|RAY A. KNIGHT, CPA/PFS, JD, is a principal with Ernst & Young in Charlotte, North Carolina. LEE G. KNIGHT, PhD, is professor of accounting at Samford University in Birmingham, Alabama. Her e-mail address is firstname.lastname@example.org.|
hat CPA hasn't been greeted by a shoebox overflowing with client tax records—some written on the back of cocktail napkins or on scraps of paper? Even after pouring over these records for hours, the CPA might not find the proof needed to substantiate a particular tax deduction. Keeping good tax records has always been important, but the IRS Restructuring and Reform Act of 1998 made it even more so. One of the act's boldest initiatives was shifting the burden of proof from the taxpayer to the IRS in civil tax matters (new IRC section 7491). Historically, with only a few exceptions, the taxpayer—not the IRS—was responsible for producing sufficient evidence to convince the court to find in the taxpayer's favor.
The burden shift played well politically by countering the public perception that taxpayers were "guilty until proven innocent" when dealing with the IRS. It also appeared to level the playing field between limited-resource taxpayers and the unlimited-resource IRS. However, taxpayers and CPAs may find the field is not as level as they first believed.
To protect their clients from unforeseen penalties and disallowed deductions, CPAs should understand the IRS's statutory right to request substantiation of income and expenses, the records the taxpayer is required to keep and the consequences to the taxpayer of failing to keep adequate records. Equipped with this knowledge, CPAs can help both individual and business clients achieve more favorable audit results, cut the time required for an IRS audit and take advantage of the new burden of proof rules.
SUFFER THE CONSEQUENCES
The burden shift applies to both individuals and businesses. It does not, however, cover all situations. It applies only in court proceedings on civil tax matters. It does not apply to a partnership, corporation or trust with a net worth over $7 million. The burden shift is not automatic; instead, it occurs only if the taxpayer fulfills the following three requirements:
1. Introduces credible evidence relevant to determining taxpayer income or estate or gift tax liability.
2. Cooperates with reasonable requests from the IRS in its investigation.
3. Complies with the substantiation and recordkeeping requirements in the code and regulations.
The last requirement is the true gatekeeper in this test. An individual or business that fails to keep adequate records will continue to bear the burden of proof if an issue goes to court and will suffer the consequences of inadequate recordkeeping that existed under prior law. A CPA who fails to warn clients of the importance of keeping good records also increases his or her malpractice exposure.
THE LONG ARM OF THE LAW
In auditing individual or business tax returns, the IRS can use many sources—provided voluntarily or involuntarily—including the taxpayer's own returns, related parties, customers and suppliers as well as information returns filed by entities the taxpayer is a member of or that make payments to the taxpayer. Less frequent sources include newspaper articles, disgruntled former employees and spouses, local law enforcement officials and informants seeking rewards. IRC section 6001 requires anyone liable for any federal tax or its collection to keep records, render statements, file returns and comply with applicable rules and regulations. The taxpayer bears the burden of proof in complying with these requirements. The courts differ on whether section 6001 gives the IRS authority to require the taxpayer to substantiate by adequate records any claims made on the return. In Ohio Bell Telephone, 475 F.Supp 697 (N.D. Ohio 1979), the court held that section 6001 contains an implied authority allowing the IRS to require taxpayers to produce records for investigation. In Mobile Corp., 543 F.Supp 507 (N.D. Texas 1981), however, the court said the IRS must use other methods, such as the summons procedures that are found in IRC sections 76027610, to access taxpayer records.
To substantiate a deduction by adequate records, a taxpayer—either an employee or a self-employed individual—must maintain.
An account book, diary, statement of expense or similar log in which the taxpayer lists each element of an expenditure at or near the time it was made.
Documentary evidence (for example, receipts or paid bills) for away-from-home lodging and other expenditures of $75 or more.
An adequate record must include a written statement of business purpose unless it is evident from the surrounding facts and circumstances, such as a salesperson's travel expenditures to call on customers on an established sales route. The documentary evidence should establish the expenditure amount, date, place and character. Thus, a hotel receipt with the date of lodging and separate amounts for lodging, meals and telephone calls probably is sufficient substantiation, while a canceled check with a bill establishes only the cost.
IRC section 274(d) imposes stiff substantiation requirements on deductions and credits for
Travel expenses—including away-from-home meals and lodging—claimed under IRC sections 162 or 212.
Entertainment, amusement and recreational activities or facilities.
Listed property, as defined by IRC section 280F(d)(4), including cars or computers.
The related regulations disallow deductions or credits for items subject to section 274(d) on the basis of the taxpayer's approximations or unsupported testimony. Together, these rules supersede the Cohan doctrine, 39 F.2d 540 (2d Cir. 1930), which required the trial court to approximate, rather than disallow, a deduction if a taxpayer could not prove its exact amount. The taxpayer must substantiate, by adequate records, four aspects of a deduction:
The time and place of the travel, entertainment (T&E) or use of the facility or the date and description of a gift.
