Substantiation – The Key To Tax Deductions

Overview

The IRS has specific rules for claiming deductions on a tax return.  Those rules differ depending on the type of deduction claimed and the Code section at issue.  In all circumstances, substantiation of the claimed deduction is critical.  How that substantiation must occur is what differs depending on the type of deduction being claimed.  Is it a business expense?  Is it a charitable deduction?  Is some other type unique expense for which a deduction can be legitimately claimed?  It’s important to know the rules that apply.

Substantiating deductible expenses – it’s the topic of today’s post.

Charitable Deductions

Regulations - TD 9836. Substantiation and Reporting Requirements for Cash and Noncash Charitable Contribution Deductions (Jul. 27, 2018).  In 2008, the Treasury issued proposed regulations governing the tax reporting of charitable contributions.  In 2018, the Treasury finalized those regulations with only slight modification.  Under the final regulations, a donor must maintain records of charitable contributions. For cash contributions, the donor must retain a canceled check, or other reliable written record showing the donee’s name, date of contribution and amount. While some charitable organizations provide a blank form for donors to complete, the Preamble to the final regulations specify that a blank form is insufficient to satisfy record keeping requirements for tax purposes to substantiate the donation. For contributions over $250, the donee organization must provide a contemporaneous written acknowledgment of the gift. I.R.C. §170(f)(8). In addition, the final regulations state that a donor may be required to complete and submit a Form 8283, depending on the type of gift and the amount. The Preamble to the final regulations provides that the Form 8283 itself does not meet the contemporaneous written acknowledgment requirement. Rather, a separate written acknowledgment is required.

The final regulations note that appraisals are required for non-money contributions over $5,000, and state that an appraiser can meet the requisite education and experience requirements by successfully completing professional or college-level coursework. But mere attendance is not sufficient, and evidence of successful completion is required. For contributions exceeding $500,000 in value, the appraisal must be attached to the donor’s income tax return. Under the final regulations, the appraisal is not attached just to the return of the contribution year but must also be attached to any return involving a carryover year (due to the limitation on the charitable contribution deduction). 

Conservation easement donations.  The rules for claiming a charitable deduction for a contributed permanent conservation easement to a qualified land trust are also particular.  I have written about those requirements in previous posts, and there continue to be cases that point out just how particular those rules are. 

Recent cases.

 Loube v. Comr., T.C. Memo. 2020-3.  In this case a married couple was denied a charitable deduction for gifts of property.  The couple bought a house on .38 acres with the purpose of demolishing the house and building a new residence on the tract. To further that purpose, they entered into an agreement with a charity to perform the deconstruction of the existing house and donate personal property in the home to the charity. An appraiser determined that the cost to reproduce the house would be $674,000. After subtracting labor costs and other fees, as well as profit for a construction company and the cost of new material cost and depreciation, the resulting fair market value for the deconstructed house was determined to be $297,000.

On their 2013 return, the couple claimed a $297,000 non-cash charitable contribution deduction for the donation of the improvements to the charity. On the appraiser summary attached to the return, the petitioners identified the donated property as “other” and noted that the “house improvements” were in “excellent” condition. However, the appraisal form did not indicate the date of the donation or the petitioners’ cost basis in the improvements. In addition, the appraiser did not sign the appraisal form.

The IRS denied the deduction on the basis that the appraisal did not appraise each donated item separately. The Tax Court upheld the IRS position and also noted that the petitioners did not strictly comply with Treas. Reg. §1.170A-13 which specifically required the petitioners to provide sufficient information to evaluate their reported contributions. The Tax Court held that basis was an important factor that needed evidentiary support. The Tax Court also noted that the petitioners failed to denote the contribution date or provide a reasonable cause explanation for their inability to provide basis information. 

TOT Property Holdings, LLC v. Comr., Docket No. 005600-17 (U.S. Tax Ct. Dec. 13, 2019).  The petitioner engaged in a syndicated easement transaction whereby it made a $6.9 million charitable contribution for an easement on 637 acres of a 652-acre parcel donated to a land conservancy. The IRS denied a charitable deduction due to the easement deed not satisfying the perpetuity requirement and imposed a 40 percent gross valuation misstatement and negligence penalties. The Tax Court agreed, determined that the actual value of the easement donation was less than 10 percent of what was originally reported on the petitioner’s return. In the process, the Tax Court gave more credibility to the approach of the appraiser for the IRS. 

Presley v. Comr., No. 18-90008, 2019 U.S. App. LEXIS 32018 (10th Cir. Oct. 25, 2019, aff’g., T.C. Memo. 2018-171. The petitioner claimed a charitable deduction in 2010 for over $107,000 attributable to land improvements to property that a charity owned. The improvements occurred over several years and were made by the petitioner’s LLC. The petitioner did not claim any charitable deductions in the years that the improvements were made. The IRS denied the deduction and the Tax Court agreed. The petitioner conceded that the did not own the improvements, and the Tax Court noted that the petitioner could not claim the deduction in 2010 because the improvements were paid for in years preceding 2010. In addition, the Tax Court noted that even if the improvements had been paid for in 2010, the amounts that the LLC paid for were not directly connected with or solely attributable to the rendering of services by the LLC to the charity as Treas. Reg. §1.170A-1(g) requires. In addition, the Tax Court determined that the petitioner did not satisfy the substantiation requirements and did not include Form 8283 and did not have an appraisal of the improvements made as required when a charitable deduction exceeding $5,000 is claimed. 

Business-related deductions. 

