Article by By Annette Nellen, Esq., CPA, CGMA | Featured on The Tax Adviser
Every year a few taxpayers go to court hoping for a better outcome than the one offered by the IRS. Usually, they lose due to poor records, not meeting all requirements for particular deductions, or inadequately separating business from personal expenditures. This article examines a few 2015 cases involving these issues and makes suggestions for practitioners to remind clients that they need timely records and should only report allowable deductions.
Legitimacy and realism
In Chen, T.C. Memo. 2015-167, the Tax Court upheld the IRS’s assessment of tax and penalty totaling over $22,000 for three tax years. In 2009, taxpayers, a married couple, formed an LLC involved in biotech with the husband as the sole shareholder. For the years involved, the LLC had no revenues or clients. Deductions the IRS and the court denied included:
- Wages of almost $10,000 paid to the taxpayers’ two 11-year-old children for office cleaning and organizing. The taxpayers submitted Forms W-2, Wage and Tax Statement, to the IRS for their “wages.” The deduction was denied because the taxpayers did not prove that the children were actually paid or performed work for the LLC.
- Car and truck expenses were denied due to lack of records required under Sec. 274(d). There was no record of mileage, time and place, or business purpose.
- Home office expenses were denied as there was no proof they had a home office. Yet, they claimed some household expenses, such as utilities, which would be permissible only if there was an office used regularly and exclusively in a business. Although the taxpayers told the IRS that their entire personal residence was used to operate the LLC, the LLC’s records at the Maryland Department of Assessments and Taxation listed a different address for its principal office.
- Other expenses were denied because they were claimed in the wrong year, and many appeared to be for personal purposes, such as purchases at Macy’s, Hair Cuttery, and music stores. The taxpayers also depreciated their children’s musical instruments and deducted their day care expenses as employee benefits.
Accuracy-related penalties were upheld as the court found that the taxpayers were negligent in not keeping accurate books and “not exercising reasonable care given the circumstances.”
In Flying Hawk, T.C. Memo. 2015-139, the IRS challenged expenses claimed over two years by a taxpayer who was an accountant and provided tax preparation and other services. She had an office, but she claimed she also used her residence and a house trailer for client work. She claimed expenses for both homes on her Schedule C, Profit or Loss From Business. She also claimed mileage on a car she owned as well as mileage on a car she neither leased nor owned. Some of her Schedule C expenses were for health products. The court agreed with the IRS’s disallowance of many of these expenses and also that she did not use her home office as her principal place of work; that she did not use it to meet clients; or that it was a separate structure, one of which must be present to take the deduction.
Although the IRS allowed a portion of the car expenses for the car she owned, despite having no records, the taxpayer argued she used the car 100% for business. At trial, she conceded that she used the car 5% of the time for personal use, including taking her father to the doctor. She later claimed, though, that she used his car for those trips. The court did not find her credible.
The court noted that taxpayers may claim mileage allowance on up to four vehicles under Rev. Proc. 2006-49 (rather than only one as the IRS argued), but this did not help the taxpayer get expenses for the second car because she did not show that she owned or leased that vehicle, which is a requirement to deduct the standard mileage rate because it includes depreciation. The taxpayer claimed this car was used 100% by her worker, but she had no Form W-2 or Form 1099 to support the position that the person who drove the car was employed by her and she did not reimburse the person for any business miles driven.
Deductions for business gifts were also denied because the taxpayer’s documentation included only “marked-up credit card statements” with the notations made about one year after she received the statements. Thus, the substantiation was “not prepared at or near the time of the gift” as required.
With one exception for payroll funds the taxpayer handled for a client, the court agreed that she was subject to negligence penalties.
Another recent case where deductions were lost due to poor records and not following all requirements for a deduction was Grossnickle, T.C. Memo. 2015-127. Despite receiving Forms 1099-MISC, Miscellaneous Income, exceeding $10,000 each year, the taxpayer did not file a return for 2010 believing she did not have sufficient income. The IRS agreed to some expenses but challenged others. Disallowed expenses included for a home office, phone and internet access, and business mileage. The court agreed, finding that the taxpayer did not have proper records to substantiate the expenses.
For the home office, the taxpayer claimed she paid rent to use a room in her sister’s home. One piece of documentation was a Google aerial picture of the house with notations on it, but no proof of regular and exclusive use was provided. For the mileage, the court reminded the taxpayer that Sec. 274(d) requires her to:
[S]ubstantiate by adequate records: (1) the mileage; (2) the time and place of the use; and (3) the business purpose of the use. … Substantiation by adequate records requires the taxpayer to maintain an account book, a diary, a log, a statement of expense, trip sheets, or a similar record prepared contemporaneously with the use or expenditure and documentary evidence (e.g., receipts or bills) of certain expenditures. [T.C. Memo. 2015-127 at *12]
Need for a bookkeeping lesson
In addition to recordkeeping problems, Rochlani, T.C. Memo. 2015-174, involved a somewhat humorous story of a 16-year-old incorporating his parents’ business. In 2006, the taxpayer, a full-time engineer, started a business called Ultimate Presales (UP), which bought and resold tickets for concerts and sporting events. In 2006, without his parent’s permission, their 16-year-old son incorporated UP in Michigan using an online legal service. The son did not know about differences between types of business entities. When the paperwork arrived, the father took no action to undo his son’s actions and filed corporate annual reports for UP.