The business purpose.
The business relationship between the taxpayer and the person entertained, using the facility or receiving the gift.
In applying these rules, each separate payment (for example, for breakfast, lunch and dinner) is a separate expenditure, but concurrent or repetitious payments during a single event (for example, a round of drinks in a cocktail lounge) represent a single expenditure.
Listed property. For section 280F(d)(4) listed property, a taxpayer must substantiate the
Amount of each related expenditure, including the purchase price, lease payments and maintenance expenses.
Amount of the business or investment use for the year and the amount of total use for the same period (for cars, measured in miles traveled).
Date of each expenditure and use.
Business purpose of each expenditure and use.
Charitable contributions. To deduct a charitable contribution, a taxpayer must meet the substantiation requirements of Treasury regulations section 1.170A-13. They require the taxpayer to keep canceled checks, receipts or other written records with specific substantiation information (for example, donee name, date and location of contribution, description and estimated fair market value of the property). If a noncash contribution exceeds $500, the taxpayer also must maintain written records indicating how he or she acquired the property and its adjusted basis. If a contribution other than cash and certain publicly traded securities exceeds $5,000, the taxpayer must obtain a qualified appraisal, attach an appraisal summary to the tax return on which the donation is first claimed and meet the requirements in regulations section 1.170A-13.
A taxpayer generally may deduct a contribution of $250 or more only if he or she receives written acknowledgment of the contribution at the time it is made. However, this proof is not necessary if the recipient files a return with the required information. If a taxpayer makes a contribution for which he or she receives goods or services—such as dinner or theater tickets from a charity—of more than $75, the charity must give the taxpayer a written statement of the value of those goods or services. The taxpayer may deduct only the excess of the value of the contribution over the value of the goods or services. If the taxpayer receives no goods or services, the receipt must state this fact.
Employee expenses. An employee who incurs expenses for his or her employer's benefit—charged to the employer or for which the employee receives advances, reimbursements or similar payments—is partly relieved of the substantiation burden if the employer requires an "adequate accounting" with which the employee complies. An adequate accounting is an account book or similar record the taxpayer submits to the employer with supporting evidence. (See "Using E-Mail and Fax to Substantiate Business Deductions," above, for the IRS ruling on whether employees should consider these forms of communication adequate documentation.) If an employee satisfies this standard and receives payments from the employer equal to his or her deductible expenses, the reimbursements are omitted from form W-2 and the employee's tax return. If the employee receives payments greater than his or her deductible expenses, the employee must include the excess in gross income.
Separation or divorce. If a taxpayer is likely to separate or divorce, he or she should make copies of all tax records. Relations may become strained and access to records difficult. The records should include a copy of the divorce decree or separate maintenance agreement to substantiate alimony and distinguish it from child support or property settlements. The taxpayer also should keep a copy of all joint returns and supporting records. The IRS may assert a deficiency for the entire tax liability against either spouse unless the taxpayer makes a proper separate liability election or the IRS absolves the "innocent spouse" under IRC section 6015, as amended by the 1998 act. The taxpayer also should keep copies of agreements or decrees identifying the custodial parent and the parent entitled to tax exemptions for any children. In addition, the taxpayer should keep records of the basis of all jointly owned property and property received from a spouse.
|Using E-Mail and
Fax to Substantiate Business Deductions |
As the number of paperless transactions increases, substantiation takes on a new meaning. The IRS addressed this issue in private letter ruling 9805007, in which an employer wanted to know whether e-mail or fax communications constituted adequate documentation for a business expense deduction under IRC sections 62 and 274.
"Ticketless travel" is the paperless transaction at issue. The scenario involves an employee making travel arrangements through a travel agent, who books a flight electronically and either faxes or e-mails the employee an itinerary and receipt; the employee does not receive a paper ticket or paper receipt. The employee then submits a copy of the fax or e-mail message with an expense report for reimbursement.
In the ruling, the IRS concluded that such communications do satisfy the substantiation requirements of sections 62 and 274. The only requirement is that the documentary evidence for travel expenses, including airfare, establish the amount, date, place and business character of the expenditure. The regulations do not require original documents or prohibit documentary evidence in the form of fax, photocopies or electronic messages. Thus, both the fax and e-mail messages are sufficient substantiation.
