The number of self-employed workers is on the rise. Recent employment data indicates 11%, or over 17 million U.S. workers, are self-employed. This increase can be attributed in part to the rise of the gig economy, as individuals seek out flexibility in work they enjoy on a schedule they set. Self-employed workers often find maintaining business records arduous, and complying with the tax requirements for business deductions can be particularly challenging.
Recent U.S. Tax Court cases emphasize the difficulty that taxpayers face if they do not have records to substantiate business expenses. This article highlights the importance of properly documenting business expenses and provides advice on tax recordkeeping in the digital age.
RECENT TAX COURT CASES
The Tax Court is often asked to decide whether taxpayers’ claimed business expense are deductible. Whether the expenses are deductible often hinges on whether they are properly substantiated, under the general requirements for substantiation or, where applicable, the heightened substantiation requirements of Sec. 274(d) (discussed more below). Below are several recent cases highlighting key issues regarding substantiation and how the Tax Court determines whether the substantiation requirements have been met.
In Eze, T.C. Memo. 2022-83, the taxpayer’s returns included two Schedules C, Profit or Loss From Business (Sole Proprietorship), for his IT consulting and construction businesses. The taxpayer claimed he paid many of his expenses in cash directly to service providers and therefore did not have sufficient evidence that the expenses incurred were his own. The court held the expenses were in some cases not credible and/or were implausible from the records or testimony presented. Nearly all of the taxpayer’s business expenses, including all his claimed vehicle expenses, were disallowed due to a lack of substantiation.
In Wolpert, T.C. Memo. 2022-70, the taxpayer was a civic engagement consultant with significant travel and vehicle expenses. The vehicle expenses were disallowed due to inadequate substantiation and a lack of contemporaneous records. His travel expenses were also disallowed for insufficient corroborative evidence of criteria including travel dates, specific destinations, and business purposes for the trips.
In Elbasha, T.C. Memo. 2022-1, the taxpayer worked as a doctor in rural Georgia and claimed business expenses including for travel to a business meeting in Cairo, Egypt. The IRS disallowed the travel deduction and some other business expenses on the taxpayer’s Schedules C because the expenses’ business purposes were not established and/or they lacked substantiation. The Tax Court agreed with the IRS and held that charts the taxpayer provided were inadequate to substantiate his expenses without further documentation of the amounts incurred and their purpose.
While the IRS prevailed in the majority of 2022 Tax Court business expense substantiation cases, the rulings in Patitz, T.C. Memo. 2022-99, and Butterfield, T.C. Summ. 2022-16, were partial victories for the taxpayers. The taxpayers in Patitz were able to adequately substantiate unreimbursed business travel expenses as employees for the 2015 and 2016 tax years. The court found the taxpayers’ testimony credible and that their electronic logbooks documenting mileage were sufficient contemporaneous records to allow for a deduction. In Butterfield, the taxpayers also scored a partial victory, with the court finding they had substantiated part of their meals and lodging deductions, while disallowing other expenses for lack of substantiation.
As can be seen from these cases, detailed and contemporaneously produced records of business expenses are generally a critical element of business expense substantiation. Any failure to produce sufficient records to substantiate the expenses underlying a deduction counts heavily against the taxpayer and may result in a disallowance of the claimed expenses. While a court may not always require documentary evidence and may accept what it believes to be the credible testimony of a taxpayer when determining whether a business expense is allowable, taxpayers cannot rely on the leniency of a court with regard to business expenses, particularly with respect to Sec. 274(d) expenses.
Taxpayers bear the burden of proving they are entitled to claimed business deductions. They also bear the burden of substantiating the amount and purpose of all claimed business deductions. In addition, Sec. 274(d) and Temp. Regs. Sec. 1.274-5T(c)(2) prescribe heightened substantiation requirements for certain business expenses, including expenses for traveling and expenses with respect to any listed property under Sec. 280F(d)(4). Under Sec. 274(d), the taxpayer must substantiate these types of expenses by “adequate records” or by sufficient evidence corroborating the taxpayer’s own statement.
An “adequate record” for purposes of Sec. 274(d) must include:
- The amount of the expense;
- The time and place the expense was incurred;
- The business purpose of the expense; and
- The business relationship related to the expense.
The Tax Court frequently considers whether a taxpayer has provided adequate records as defined by Sec. 274(d) for substantiation of travel expenses. Examples of adequate records for substantiation of these expenses include an account book, diary, log, statement of expense, trip sheet, or similar record, as well as corroborating documentary evidence that together establish each required element of the expense.
Listed property as defined under Sec. 280(d)(4) includes “any passenger automobile.” For automobile and other vehicle expenses to be deductible under the adequate-records requirement, the taxpayer must substantiate the expenses by maintaining records indicating the amount of the expense, the mileage for each business use and the total mileage for all business use during the year, the date of each business use, and the business purpose for each use (Temp. Regs. Sec. 1.274-5T(b)(6)).
The Cohan rule, named for Cohan, 39 F.2d 540 (2d Cir. 1930), allows a court to approximate a deduction amount if the taxpayer is unable to fully substantiate the underlying expense. The Tax Court generally will not employ the rule, however, unless the taxpayer presents sufficient evidence to provide a basis for the estimate. Also, the rule cannot be applied to deductions subject to the Sec. 274(d) heightened substantiation requirements. The Tax Court applied the Cohan rule in several of the cases cited above.
