued a Notice of Deficiency to the taxpayers and disallowed various deductions claimed on the McRae’s Schedule C’s, as well as itemized deductions for mortgage interest expenses and all NOL deductions. Accuracy-related penalties were also proposed for the tax years of 2013–2015. The McRaes filed a Tax Court Petition against the IRS, challenging its decision.

Unreported Gross Receipts

The Tax Court noted that when the IRS issues a notice of deficiency, the IRS’s determination is generally presumed to be correct and “the burden shifts to the taxpayer to prove by a preponderance of the evidence that the Commissioner’s determinations are arbitrary or erroneous (citation omitted).” This underscores the need for good legal counsel who is familiar with Tax Court procedure and the procedural burdens at play in a tax dispute.

The Tax Court found that the IRS Revenue Agent who conducted the audit had testified credibly as to the method and findings of her analysis, and had presented documentary evidence to support her findings. The Tax Court found that the taxpayers, however, failed to demonstrate that the IRS’s findings were inaccurate, and failed to supply documentation or records to support their arguments. Thus, the findings of unreported income were upheld.

Unsubstantiated Deductions and NOLs

A taxpayer has the evidentiary burden to prove that they are entitled to deductions. The court further noted that “[t]axpayers also bear the burden of substantiating the amounts of the deductions by keeping and producing records sufficient to enable the IRS to determine the correct tax liability. (citations omitted).” In addition, taxpayers have the burden of establishing NOL carrybacks and carryforwards and their amounts, which requires taxpayers to submit evidence of previous tax years.

The judge found that the McRaes improperly claimed living expenses, rent substitutions, and rent as mortgage interest expenses, as they did not prove that they owned the property or had any mortgage on the property. The taxpayers also claimed several Schedule C deductions for their business activities, including utilities expenses, car and truck expenses, travel expenses, and professional services expenses.

The court found that the taxpayers failed to provide any documentary or testimonial evidence that would substantiate that the expenses related to their home, vehicles, travel expenses, or that legal and professional services were made in the course of operating the Schedule C businesses. The deductions for restitution payments made by Mr. McRae were also disallowed, as no evidence was provided concerning the circumstances under which Mr. McRae was ordered to pay restitution. Similarly, the McRaes failed to submit previous tax returns and proper evidence to substantiate their NOL carryforward deductions.

Following these findings, the Tax Court judge sustained all of the disallowances at issue in the case.

Accuracy-Related Penalties

The court found that the Commissioner met the burden of production for penalty approval, which involved demonstrating that the initial determination by the Revenue Agent was approved in writing by her immediate supervisor. The IRS assessed the standard accuracy-related penalties provided under Sections 6662(a) and (b)(2) of the Internal Revenue Code. The standard penalty is 20% of the amount of any underreported income exceeding $5,000 or 10% of the tax required to be reported.

An exception exists for taxpayers who acted with “reasonable cause and good faith . . . ‘include[ing] an honest misunderstanding of fact or law that is reasonable (citations omitted).’” The court found that Petitioners did not establish reasonable cause or good faith, particularly after taking into consideration that Mr. McRae was a certified public accountant who engaged in tax preparation services. Despite his experience, the taxpayer failed to maintain proper business records and offered no evidence to substantiate the deductions or cause for failing to report substantial amounts of income. Thus, the court determined that the Petitioners were liable for accuracy-related penalties.

Taxpayers Should Take Note to Maintain Adequate Records

The McRae decision demonstrates that it is critical to maintain proper records and documentation to substantiate any income and expenses. Failure to do so could result in a deficiency notice from the IRS, as well as assessment of penalties. Taxpayers should be careful to retain all records and documents necessary for tax filings—at least if they want to avoid additional assessments from the IRS.

Have a question? Contact Jason Freeman.