Are Your Business Deductions at Risk of Being Disallowed by the IRS?

by M. Robinson & Company, P.C.
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Small businesses run on tight margins. The last thing a business owner wants is an IRS notice announcing the disallowance any of their business expense deductions. This is particularly the case for sole proprietorships who report their business expenses on Schedule C of IRS Form 1040. For instance, deductions on Schedule C not only reduce reportable business income, but also impact the amount of self-employment tax owed by the sole proprietor taxpayer.

Pokawa v. Commissioner

A recent case, Pokawa v. Commissioner, T.C. Memo. 2017-186 (September 21, 2017), stands as a classic example of a “what-not-to-do” for small businesses deducting business expenses. In this case, the U.S. Tax Court mostly upheld the disallowance of substantially all business expenses by the IRS. Here’s the background:

In taxable years 2013 and 2014, the married taxpayers owned a number of small businesses, including a tax preparation service. In total, the taxpayers claimed more than $130,000 in business expense deductions on Schedule C for both years and all businesses. As a result, the taxpayers reported a Schedule C losses of almost $70,000 in 2013 and about $5,000 in 2014.

The IRS reviewed the taxpayers’ returns and sent them a notice of deficiency, which disallowed all business expense deductions for 2013 and all but about $2,500 of the deductions for 2014. Whether the taxpayers operated bona fide businesses was never at question. Instead, the disallowance of deductions by the IRS was because of the taxpayers’ “failure to establish that these amounts were (1) paid or incurred (2) during the relevant taxable year (3) as ordinary and necessary business expenses.”

In response, the taxpayers provided “scant” documentation to support their deductions. They claimed that the lack of documentation was due to a flood in their building. However, aside from their own testimony, they had no evidence of a flood occurring. Nor did they attempt to reconstruct some of their expenses. Reconstruction can often be done by obtaining bank records or contacting third-party payees, such as property managers, insurance companies and utility companies. When the case was decided, except for some estimated rent and utilities expenses for just one of the small businesses, the Tax Court upheld the disallowance of deductible expenses by the IRS.

This was an unfortunate outcome for the taxpayers. The taxpayers’ income was increased for both tax years as a result of the business expense deduction disallowance. Additionally, penalties and interest also applied. However, the text of this case provides good insights on how other small business owners can avoid full disallowance of business expenses and withstand IRS scrutiny.

Case Takeaways for Other Sole Proprietors of Small Businesses

  1. Don’t treat business expense deductions as a “gimme.” It’s very easy for the IRS to disallow business expense deductions. First of all, if the IRS sends a notice of deficiency to a taxpayer, normally, it will be presumed as correct by the courts, unless the taxpayer can prove the IRS made an error. Next, the existence of these deductions arises through what’s called “legislative grace.” This means that a taxpayer is only permitted those specific deductions that Congress has deemed deductible and to which the taxpayer can prove they are entitled.
  • Ordinary and Necessary Business Expenses: In general, this refers to “ordinary and necessary” business expenses. The Tax Court pointed out in its memorandum that “ordinary “refers to expenses that are a common or frequent occurrence in the conduct of a certain type of business. Meanwhile, “necessary” refers to those expenses that are “appropriate and helpful to a taxpayer’s business.”

2. Proving entitlement to deductions requires substantiation of business expenses by the taxpayer. Basically, this boils down to good recordkeeping, which the Tax Court explained consists of “…keeping and producing adequate records that enable the Commissioner to determine the taxpayer’s correct tax liability.” This includes documents such as invoices, receipts, and canceled checks.

How you keep the documentation isn’t prescribed by the IRS; keeping your receipts in a shoebox may be appropriate. Just remember the better organized you are, the faster you can resolve your issues with the IRS.

3. If you can’t fully substantiate, estimates of the business expenses may be permitted. Let’s say you kept your documentation of business expenses in a shoebox, which was stored in a closet so they didn’t get lost. One day water pipes running through that closet burst and the shoebox and its contents are ruined. All is not lost; you may be able to provide acceptable estimates of those expenses. This is referred to as the Cohan Rule. However, the taxpayer needs to provide evidence that they have a sufficient basis for making the estimate.

  • Important Note: Not all expenses can be estimated. In particular Section 274(d), prohibits deductions for the following business expenses without substantiation:
    • Travel, including meals and lodging,
    • Activities that constitute entertainment, amusement or recreation
    • Expenses for gifts, or
    • Expenses related to listed property as defined under Section 280F(d)(4) (such as passenger automobiles).

4. It’s not just the disallowance of the business expense deductions at stake, it’s also about exposure to Section 6662 penalties. Under Section 6662, the IRS can impose a 20% accuracy-related penalty for the portion of the underpayment of taxes attributable to a number of issues, such as negligence, substantial understatement of income tax – or both as they did in this case.[1] In Pokawa, it was pointed out that negligence can exist if the taxpayer failed to maintain adequate recordkeeping or if they cannot substantiate deductions properly.

  • Possible Reasonable Cause and Good Faith Relief: There may be relief for this penalty if it can be established through facts and circumstances that the taxpayer acted with reasonable cause and in good faith. This sounds easier than it is because reasonable cause and good faith must be established under IRS requirements. The better thing to do is to set up good recordkeeping procedures from the start.

5. If the reconstruction effort is overwhelming, consider getting help. The taxpayers in the above case represented themselves “pro se.” They did not have legal counsel represent them, nor does it appear from the text of the Tax Court memorandum that they had an independent tax professional assist them in preparation of documents for the trial.

As the saying goes, this may have been penny wise and pound foolish. At stake were more than $130,000 in Schedule C business deductions as well as another $30,000 in unreimbursed employee business expense deductions. With more than $160,000 in business-related deductions in dispute, the taxpayers might have been benefited from at least a consultation with a tax professional or tax attorney as part of trial preparation.

Such a consultation may have determined if there was a reasonable basis for reconstructing qualified business expenses incurred in the tax years at issue. It may also have helped in establishing the elements of a reasonable cause and good faith argument to avoid or mitigate the imposition of penalties under Section 6662.

 

[1] As long as the total penalty rate does not exceed 20%.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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