Short Summary: This case involves taxpayers’ entitlement to Schedule A itemized deductions and Schedule C deductions and the taxpayers’ obligation to substantiate those expenses to which the deductions were related were paid or incurred for the 2015 and 2016 tax years. Petitioners were husband and wife that jointly filed their tax return for the years at issue. Mrs. Patitz was an account executive with a copying company and she also operated her own insurance business selling supplemental insurance policies. Mrs. Patitz’s job responsibilities for the copying company required her to travel to client sites in Central Florida. Her employer reimbursed her for travel expenses incurred outside of her home base in Jacksonville, FL. Her weekly mileage expenses only accounted for her local trips in Jacksonville. In 2015 and for part of 2016 Mr. Moody was employed as an area manager for a courier service. His service area spanned from Vero Beach, FL to Key West, FL and his job duties required him to deliver “on demand” packages to clients in the service area. He had to travel to the employer’s warehouses weekly and occasionally had to stay overnight in hotels. For the second half of 2016, Mr. Moody began a new career as a teacher in Jacksonville, FL.
On their 2015 and 2016 joint income tax return petitioners claimed Schedule A deductions for their various businesses expenses which included vehicle expenses, meals and entertainment expenses, tool and supply expenses, uniform expenses, other business expenses, and medical expenses. The petitioners also claimed Schedule C deductions for business use of home, meals and entertainment, supplies, repairs and maintenance, legal and professional services, insurance, utilities, office, car and truck, travel, and mortgage interest. Mrs. Patitz did not provide any records, bank statements, itemized receipts, or credit card statements substantiating her 2015 or 2016 Schedule C expenses. Additionally, petitioners only substantiation of their Schedule A expenses were contemporaneous mileage logs while travelling, certain bank statements and receipts relating to Mr. Moody’s teaching expenses, and receipts for certain medical expenses on behalf of wife’s father, as well as some medical expenses incurred for themselves. At trial petitioner admitted receiving financial assistance from other family members for her father’s medical expenses.
On August 6, 2018, an IRS agent made the initial determination to assert accuracy-related penalties for 2015 and 2016, and on August 7, 2018, the agent’s immediate supervisor approved the penalty. IRS issued the Notice of Deficiency on November 7, 2018. The Notice of Deficiency disallowed all Schedule A deductions and applied the standard deduction to petitioner’s 2015 return. IRS also disallowed $19,534 of deductions petitioners claimed on their 2016 Schedule A and disallowed all deductions claimed on Schedules C for 2015 and 2016. IRS asserted accuracy-related penalties for substantial understatements of tax under section 6662(a) and (b)(2) for both years. The issues for decision were whether petitioners were (1) entitled to Schedule A deductions for 2015 and 2016, (2) entitled to Schedule C deductions for 2015 and 2016, and (3) liable for accuracy-related penalties under section 662(a) for 2015 and 2016.
- The taxpayers were entitled to Schedule A deductions for 2015 and 2016 for vehicle mileage on behalf of their respective employers.
- The taxpayers were denied a deduction for all other Schedule A employee expenses because there was insufficient evidence in the record to substantiate the deductions.
- The taxpayers were denied a deduction for Schedule A medical expenses related to wife’s father because record had insufficient evidence to substantiate the medical expense deductions.
- The taxpayers Schedule C deductions were denied because Mrs. Patitz did not submit any business records, accounting records, bank statements, or credit card statements to substantiate reported expenses.
- The Court rejected petitioners’ argument that they were unable to provide documentation, such as receipts and financial statements, that could substantiate their Schedule A and Schedule C expenses because credit card accounts had been closed as a result of fraud, some boxes containing potential statements were left behind from moving three times in 2015, and the documents were destroyed from Hurricane Matthew water damage.
- Petitioners were liable for the accuracy-related penalty because they did not meet their burden to show reasonable cause because they did not offer any corroborating evidence to substantiate expenses and the Court was unconvinced that they were unable to account for their alleged lost and inaccessible documents that the taxpayers alleged were lost as a result of Hurricane Matthew water damage.
