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.

 

 

 

2 thoughts on “Substantiating Your Business Expenses Is Critical to Keeping Them

    • Receipts are required for lodging expenses and other items. Substantiation also requires that you document the “business purpose” of any business expense. Example: not only should
      you have a motel/hotel receipt for out-of-town lodging expense but you will also need a contemporaneous record (separate journal or at least documented on the lodging receipt) to document
      the reason or business purpose for incurring the lodging expense. Standard mileage is also documented in a mileage log or journal and must also include an explanation of business purpose.

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