If you operate a business, or you’re starting a new one, you’ll need to keep records of your income and expenses. Specifically, you should carefully record your expenses to claim all the tax deductions to which you’re entitled. You’ll also want to make sure that you can defend the amounts reported on your tax returns in case you’re ever audited by the IRS.
While there’s no one correct method of business recordkeeping, there are strict rules when it comes to keeping records and proving that expenses are legitimate for tax purposes. Certain types of expenses, such as automobile, travel, meals and home office costs, require special attention because they’re subject to special recordkeeping requirements or limitations.
Below are two case studies that illustrate some of these issues.
Case Study 1: To claim deductions, an activity must be engaged in for profit
A business expense can be deducted if a taxpayer can establish that the primary objective of the activity is making a profit. The expense must also be substantiated, and be both an ordinary and necessary business expense. According to an IRS publication: an "ordinary expense" is one that is common and accepted in your industry. A "necessary expense" is one that is helpful and appropriate for your trade or business.
In one recent court case, a taxpayer claimed deductions that created a loss, which she used to shelter other income from tax. She engaged in various activities including acting in the entertainment industry and selling jewelry. The IRS found her activities weren’t engaged in for profit, and therefore disallowed her deductions.
The taxpayer took her case to the U.S. Tax Court, where she found some success. The court found that she was engaged in the business of acting during the years in issue. However, she didn’t prove that all claimed expenses were ordinary and necessary business expenses. The court did allow deductions for expenses including headshots, casting agency fees, lessons to enhance the taxpayer’s acting skills and part of the compensation for a personal assistant. But the court disallowed other deductions because it found insufficient evidence “to firmly establish a connection” between the expenses and the business.
In addition, the court found that the taxpayer didn’t prove that she engaged in her jewelry sales activity for profit. She didn’t operate it in a businesslike manner, spend sufficient time on it or seek out expertise in the jewelry industry. Therefore, all deductions related to that activity were disallowed.
Case Study 2: A business must substantiate claimed deductions with records
A taxpayer worked as a contract emergency room doctor at a medical center. He also started a business to provide emergency room physicians overseas. On Schedule C of his tax return, he deducted expenses related to his home office, travel, driving, continuing education, cost of goods sold and interest. The IRS disallowed most of the deductions.
As evidence in Tax Court, the doctor showed charts listing his expenses but didn’t provide receipts or other substantiation showing the expenses were actually paid. He also failed to account for the portion of expenses attributable to personal activity.
The court disallowed the deductions stating that his charts weren’t enough and didn’t substantiate that the expenses were ordinary and necessary in his business. It noted that “even an otherwise deductible expense may be denied without sufficient substantiation.” The doctor also didn’t qualify to take home office deductions because he didn’t prove it was his principal place of business.
These case studies are good examples of the need for meticulous recordkeeping when it comes to business expenses. Taking a proactive approach can protect your deductions and help make an audit much less difficult. If you have questions about how to approach recordkeeping for your business, leave a comment below or feel free to contact me directly. I’m happy to help.