Proper tax planning and tax preparation considerations require that taxpayers substantiate their tax deductions and document them. If these two steps are done, then most tax deductions will be sustained if audited by the IRS. Let’s take a peek at a court case that discusses what happens when substantiation and documentation are lacking (K.D. Humphrey, TC Memo. 2013-198, Dec. 59,619(M)).
Kenneth Humphrey claimed as deductions: legal fees incurred in connection with his employment; Medicare taxes, dental care, and the cost of a gym membership as medical deductions; charitable contributions; a home office where utility, Internet and cable expenses were claimed; business expenses such as business gifts, meal and entertainment expenses, auto expenses, cell phone, and computer expenses.
The disallowance of Humphrey’s deductions are presumed correct by the courts since deductions are a matter of legislative grace and taxpayers bear the burden of proving that they are entitled to the claimed deductions. In addition, a taxpayer must keep sufficient records to substantiate the deductions claimed.
Looking at the facts of this case illustrates what the IRS looks at and how taxpayers need to substantiate their deductions. Taxpayers who claim these deductions need to assess their documentation and whether they have sufficient substantiation to claim these deductions. Looking at the facts in this case . . .
- The legal fees were related to Humphrey’s employment and would be deductible as a miscellaneous itemized deduction subject to the 2% AGI floor. The problem was that although Humphrey had carbon copies of checks for such legal expenses, he could not corroborate most of the payments against his bank statements. The payments he could corroborate were less than the 2% limitation. Lesson learned: the IRS may ask the taxpayer to verify the deduction in multiple ways and bank statements showing the deductions are vital.
- Although Humphrey had carbon copies of check payments to his dental care provider, again he could not corroborate the payments with his bank statements. The gym membership was denied because the cost of the membership did not exceed that which he would normally spend for a gym membership . . . thus there was no medical expense component to this membership. Hmmm . . . carbon copies of checks that somehow never cleared the bank.
- Charitable contributions were denied because for any contribution of $250 or more the taxpayer must substantiate the contribution with a contemporaneous written acknowledgement of the contribution by the donee organization.
- The home office was denied because Humphrey failed to prove that the home office was for the convenience of this employer.
- Business gifts are limited to $25 per person per year and the taxpayer must show the cost of the gifts, the dates the gifts were made, descriptions of the gifts, the business purpose of the gifts, and the business relationship between the parties. The business gift deduction was denied.
- While Humphrey could provide monthly cell phone statements, he failed to meet the substantiation requirements of Code Sec. 274(d). The Tax Court also found that Humphrey was unable to prove that his computer was not used for personal use and his receipts for computer expenses lacked the substantiation requirements.
- Although Humphrey was able to produce some auto receipts, his auto expenses were denied because he failed to maintain a mileage log book and his records failed to state the business purpose of the expenses. It was also found that he was including his commuting mileage as business mileage.
Not only did Humphrey have to pay the IRS additional taxes, interest, and penalties for failure to timely pay, but he was liable for the Sec. 6662(a) accuracy-related penalty which is assessed when the taxpayer’s underpayment of income tax results from negligence or disregard of rules and regulations. He failed to show that he had consulted any professionals before claiming deductions without a reasonable basis, or that his underpayment was due to reasonable cause and good faith.
What was this taxpayer thinking when he took the IRS to court?
Note: Because each individual’s tax situation is different, if you want to learn more about the IRS’s substantiation requirements we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here. To learn more about various tax and business services, visit Tax Preparation Services and Small Business Accounting Services
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