The parents and two sons traveled around the country to buy and resell tickets. Since the finances were handled through personal accounts, the mother closed UP’s bank account because it was never used. No travel logs were kept; credit card statements were used to reconstruct expenses.
The parents reported UP’s activities on Schedule C. Upon audit, the IRS removed the Schedule C and asserted that UP was a C corporation. The father passed away before the case was heard in court.
The court found that UP was a legitimate business, but it still had to decide the issue of whether it was a sole proprietorship as the taxpayers reported or a C corporation because of the incorporation. While the minor son was not authorized to incorporate UP, once the father followed through on his actions, it was valid. The court dismissed the taxpayers’ argument that the corporation had no books or accounts and therefore should not be respected, citing Moline Properties, 319 U.S. 436 (1943). The court also upheld the imposition of penalties for substantial understatement of tax should the IRS’s calculation of the tax the C corporation owed result in an understatement under Sec. 6662(d)(1)(A).
Two recent cases involved sellers of medical marijuana. Olive, 792 F.3d 1146 (9th Cir. 2015), aff’g 139 T.C. 19 (2012), involved a seller of medicinal marijuana with missing and unreliable records. Because marijuana is a controlled substance, Sec. 280E mandates that a seller may reduce gross receipts only by the cost of goods sold; nothing else is deductible. Based on expert testimony, the Tax Court estimated that 75.16% was a “reasonable measure” of the taxpayer’s cost of sales. The court further adjusted this percentage to address inventory given to customers for free or withdrawn for personal use.
The court rejected the taxpayer’s argument that Sec. 280E did not apply to medical marijuana dispensaries because they did not exist when Congress enacted Sec. 280E. The Ninth Circuit noted that marijuana is still a controlled substance under federal law and that if Congress wanted a different result today, it could change the statute.
In Beck, T.C. Memo. 2015-149, the taxpayer was assessed tax for 2007 of just over $1 million, as well as an accuracy-related penalty of almost $210,000. The IRS concluded that the taxpayer did not properly follow Sec. 280E; claimed as cost of sales marijuana seized by the Drug Enforcement Administration; and did not pay self-employment tax. The court upheld the IRS’s assessments.
The taxpayer had no records to prove a deduction of $600,000 for the seized drugs. The failure to substantiate led the court to disallow these amounts in the cost of sales. The court noted though, that even with substantiation, “the seized marijuana would still not be allowable as COGS because the marijuana was confiscated and not sold” (T.C. Memo. 2015-149 at *18).
The court disallowed a Sec. 165 loss for the seized drugs because of Sec. 280E. According to the court, “no deduction or credit (including a deduction pursuant to section 165) shall be allowed for any amount paid or incurred in connection with trafficking in a controlled substance.”
Finally, the court upheld penalties because the taxpayer “intentionally destroyed most of the inventory and sales records related to his … dispensaries” and also did not keep adequate records to support items reported on his Schedule C and underreported his income.
Advice for clients
While the cases summarized here do not provide new legal interpretations, the fact patterns and the adverse holdings for taxpayers offer lessons and reminders for business owners that CPAs may find appropriate to share with their clients:
- Taxpayers lacking records or with incomplete records or who treat personal expenses as business expenses will have those deductions disallowed. Invalid and unsubstantiated expenses, of course, should never be included in the information provided to the return preparer.
- Keep separate bank accounts and credit cards for business and personal expenses.
- Employing your children can provide tax benefits and helpful experience but needs to be legitimate work. A good rule regarding the appropriate age might be whether any other business would hire the children.
- Beyond the application of Sec. 162, some expenses require additional records such as home office expenses (Sec. 280A) and travel, gifts, and entertainment (Sec. 274(d)).
- Per Rev. Proc. 2010-51, Section 4.05(1), the standard mileage rate may not be used for more than four vehicles a taxpayer owns or leases.
- Many aspects of operating a marijuana business allowed under state law present problems for the operator and the tax adviser. These operations are illegal under federal law, and Sec. 280E prohibits any deductions (only cost of goods sold is allowed). If the operations follow the approach in the Beck case and destroy most records daily, determining gross receipts and cost of sales will be difficult. These businesses are usually all cash without a bank account because banks will not do business with them, adding further challenges. Efforts still need to be made, though, to properly measure gross receipts and cost of sales.
The cases summarized involve long-standing problems for individual taxpayers who claim business deductions. One unfavorable change from past decades is that people tend to be busier, leaving less time for adequate recordkeeping. A positive change, though, is the availability of various apps and software programs to simplify recordkeeping that may also be assisted by electronic records maintained by suppliers. One fact that remains unchanged today is that regular visits and conversations with clients are likely to catch poor recordkeeping procedures and improper expenses before they create filing problems.
Annette Nellen, Esq., CPA, CGMA, is a tax professor and director of the MST Program at San José State University. She is an active member of the tax sections of the AICPA, ABA, and California State Bar. She is a member of the AICPA Tax Executive Committee and Tax Reform Task Force. She has several reports on tax policy and reform and maintains the 21st Century Taxation blog .
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