Substantiating Your Business Expenses Is Critical to Keeping Them

By Gary A. Hensley, MBA, EA

By and large, the rules are straightforward:  the burden of substantiating the “income” of a taxpayer falls on the Internal Revenue Service (IRS) and the burden of substantiating expenses (or deductions) falls totally on the taxpayer.

The position of the IRS and their field revenue agents has been and will be inadequate or no expense documentation/substantiation equals no deduction.  The next recourse for the taxpayer is to go to IRS Appeals and argue that the revenue generated couldn’t have taken place without incurring “some” associated expenses (the Cohan Rule).  The results at the Appeals level varies widely in each case and, generally, the best case scenario is an allowance of “some” of the deductions claimed.  The expense of going to Appeals can more than offset whatever expenses are allowed by the appeals officer (especially if you retain professional representation).

Recent Court Decisions

Under Internal Revenue Code (IRC) section 274(d), for certain expenses, taxpayers are required to be able to provide specific detailed information to substantiate the expenses.

As demonstrated In the recent case of Garza, T.C. Memo. 2014-121, the result boiled down to an all-or-nothing proposition.  Without proper substantiation, no deduction is allowed for a Sec. 274(d) expense, even if the court believes that a legitimate expenditure was made.

Sec. 274(d) identifies four classes of expenses for which specific substantiation is required:

  • Sec. 274(d)(1) for travel expenses (including meals and lodging while away from home);
  • Sec. 274(d)(2) for any item with respect to an activity that is of a type generally considered to constitute entertainment, amusement, or recreation, or with respect to a facility used in connection with such an activity;
  • Sec. 274(d)(3) for business gifts (which are limited to $25); and
  • Sec. 274(d)(4) for expenses with respect to any listed property (as defined in Sec. 280F(d)(4)).

In Garza, the court said that “while we believe that petitioner had business travel expenses in relation to his employment, the Court must heed the strict substantiation requirements of section 274(d).”  To support its ruling, the court cited DeLima, T.C. Memo. 2012-291, in which the Tax Court indicated that it had no doubt that the taxpayer used a vehicle for business purposes, but it was bound to deny the vehicle expense deduction because she failed to follow the requirements of Sec. 274(d) and the regulations.

Substantiation Required

Sec. 274(d)(4) requires the taxpayer to substantiate “by adequate records or by sufficient evidence corroborating the taxpayer’s own statement”:

  • The amount of the expense or other item;
  • The time and place of the travel, entertainment, amusement, recreation, or use of the facility or property, or the date and description of the gift;
  • The business purpose of the expense or other item; and
  • The business relationship to the taxpayer of persons entertained, using the facility or property, or receiving the gift.

In light of the above requirements, the message from the above paragraph is that “a taxpayer’s own statement” by itself is not sufficient in the IRS’s consideration of whether to allow a deduction.  As Garza and other cases show, the IRS and the courts look for contemporaneous records with the details listed above and, without it, they may disallow the deduction.

Taxpayers and their tax advisers need to understand what type of substantiation is required to take a deduction (with a solid foundation) on a tax return.

 

 

 

Warning! Form 1099-MISC and Payments to LLCs

By Gary A. Hensley, MBA, EA

Most of you are aware that you need to issue a Form 1099-MISC to independent contractors you paid $600 or more for services (not goods) during 2014 no later than February 2, 2015 (also you send a copy to the IRS by March 2, 2015).  The payments reported cover only those payments made in the course of your trade or business.

Many entrepreneurs believe (incorrectly) that if a vendor has LLC or L.L.C. after their company name (meaning limited liability company) that no Form 1099-MISC is required to be sent.  Compounding this belief?  The member(s) of many LLCs will tell those that they have rendered services to that it isn’t necessary or required to send them a Form 1099-MISC.  The requirement to file Form 1099-MISC is the government’s attempt to reduce the multi-billion underground (untaxed) economy.  Thus, if you are required to file a Form 1099-MISC and do not, a penalty will be assessed for each form not filed.  The penalty for not filing or filing late depends on the extent of tardiness.

A LLC can fall into three different categories:  (1) a single-member LLC which is a sole proprietorship (filing Schedule C as part of the individual’s personal Form 1040); (2) two or more members organized as a partnership LLC (filing Form 1065); and (3) one or more members filing as a corporate LLC (either a “C” corporation or a “S” corporation, filing Form 1120 or Form 1120-S, respectively).  Categories (1) and (2) should always be sent a Form 1099-MISC if they provided $600 or more in services to you in 2014.  With very few exceptions, you are not required to send Form 1099-MISC to category (3) organizations.  Most LLCs choose to be taxed as sole proprietors (commonly referred to as a “disregarded entity” in tax-speak) and partnerships.  When in doubt, send a Form 1099-MISC to all vendors you paid $600 or more for services in 2014.  There is no down side in doing so.

One exception that will be relevant to writers, literary agents and publishers:  Any amount you pay in royalties of $10 or more, in the course of your trade or business, requires you to send a Form 1099-MISC.  [Please refer to my article on properly reporting royalties.]

The following steps will help you nail down your compliance in this area:

  1.  Review all your payments for services to each vendor during 2014 and determine who received $600 or more in payments from you.
  2. Review your vendor records to determine if you have the complete name and address for those identified in step 1 above and also that you either have the vendor’s Social Security Number (SSN) or Employer Identification Number (EIN).  If you are lacking any of these critical items, you will need to mail a Form W-9 to the vendor requesting this information.  Keep a copy of the W-9 in your vendor file documenting your attempt to get the needed information along with the date you mailed it.  A USPS Certificate of Mailing is an inexpensive way to show proof of mailing.  In the future, obtain the W-9 information at the time you retain the vendor.  If the vendor refuses to furnish the information or sign the form—buyer beware!
  3. Next, you will use the official IRS Form 1099-MISC for each vendor.  The form is in triplicate with the top copy (shaded in red) going to the IRS and the other two copies going to the vendor and your vendor file.
  4. Finally, you will summarize your Form 1099-MISC information on IRS Form 1096 which you can mail to the IRS or file electronically along with the red copy(ies) of Form 1099-MISC.

You may wish to engage a local accountant or payroll processing specialist to help you with steps 3 and 4.

For additional IRS information on this topic, you may refer to IRS Form 1099 at the IRS website—www.irs.gov.

I hope this article will clarify your reporting requirements and further audit-proof your returns.