Deductions are a matter of legislative grace, and taxpayers bear the burden of proving entitlement to any claimed deduction.[i] A taxpayer must identify each deduction available, show that he or she has met all requirements therefor, and keep books or records that substantiate the expenses underlying the deduction.[ii] The mere fact that a taxpayer claims a deduction on an income tax return is not sufficient to substantiate the underlying expense.[iii] Rather, an income tax return “is merely a statement of the * * * [taxpayer’s] claim * * *; it is not presumed to be correct.”[iv]
Ordinary and Necessary Business Expenses. Internal Revenue Code Section 162(a) allows a taxpayer to deduct all ordinary and necessary business expenses paid or incurred during the taxable year. However, a taxpayer’s personal or living expenses are not deductible.[v] Pursuant to Code Sections 67 and 162(a), an employee taxpayer may deduct as miscellaneous itemized deductions all of the ordinary and necessary unreimbursable business expenses paid or incurred during the taxable year in carrying on the trade or business of the taxpayer’s employment.[vi] “To qualify as an allowable deduction under [section] 162(a) * * * an item must (1) be ‘paid or incurred during the taxable year,’ (2) be for ‘carrying on any trade or business,’ (3) be an ‘expense,’ (4) be a ‘necessary’ expense, and (5) be an ‘ordinary’ expense.”[vii] An expense satisfies the second element only if it is “directly connected with or pertaining to the taxpayer’s trade or business.”[viii] An expense qualifies as necessary if it is “appropriate and helpful” to the taxpayer’s business[ix] and as ordinary if the underlying transaction is a “common or frequent occurrence in the type of business involved.”[x] A taxpayer must establish these essential elements with credible evidence.[xi]
Personal Expenses Not Deductible. While business expenses are generally deductible, personal, living, and family expenses are typically nondeductible.[xii] A business expense claimed as a deduction must be incurred primarily for business rather than personal reasons.[xiii] Where an expense exhibits both personal and business characteristics, the “test requires a weighing and balancing of all the facts * * * bearing in mind the precedence of section 262, which denies deductions for personal expenses, over Section 162, which allows deductions for business expenses.”[xiv]
Personal / Business Expenses. In the personal/business context, a taxpayer must provide evidence from which the government can reasonably apportion the expenses between business and personal use. A taxpayer must generally have “adequate records” for all his or her claimed deductions, and has to have extra evidence for some deductions (the ones listed in Section 274(d)).[xv] While it is within the purview of a Court to estimate the amount of allowable deductions where there is evidence that deductible expenses were incurred, there must be some basis on which an estimate may be made.
Approximations of Expenses. Under Cohan v. Commissioner[xvi], if a taxpayer claims a deduction but cannot fully substantiate the expense underlying the deduction, the Court may generally approximate the allowable amount, bearing heavily against the taxpayer whose inexactitude in substantiating the amount of the expense is of his own making. The Court must have some basis upon which to make its estimate, however, else the allowance would amount to “unguided largesse.”[xvii]
If a taxpayer’s records are lost or destroyed because of circumstances beyond his control, the taxpayer may instead substantiate the expenses with other credible evidence.[xviii] Here again, although the Court generally may estimate amounts, any estimate must have a reasonable evidentiary basis.[xix]
As we approach tax filing season, it must be remembered that taxpayers (and return preparers) are required to sign their return under penalties of perjury. Information set forth within the tax return must be as accurate and complete as possible – a tax return does not represent an offer to negotiate with the government.
The mere failure to possess all required substantiation should not preclude the ability to claim otherwise deductible expenses if there is a sufficient basis to estimate the amount of such expenses. Finally, acknowledging amounts estimated within the return as estimates should avoid a later difficult discussion regarding the failure to do so.
Form 8275 – Disclosure Statement. In closing, remember that information set forth on the IRS Form 8275 – Disclosure Statement not otherwise adequately disclosed elsewhere within the tax return can avoid certain penalties. Form 8275 is filed with the income tax return to avoid the portions of the accuracy-related penalty due to disregard of rules or to a substantial understatement of income tax if the return position has a reasonable basis. (See also IRS Rev. Proc. 2015-16 for information that can be disclosed elsewhere in the tax return).
[i] U.S. Tax Court Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992).
[ii] Roberts v. Commissioner, 62 T.C. 834, 836 (1974).
[iii] Wilkinson v. Commissioner, 71 T.C. 633, 639 (1979).
[iv] Roberts v. Commissioner, 62 T.C. at 837.
[v] Code Sec. 262.
[vi] Lucas v. Commissioner, 79 T.C. 1, 6 (1982).
[vii] Commissioner v. Lincoln Sav. & Loan Ass’n, 403 U.S. 345, 352 (1971).
[viii] Sec. 1.162-1(a), Income Tax Regs.
[ix] Welch v. Helvering, [*32] 290 U.S. at 113
[x] Deputy v. du Pont, 308 U.S. 488, 495 (1940).
[xi] See sec. 1.6001-1(a), Income Tax Regs.
[xii] Code Section 262(a).
[xiii] See Walliser v. Commissioner, 72 T.C. 433, 437 (1979).
[xiv] Sharon v. Commissioner, 66 T.C. 515, 524 (1976) (citing costs of commuting and ordinary clothing as examples of expenses helpful and necessary to an individual’s employment that are “essentially personal” and hence nondeductible), aff’d per curiam, 591 F.2d 1273 (9th Cir. 1978).
[xv] Section 272(d) generally provides “No deduction or credit shall be allowed– (1) under section 162 or 212 for any traveling expense (including meals and lodging while away from home), (2) for any item with respect to an activity which 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, (3) for any expense for gifts, or (4) with respect to any listed property (as defined in section 280F(d)(4)), unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating the taxpayer’s own statement (A) the amount of such expense or other item, (B) 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, (C) the business purpose of the expense or other item, and (D) the business relationship to the taxpayer of persons entertained, using the facility or property, or receiving the gift. The Secretary may by regulations provide that some or all of the requirements of the preceding sentence shall not apply in the case of an expense which does not exceed an amount prescribed pursuant to such regulations.
[xvi] Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930),
[xvii] Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957); Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985).
[xviii] See Malinowski v. Commissioner, 71 T.C. 1120, 1124-1125 (1979). But cf. sec. 1.274-5T(c)(5), Temporary Income Tax Regs., 50 Fed. Reg. 46022 (Nov. 6, 1985) (providing that for deductions governed by section 274, taxpayer may substantiate the deductions by a reasonable reconstruction of the expenditures or uses).
[xix] See Villarreal v. Commissioner, T.C. Memo. 1998-420, 76 T.C.M. (CCH) 920, 921-922 (1998).