Documentation of Expenses Not Adequate to Allow Deductions

The experience of tax advisers over the years suggests that most often the key disputes in tax exams arise not so much over the arcane issues in the tax law as over the state of the taxpayer’s records to support the facts in the case.  The case of Dasent v. Commissioner, TC Memo 2018-202 is just such a case.  While the question of hobby loss does arise for a portion of the deductions (and the activity clearly met that test), the Court pointed out that even had that not been an issue, none of the taxpayers’ deductions could be allowed due to lack of adequate records.

The taxpayers had reported business expenses in two locations on their tax return for the year in question.  First, each spouse had incurred employee business expenses:

On the Schedule A petitioners reported, among other items, $23,931 of unreimbursed employee business expenses. The details of their unreimbursed employee business expenses were shown on a Form 2106, Employee Business Expenses, and a Form 2106-EZ, Unreimbursed Employee Business Expenses, also attached to the joint return. The expenses consisted of the following: for Mrs. Walcott-Dasent in connection with her employment with Robert Half and Randstad: $6,358 for vehicle expenses, $4,170 for travel expenses, $7,195 for other business expenses, and $1,395 for meals and entertainment; for Mr. Dasent in connection with his employment with Britax: $320 for parking fees, tolls, and transportation, $2,220 for travel expenses, $1,810 for other business expenses, and $463 for meals and entertainment. Mrs. Walcott-Dasent may receive reimbursement for employee business expenses from Robert Half and Randstad, and Mr. Dasent was reimbursed by Britax for the mileage he drove his personal vehicle for work-related trips.

As well, Kendra reported expenses related to business she claimed to operate:

During 2014 in addition to being a “W-2 wage earner” for Robert Half and Randstad, Mrs. Walcott-Dasent claimed to operate an education consulting business, assisting recent college graduates, military personnel reacclimating to civilian life, and at-risk women rejoining the workforce with finding suitable employment. Mrs. Walcott-Dasent has never charged a fee for her services; thus, for 2014 she had no gross receipts or other income attributable to her education consulting activities; she claimed to have incurred only certain expenses which, as discussed below, petitioners reported on a Schedule C.

This business had a fatal flaw--it clearly runs afoul of what we commonly refer to as the “hobby loss rule” found at IRC §183(a) which provides:

(a) General rule

In the case of an activity engaged in by an individual or an S corporation, if such activity is not engaged in for profit, no deduction attributable to such activity shall be allowed under this chapter except as provided in this section.

The opinion notes that the fact that she had no way to make a profit from this activity and, in fact, charges no fees for it, brought it directly under the bar on claiming a hobby loss found in IRC §183(a).

Petitioners offered no credible, objective evidence to establish a profit motive for Mrs. Walcott-Dasent's education consulting activities. Indeed, she acknowledged at trial that she did not charge a fee for the services she performed in 2014 (or in any year in which she has held herself out as operating an education consulting business, for that matter). Likewise, petitioners did not attempt to rebut their return position for 2014 concerning Mrs. Walcott-Dasent's education consulting activities; to wit, that she had no gross receipts or other income and only allegedly incurred certain expenses. They produced no records — accounting records, invoices, and the like — traditionally associated with a business operating for profit. On the basis of the record, laudable as her activities may be, we conclude that Mrs. Walcott-Dasent was not engaged in carrying on a trade or business for profit under section 162. Under section 183(a) and (b) the deductions attributable to Mrs. Walcott-Dasent's education consulting activities are limited to the gross income she derived therefrom. Since she derived no gross income from those activities in 2014, petitioners are entitled to no deductions.

Of course, such issues wouldn’t affect their employee business expense deductions.  But the Court pointed out that in all cases they had insufficient documentation to support the deduction.

Certain deductions are subject to the strict documentation rules of IRC §274(d).  In this case, the automobile expenses claimed were subject to the strict substantiation rules.  The Court found the taxpayers had simply not met the burden.

First, the Court commented on the Schedule C deductions and the inadequacy of the documentation:

The car and truck expenses are subject to the strict substantiation rules of section 274(d) and thus they cannot be estimated. Petitioners produced a mileage log for 2014 prepared by Mrs. Walcott-Dasent. This log reported only the months and year of her travel, the names of the events she attended, the cities of departure and destination, and the miles she drove. It did not include a business purpose for the travel or the actual dates of travel. Neither did petitioners retain or otherwise produce any documentary evidence relating to each event she attended in 2014. Accordingly, we conclude that petitioners have not established for 2014 that they are entitled to a deduction for any amount of car and truck expenses under section 274(d) even if Mrs. Walcott-Dasent had engaged in a trade or business for profit in 2014. See Fleming v. Commissioner, T.C. Memo. 2010-60, slip op. at 7.