Gebman v. Comr., T.C. Memo. 2020-1.  In this case, the petitioners (a married couple) claimed a large net operating loss (NOL), but failed to file with the return a concise statement detailing the amount of the NOL claimed and all material facts relating to the NOL including a schedule showing how the NOL deduction was computed. The IRS rejected the NOL deduction and the Tax Court agreed. The Tax Court noted that the petitioners bore the burden to substantiate the claimed deduction and that the petitioners had provided no detailed information supporting the NOL. The Tax Court also noted that the petitioners bore the burden of proof to establish both the existence of the NOLs for prior years and the NOL amounts that can be carried forward to the years at issue. The petitioners did not satisfy these requirements either. The only “proof” the petitioners had was submitted copies of tax returns on which they reported the losses. The Tax Court declined to hold that submitted copies of returns was sufficient substantiation. 

Taylor II v. Comr., T.C. Memo. 2019-102.  The petitioner claimed a casualty loss on the 2008 return (before the rules deducting casualty losses changed to what they are now) for damage from a hurricane. An insurance company paid over $2.3 million in claims, and the claimed deduction was $888,345. The petitioner reported a basis in the property of $6.5 million, insurance reimbursement of $2.3 million and a pre-casualty fair market value of $15,442,059 and a post-casualty fair market value of $12,250,000. The pre-casualty FMV was based on the 2009 listing price of the property reduced for time spent on the market. No testimony was provided as to post-casualty FMV. The Tax Court (Judge Paris) noted that to compute a casualty loss deduction, the pre and post-FMV values of the impacted property must be computed and the property basis must be established. The Tax Court noted that decline in value can alternatively be established via the regulations under I.R.C. §165 if the taxpayer has repaired the property damage resulting from the casualty, the taxpayer may use the cost of repairs to prove the loss of value to the property from the casualty. In that instance, the taxpayer must show that (a) the repairs are necessary to restore the property to its condition immediately before the casualty, (b) the amount spent for such repairs is not excessive, (c) the repairs do not care for more than the damage suffered, and (d) the value of the property after the repairs does not as a result of the repairs exceed the value of the property immediately before the casualty. The Tax Court noted that the record did not establish that the valuations were based on competent appraisals, and didn’t indicate how the petitioner’s CPAs determined the pre or post-casualty FMV of the property, even though the pre-casualty FMV was consistent with the value reported to the insurance company. The Tax Court concluded that the appraisals were not reliable measures of the taxpayer's casualty loss and didn’t rely on them. In addition, the taxpayer received insurance payments that exceed the cost of repairs. That meant that a casualty loss deduction couldn’t be claimed based on the regulations. The Tax Court disallowed any casualty loss deduction. 

Draper v. Comr., T.C. Memo. 2019-95. The petitioner operated a property development business through his C corporation, but failed to properly document the business purpose of some of the claimed expenses. The Tax Court, agreeing with the IRS, denied business expense deductions for numerous meals, entertainment and travel expenses. The Tax Court allowed current deductions for marketing and promotional expenses , but noted that some expenses involved the cost of bidding on a contract which were not currently deductible. In addition, the Tax Court determined that assets sold did not qualify for capital gain treatment, and that deductions claimed in one year that were recovered in another year (such as a refund of state income tax) had to be included in income in the received. 

Baca v. Comr., T.C. Memo. 2019-78.  The petitioner’s job required him to move and operate oil fracking equipment away from his home residence. He deducted the associated travel costs and the IRS disallowed the deductions. The Tax Court agreed with the IRS because the petitioner’s tax home had shifted due to the indefinite work position. The petitioner also owned multiple businesses for which deductions were claimed. The Tax Court also upheld the denial of the business-related deductions due to lack of documentation. Auto-related expenses were also denied due to a lack of a log or diary and the necessary detail for vehicle expense substantiation. Also disallowed was the petitioner’s expense method depreciation deduction for tools on the petitioner’s 2012 return because they were purchased and placed in service in 2011. The Tax Court also denied other expenses due to a lack of documentation or failure to show a business relationship to the expense including a deduction for contract labor because the petitioners could not show how much the worker was paid. 

Dasent v. Commissioner, T.C. Memo. 2018-202.  The petitioners, a married couple 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 took the position that the petitioners failed to report $25,622 of IRA distributions (and the associated penalty for early withdrawal). The IRS also determined that the petitioners 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. In addition, the court noted that the Cohan rule has no application to I.R.C. §274(d) expenses (e.g., travel and entertainment expenses, gifts and listed property which are subject to strict substantiation requirements). While the petitioners 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), that software was not the same as relying on professional tax advice. 

Hagos v. Comr., T.C. Memo. 2018-166.  The petitioner claimed deductions for uniforms, shirts, shoes, mileage and other expenses associated with his job as a driver for a ride sharing company. While the IRS allowed some deductions, many were disallowed due to lack of substantiation and the lack of supporting records. 

Wax v. Comr., T.C. Memo. 2018-63.  The petitioners, a married couple, claimed various deductions on behalf of their children as well as auto expenses and meal and entertainment expenses. However, the court held that they failed to meet the strict substantiation requirements of I.R.C. §274(d). They failed to show that the expenses for the children were bona fide or reasonable compensation relating to the value of the services provided. Expenses also failed to be separated between business-related and personal.

Conclusion

The cases are many and varied that point out just how important it is to properly substantiate deductions.  The substantiation rules differ depending on the type of deduction being claimed.  Good recordkeeping is essential and the failure to do so can make a return “low-hanging fruit” for the IRS to easily pluck.