Key Points of Law:
- Under section 162(a), a deduction is allowed for ordinary and necessary expenses pair or incurred during the taxable year in carrying on any trade or business. However, the deduction is not available for personal, living, or family expenses. See 262(a). Whether an expenditure satisfies the requirements for deductibility under section 162 is a question of fact.
- An ordinary expense is one that commonly or frequently occurs in the taxpayer’s business, Deputy v. du Pont, 308 U.S. 488, 495 (1940), and a necessary expense is one that is appropriate and helpful in carrying on the taxpayer’s business, Commissioner v. Heininger, 320 U.S. at 471; Treas. Reg. § 1.162-1(a).
- A taxpayer claiming a deduction in a federal income tax return must demonstrate that the deduction is allowable pursuant to the Internal Revenue Code and must further substantiate that the expense to which the deduction relates has been paid or incurred. See 6001; Treas. Reg. § 1.6001-1(a).
- A taxpayer must substantiate deductions claimed by keeping and producing adequate records that enable the Commissioner to determine the taxpayer’s correct tax liability. See 6001; Hradesky v. Commissioner, 65 T.C. 87, 89-90 (1975).
- If a taxpayer establishes that he has paid or incurred a deductible expense but cannot adequately substantiate the amount, the Court may estimate the amount and allow a deduction to the extent there is a reasonable basis to support the estimate. See Cohan v. Commissioner, 39 F.2d 540, 543–44 (2d Cir. 1930).
- Even if an expense may be otherwise deductible, taxpayers must satisfy the stringent substantiation requirements of section 274(d) for certain categories of expenses, including travel expenses, meals and lodging while away from home, and expenses with respect to listed property as defined in section 280F(d)(4), which includes passenger automobiles. See Sanford v. Commissioner, 50 T.C. 823, 827 (1968), aff’d per curiam, 412 F.2d 201 (2d Cir. 1969).
- For purposes of substantiating an expense under section 274, Temp. Treas. Reg. § 1.274-5T(c)(2) provides in relevant part that “adequate records” generally consist of an account book, diary, log, statement of expenses, trip sheet, or similar record made at or near the time of the expenditure or use, along with supporting documentary evidence. The court may not estimate expenses covered by section 274(d).
- If a taxpayer’s records are lost or destroyed through circumstances beyond his or her control, he or she may substantiate expenses through reasonable reconstruction. See Boyd v. Commissioner, 122 T.C. 305, 320 (2004); Temp. Treas. Reg. § 1.274-5T(c)(5).
This case illustrates the importance of maintaining proper documentation for Schedule A and Schedule C expenses that are claimed on a return. Aside from adequately documenting vehicle mileage through contemporaneous logs and satisfying the strict requirements of section 274(d), the taxpayers did not provide the court with any other evidence to substantiate the expenses to which the other Schedule A and Schedule C expenses related. The Court was unpersuaded by the taxpayers’ argument that they couldn’t provide evidence of the expenses because they were lost for various reasons including that they were damaged from Hurricane Matthew flooding. A taxpayer’s argument that records or evidence that could have been used to substantiate an expense was lost is unlikely to be successful in today’s digital world where every type of account has electronical statements available.
Taxpayers have a greater ability to reconstruct records today than in any time in the past. In the absence of evidence to substantiate the taxpayer’s various claimed expenses the law required the court to sustain the Commissioner’s disallowances. In addressing the accuracy-related penalty and whether the petitioners met their burden to show reasonable cause, the court noted that the petitioners’ failure to provide documentation or detailed accounts of the water damage from Hurricane Matthew nor did they provide any documents to substantiate their claim related to credit card fraud which prohibited them from recovering statements. The court’s mention of these items suggests that the petitioners may have been able to meet their burden to show reasonable cause if they presented some evidence or testimony regarding flooding they experienced because of Hurricane Matthew or that they had been the victim of credit card fraud.
So, even if a taxpayer cannot reconstruct the record for reasons outside of its control, the taxpayer may be able to show reasonable cause to avoid the accuracy-related penalty if it can provide substantiating evidence demonstrating what occurred that prohibits the taxpayer from reconstructing the documentation that could otherwise substantiate the expense at issue.
Have a question? Contact Jason Freeman, Freeman Law, Texas.
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