On the Form 2106, the §274(d) expenses expanded to include travel and meals and entertainment along with automobile expenses.  Again, the available documentation was found insufficient to support a deduction:

In support of their vehicle expenses petitioners at trial produced a log for only Mr. Dasent which reported the months and year of his work-related travel, the business purpose of his travel, the cities of departure and destination, and the miles he drove. It did not include the actual dates of his travel. Petitioners did not retain or otherwise produce any other records to substantiate their Schedule A unreimbursed employee business expenses.

While other expenses are not subject to the strict substantiation rule, that doesn’t mean that no evidence in support of them is required.  As the Court explains:

To this end, under the Cohan rule, if a taxpayer establishes that an expense is deductible but is unable to substantiate the precise amount, the Court may estimate the amount of the deductible expense, bearing heavily against the taxpayer whose inexactitude is of his or her own making. See Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930); see also Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985). In order for the Court to estimate the amount of a deductible expense, the taxpayer must establish some basis upon [*13] which an estimate may be made. Norgaard v. Commissioner, 939 F.2d 874, 879 (9th Cir. 1991), aff'g in part, rev'g in part T.C. Memo. 1989-390; Vanicek v. Commissioner, 85 T.C. at 742-743. Otherwise an allowance would amount to “unguided largesse.” Norgaard v. Commissioner, 939 F.2d at 879 (quoting Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957)).

The Court found that for the other expenses claimed the taxpayers had not met the requirements to allow for a Cohen estimation of allowable business expenses:

With respect to the other expenses, we similarly conclude on the basis of the record that petitioners are not entitled to deductions for these expenses in any amount for 2014 even if Mrs. Walcott-Dasent had engaged in a trade or business for profit. Petitioners produced bank statements, monthly expense summaries, and receipts from various corporations and companies. A review of this documentary evidence shows that there is no distinction between petitioners' personal living [*16] expenses, expenses Mrs. Walcott-Dasent incurred in connection with her education consulting activities, and expenses she incurred in connection with her employment with Robert Half and Randstad. In fact, at trial petitioners were unable to specifically identify which of the numerous expenses reflected in the bank statements, summaries, and receipts should be deductible under section 162. See Hale v. Commissioner, T.C. Memo. 2010-229, slip op. at 6 (stating that we need not sort through a taxpayer's evidence “in an attempt to see what is, and what is not, adequate substantiation of the items” on the taxpayer's returns). And thus, on the basis of the record before us, the Court is unable to make an estimate of these remaining expenses for 2014 under the Cohan rule. Accordingly, petitioners have not established that they are entitled to a deduction for any amount of the remaining expenses.

The taxpayers also faced a substantial understatement penalty issue raised by the IRS.  This penalty under IRC §6662 arises whenever the understatement of tax exceeds 10% of the proper amount due or $5,000, whichever is greater.  The penalty applies unless one of three exceptions applies:

  • The position giving rise to the understatement had substantial authority;

  • The position giving rise to the understatement had a reasonable basis and was properly disclosed (normally on a Form 8275 or Form 8275-R); or

  • The taxpayers had reasonable cause and acted in good faith in taking the position.

As the issue did not involve an interpretation of the law, the first two exceptions were not available.  Rather, the taxpayers needed to establish reasonable cause and good faith.  A key factor in establishing such good faith is a demonstration that the taxpayers attempted to properly determine their tax liability.

What the taxpayers had done was described by the Court as follows:

At trial petitioners, who have bachelor's degrees — one in business administration and the other in mechanical engineering — appeared sincere but confused, particularly about the tax treatment of the expenses they reported on their Schedules A and C and the IRA distributions that Mr. Dasent admitted receiving in 2014. They did not provide any testimony that they relied on advice from a tax professional when preparing the joint return. They used TurboTax to prepare the return.

Unfortunately, solely relying on “off the shelf” software is not deemed to meet the reasonable cause exception.  As the Court continued:

This Court has found that “[t]ax preparation software is only as good as the information one inputs into it.” See Bunney v. Commissioner, 114 T.C. 259, 267 (2000). The software does not constitute professional advice for which this Court can rely in a reasonable cause/good faith analysis. Accordingly, we cannot find in the record either evidence of a cognizable effort to assess their proper tax liability or reasonable cause for the error.