Monday, December 17, 2018
A fundamental point about tax law is that deductions, especially those associated with a business, must be substantiated. In addition, given the complexity of the tax Code, it is often in the best interest of a small business owner or farmer/rancher to hire a professional tax preparer. Simply relying on tax software will not eliminate penalties that the IRS can impose if the tax liability is understated.
Substantiating deductions and the peril of self-prepared business returns – that’s the topic of today’s post.
A recent Tax Court case illustrates the necessity of properly substantiating business deductions. In Dasent v. Commissioner, T.C. Memo. 2018-202, the taxpayers were a married couple that claimed various business expenses on Schedule C. They self-prepared their return for 2014, the year in issue. Their Schedule C reported no gross receipts and total expenses of $28,173. They also claimed unreimbursed employee expenses of $23,931 on Schedule A. The IRS denied the Schedule C and Schedule A deductions and also asserted that the couple failed to report $25,622 of IRA distributions (and the associated penalty for early withdrawal). The IRS also determined that the couple failed to report $123,168 of cancelled debt income. The IRS also imposed a penalty for underpayment of tax associated with the substantial understatement of tax.
The Tax Court determined that the wife failed to provide sufficient evidence that she was engaged in a business with a profit motive. The Tax Court also concluded that the wife failed to substantiate any of the business expenses associated with the wife’s business and provided no means for the court to estimate those expenses under the Cohan rule.
The Cohan rule. What’s the Cohan rule? The rule comes from a 1930 decision of the U.S. Court of Appeals for the Second Circuit involving George M. Cohan. Cohan was an American entertainer, playwright, composer, lyricist, actor, singer, dancer and producer. He wrote, composed, produced and appeared in about 40 Broadway musicals (which means that I would never have heard of him had he not found himself the subject of a tax case!).
Mr. Cohan might have been a good entertainer, but he wasn’t so hot at keeping good records for his travel and entertainment expenses associated with his business activities. In Cohan v. Comr., 39 F.2d 540 (2nd Cir. 1930), the famous judge Learned Hand ruled for the IRS on numerous points but in the process set forth the principle that when the IRS asserts a tax deficiency in cases where the evidence clearly shows that some deduction should be allowed, the court can estimate those expenses. As a result, the court allowed Mr. Cohan to use estimates to establish his business expenses.
But, it’s not a sure thing when a taxpayer relies on the use of the Cohan rule to get deductions for expenses that haven’t been properly substantiated. There are numerous cases where the court has refused to use the rule. See, e.g., Sam Kong Fashions, Inc. v. Comr., T.C. Memo. 2005-157; Stewart v. Comr., 2005-212; Harlan v. Comr., T.C. Memo. 1995-309. That means that the burden remains on the taxpayer when records substantiating expenses are missing. In addition, under I.R.C. §274(d) (which was enacted after the Cohan decision) substantiation is required for travel, entertainment, business gifts and any expenses associated with “listed property” (a special classification for assets that can be used for both personal and business purposes). Indeed, in the present case, the Tax Court noted that the Cohan rule has no application to I.R.C. §274(d) expenses.
Other points of the case. The petitioners also claimed that they should not be subject to the 10 percent penalty for early withdrawal from their IRA because the withdrawn funds were used to pay for their daughter’s college tuition, The Tax Court, however, upheld the penalty because the petitioners failed to establish that the withdrawn funds were actually used to pay the daughter’s tuition. The Tax Court also upheld the imposition of a 20 percent penalty for substantial understatement of tax. On that issue, the Tax Court noted that the petitioners were college-educated and used a tax software (TurboTax). However, the Tax Court noted, tax software is not the same as relying on professional tax advice. The software only produces a result that is as good as the information that is input. The taxpayer must still understand tax law good enough to properly use the software.
Return Prep – Post TCJA
Given the increased complexity of many parts of the Code that the Tax Cuts and Jobs Act (TCJA) has introduced, self-prepared returns will be even more difficult for those taxpayers with a Schedule C or F business. That’s particularly true with respect to the new I.R.C. §199A, the 20 percent pass-through deduction for non-C corporate businesses. Some taxpayers may assume that they are entitled to a straight-up 20 percent deduction from their taxable income (some may even incorrectly assume it’s taken from gross income). While a full 20 percent deduction is possible, it’s not likely to be the case in many situations due to the presence of capital gain income, other types of non-qualified income, certain deductions, and income level. In addition, what about rental income? Is it business income or not? We won’t know the answer to that question (and numerous others) until the final regulations are issued. I.R.C. §199A is just one area of complexity added by the new law. Many other changes also apply, such as with respect to depreciation, that will make preparation of the return for taxpayers with businesses more difficult for 2018 as compared to prior years.
Properly substantiating business expenses is the key to claiming deductions for them. Don’t assume that the court will estimate them for you under the Cohan rule even if the expenses involved are those for which the rule could apply. The TCJA has ramped-up the complexity of return preparation (and planning) for those with small businesses (including farms and ranches). Relying on tax software will not be enough to eliminate penalties for an understatement of tax. This might be the year, for those that haven’t done so already, to hire a professional return preparer.