ELECTRONIC STORAGE AND ADP SYSTEMS
Businesses using electronic storage systems to maintain books and records or ADP systems to produce and process books and records may qualify the entire systems under section 6001. (See "Electronic Storage Requirements" below for more details.) During an IRS examination, the taxpayer must be able to retrieve and reproduce electronically stored and machine-sensible books and records (including hard copies, if requested). Machine-sensible books and records contain data in an electronic format intended for computer use. The taxpayer also must give the IRS the resources (such as the appropriate hardware and software, personnel and documentation) to process these documents. The storage system may not be subject to an agreement (such as a contract or license) that limits or restricts IRS access.
The IRS district director periodically may test a taxpayer's electronic storage and ADP systems. By actually using the electronic storage system, the district director can evaluate the equipment and software as well as the procedures to prepare, record, transfer, index, store, preserve, retrieve and reproduce electronically stored documents. He or she can review the system's internal controls, security procedures and documentation. IRS tests of an ADP system are designed to establish the authenticity, readability, completeness and integrity of the machine-sensible records. Such tests may include a review of the electronic data interchange or electronic storage system and the internal controls and security procedures for creating and storing records. The district director must inform the taxpayer of the results of all IRS tests.
Many businesses use electronic storage systems to keep tax records. Such a system prepares, records, transfers, indexes, stores, preserves, retrieves and reproduces books and records by either
An ADP system is an accounting or financial system that processes all or part of a taxpayer's transactions, records or data by nonmanual methods. This includes a mainframe computer, a standalone or networked microcomputer, a database management system (DBMS), a system that uses electronic data interchange (EDI) technology or an electronic storage system. DBMS is software that creates, controls, relates, retrieves and provides access to stored data while EDI technology is the computer-to-computer exchange of business information.
Electronic storage system requirements. Revenue procedure 97-22 specifies what the IRS considers essential in using an electronic system to maintain books and records. The bottom line is the system must ensure an accurate and complete transfer of the hard copy or computerized books and records to the electronic storage medium.
Taxpayers may use data compression or formatting technologies as part of the system, but all books and records must be legible and readable when displayed on a video display terminal or reproduced in hard copy. Information a taxpayer maintains in an electronic storage system must support his or her books and records (including those in an ADP system). The easiest way to do this is to cross-reference the information to the taxpayer's books and records in a way that provides an audit trail between the general ledger and the source document(s).
ADP documentation requirements. Revenue procedure 98-25 specifies the required documentation for ADP systems and the machine-sensible records they produce. Machine-sensible records contain data in an electronic format intended for computer use. They do not include paper records—even those converted to an electronic storage medium such as microfilm, microfiche, optical or laser disk. Machine-sensible records must provide sufficient information to support and verify entries on a taxpayer's return and to determine the correct tax liability. Records meet this requirement only if they reconcile with both the taxpayer's books and the return.
A taxpayer must maintain and make available to the IRS on request documentation of the business processes that
This documentation must be detailed enough to identify the flow of data through the system; the internal controls the taxpayer uses to ensure accurate, reliable processing and the unauthorized addition, alteration or deletion of records; and the chart of accounts with account descriptions.
The taxpayer should label all machine-sensible records and store them in a secure area, storing the backup copies off-site. He or she should periodically check for any loss of data, report any loss to the IRS and recreate the data within a reasonable time.
HOW LONG IS ENOUGH?
The section 6001 regulations require a taxpayer to retain books of accounts or records for as long as the contents are "material in the administration of any internal revenue law." This requirement makes it virtually impossible to generalize about how long a taxpayer should maintain tax records. For example, the cost of a capital outlay or investment becomes relevant when the taxpayer sells or abandons the asset, which could be many years after it is acquired. The normal three-year statute of limitations extends to six years if the taxpayer omits more than 25% of gross income and to an indefinite period if he or she commits fraud. While the IRS bears the initial burden of proof to invoke these provisions, the burden then shifts to the taxpayer.
None of the required periods for retaining records begins until the taxpayer files a return. Thus, if the IRS claims a taxpayer never filed a return for a particular year, it can assess tax for that year at any time (even beyond three or six years) unless the taxpayer can prove a return was filed. The easiest and safest way to do this is to file electronically, because the IRS sends a receipt acknowledging the return.
AN UNCERTAIN FUTURE
The impact of the new burden of proof rules is difficult to assess. In June 1998, a Treasury spokesperson said the courts largely will determine how to apply the new rules. It is, however, possible to make some preliminary observations. An IRS document, Tax Regulations in English—available at www.irs.ustreas.gov —offers CPAs insight into how the IRS views its task.
The credible evidence requirement, one of the three prerequisites for shifting the burden of proof to the IRS (see page 89), may force a taxpayer to prepare for a worst-case scenario—where the taxpayer retains the burden of proof—if the court does not decide the burden issue at the trial's outset. The IRS also may be less candid in its notice of deficiency lest it help the taxpayer pass the credible evidence hurdle. The 1998 act suspends the accumulation of interest and certain time-dependent penalties if the IRS fails to mail the notice within 18 months of the due date of a timely filed return. The IRS therefore has little motivation to fully investigate its concerns before including them in the deficiency notice—or it may include them with fewer details. An alternative scenario is when the IRS prolongs and expands its initial inquiry while the burden is still on the taxpayer, giving itself time to gather the information it might need before the court decides the burden shift issue.
In Tax Regulations in English, the IRS acknowledges it will have to better document its work both before and during litigation so it is prepared to argue whether the taxpayer meets the three requirements for shifting the burden of proof. The agency will focus primarily on documenting the taxpayer's cooperation and substantiation (the second and third requirements). Noting that taxpayers may not realize the significance of the requirements, the IRS cautions its personnel to remind taxpayers the burden of proof shifts only if the taxpayer meets those requirements. The IRS says it anticipates little change in its investigation procedures other than requiring enhanced documentation—from taxpayers and its own personnel.
CPAs should remind clients that the burden shift depends largely on their compliance with the recordkeeping and substantiation requirements in the code and regulations. But even without the new burden of proof rules, the taxpayer failing to maintain adequate records faces serious consequences. The IRS may disallow a deduction, impose penalties for negligence or fraud or require the client to use an IRS-prescribed method to determine income. The courts have made a hierarchy of these sanctions. For example, in Harrison's Estate, 62 TC 524, 535 (1974) (acq.), the Tax Court found a taxpayer's records were insufficient to substantiate T&E expense deductions but were sufficient to justify penalties (under the predecessor of IRC section 6662) for negligence or intentional disregard of IRS rules and regulations. The court observed it could not impose such penalties "solely for inadequate bookkeeping."
The courts also seem hesitant to impose stiff sanctions for inadequate recordkeeping. For example, while violations of the recordkeeping obligation can constitute civil fraud under IRC section 6663, in practice the failure to keep or retain records usually is accompanied by other badges of fraud, making it difficult to know whether the courts would impose the fraud sanctions solely for poor recordkeeping. Similarly, while willful failure to keep required records is a misdemeanor under IRC section 7203, the IRS usually prosecutes violations only if criminal misconduct accompanies them—again making it difficult to know the true consequences of inadequate recordkeeping (see Johnson, 325 F.2d 709, 1st Cir. 1963).
BUT I LOST IT!
If a taxpayer can prove the records were lost or destroyed by casualty (fire, flood or earthquake), he or she can substantiate expenses by reconstructing them. The courts also have allowed taxpayers to reconstruct records in nonnatural casualties when the records were
Stolen from the taxpayer's car.
Lost by the IRS or in the mail.
Lost by an employee who had control of them.
Lost when the taxpayer was evicted from his or her apartment.
Left with one spouse under a court-ordered separation.
Permitting a taxpayer to reconstruct records under these circumstances represents a limited retention of the Cohan doctrine. Nevertheless, even when the records are destroyed by natural causes, the courts have been less than generous in applying this doctrine; they have held that Cohan does apply when the loss or destruction of records was caused by circumstances beyond the taxpayer's control or by the taxpayer's own carelessness.
A taxpayer who loses or misplaces his or her tax return may obtain a copy by filing Form 4506, Request for Copy or Transcript of Tax Form, along with the applicable fee to the IRS center where the return was filed. Other information from the return (such as form W-2) may be obtained free of charge from IRS taxpayer service offices.
For taxpayers failing to keep adequate books and records, the IRS may gather evidence from information returns or records maintained by the taxpayer's employer, customers, stockbrokers and others. While the IRS may use one or more methods to reconstruct the taxpayer's income, under section 7491 the burden of proof shifts to the IRS if it reconstructs income based solely on statistical information on unrelated taxpayers (for example, on the basis of the average income of the population where the taxpayer lives). Tax Regulations in English suggests that although this will not preclude the IRS from relying on statistical data to demonstrate unreported income, the IRS no longer will be able to rely solely on these data.
SURVIVING IRS ATTACK
Before the 1998 act passed, taxpayers needed to know the recordkeeping and substantiation requirements in the code, regulations and judicial authority to survive an IRS attack. While taxpayers still face these consequences, a new one has been added. Failure to comply with these requirements also means the taxpayer will forgo the opportunity to shift the burden of proof if an audit winds up in court. For CPAs, the 1998 act reinforces the need to make clients aware of recordkeeping and substantiation requirements. What formerly was an important client service now is a critical one.
|Recordkeeping Help From the IRS
Publication 463, Travel, Entertainment, Gift and Car Expenses (chapter 5)
Publication 508, Educational Expenses; Recordkeeping
Publication 526, Charitable Contributions; Records to Keep
Publication 552, Recordkeeping for Individuals
Publication 583, Starting a Business and Keeping Records