BUSINESS RECORDS HELD INSUFFICIENT
The courts evaluate business records and disallow deductions with insufficient documentation. This may occur, for example, when calendar entries are not made contemporaneously, taxpayers fail to provide evidence that their travel relates to particular locations or business purposes, or the mileage claimed does not appear consistent.
The court may disallow expenses for reasons including:
- Lack of substantiation;
- Concerns about the authenticity of receipts provided;
- Failure to provide contemporaneous documentation; or
- The expenses are not related to a trade or business.
AVOIDING THE DISALLOWANCE OF EXPENSES
Recent business expense substantiation cases highlight the danger of a poor or essentially nonexistent recordkeeping system. However, many options are available to business owners to assist in creating a functional recordkeeping system that documents expenses with relative ease.
Business owners must make the following determinations regarding expense substantiation:
- Do they want to use electronic means to streamline their recordkeeping?
- Do they need their accounting system to integrate with other platforms (for example, apps, as described below)?
CPAs can aid business owners in making these determinations by asking additional focused questions on their operations and preferences (see the sidebar, “Key Questions to Ask Business Owners”).
APP OPTIONS ABOUND
The substantiation cases also demonstrate how documenting business expenses can be particularly challenging when they are commingled with personal expenditures. With 97% of Americans owning a cellphone, and 85% owning a smartphone, the most convenient option for many business owners is to track expenses digitally through a smartphone app. This is particularly true for business owners who do not regularly conduct business in an office setting.
Options to consider when selecting a business expense documentation app include cost. Many apps are free with optional add-ons, while others offer monthly subscription pricing. Some examples of apps that have consistently received good reviews include:
- QuickBooks Accounting;
- SimplyWise receipt scanner;
- FreshBooks; and
The chart “Business Expense Apps,” below, presents relevant features for these five business expense tracking apps. The chart compares their features, with a focus on business travel and expense substantiation. Self-employed individuals may review the website of each app to further understand any additional features available, which can include invoicing, financial statement reporting dashboards, and time tracking. Business owners can consider which option best fits their needs and price range.
ACCOUNTING SYSTEM INTEGRATION
Some business owners may prefer that an app integrate with their accounting system by synchronizing invoices and expenses directly into the accounting software. Integration allows continuous and automatic synchronization of new accounts, expense reports, and invoices in real time.
For the many small businesses using a Quick- Books product, using its mobile app to document expenses can be a convenient option. Other accounting software platforms, such as FreshBooks, Quicken, and Sage, offer similar integration. Newer accounting systems may offer a discounted price structure that appeals to cost-conscious clients. Users must be cautious to understand what is included in monthly fee programs.
Business owners may also require a system to record expenses for their employees, particularly those who incur out-of-pocket expenses on the company’s behalf. These businesses should consider integrating their payroll function into the expense recordkeeping system. Paycor and similar competitors, such as ADP, OnPay, and Paychex, offer optional integrated capability for reimbursement requests and payments.
BUSINESS TRAVEL RECORDKEEPING CHALLENGES
Business travel entails recordkeeping challenges, especially for taxpayers who travel frequently. If those taxpayers are audited, the IRS will request contemporaneous records for the business travel. Using electronic calendars to document location and business purpose can be efficient and make data easily sharable. Calendar options to substantiate expenses, such as those by Apple, Google, and Microsoft Outlook, are available on mobile devices.
Besides tracking the location of travel, documenting mileage is a growing need for many small businesses, as fewer interactions are occurring in traditional brick-and-mortar environments. While most of the apps discussed above offer options to substantiate travel, other apps are specifically dedicated to business travel. These apps appeal to business owners who primarily travel to clients to provide services.
An analysis of apps for documenting travel, particularly mileage, yields numerous options. Some apps with automatic mileage tracking include Mileage Tracker by Driversnote, Stride, MileIQ, and TripLog. For mileage tracking, it is important to understand the data being collected and have safeguards in place to protect the app user’s privacy. Features of automatic mileage tracking vary by app and can include:
- Motion detectors in the app to record trips automatically, including via optional Bluetooth sensors to indicate when a driver is using a vehicle;
- Individual trip tracking at any time, through start and stop features in the app;
- Manual trip additions by entering the starting and ending address, with the app automatically calculating the route and mileage;
- Business or personal trip classification, with the ability to add detailed notes to each trip;
- Segmentation of trips and reporting for different vehicles or workplaces; and
- Mileage report creation for the IRS, an accountant, or employers/employees.
CONSISTENCY, CONTEMPORANEOUS RECORDS, AND REGULAR REVIEW
While apps can be extremely effective, they can be relied upon only if used consistently. For this reason, apps with automatic mileage tracking may appeal to frequent travelers.
Creating a process to review business expenses periodically is an important component of a tax recordkeeping system. The type and frequency of the expenses determine how often to review supporting documentation.
Tax Court decisions reinforce the notion that business expenses are not meant to be calculated only at year end. To meet the contemporaneous documentation requirement, electronic recordkeeping can help business owners systematically document and regularly review their business expenses to avoid a disallowance.
THE PAPER TRAIL HAS GROWN COLD
Re-creating a paper trail of expenses in the digital age can be costly (and likely fail the documentation requirements if not contemporaneous). Gone are the days of canceled checks returned to customers. Bank records become more difficult and expensive to obtain as time passes. Ensuring a sufficient record, electronic or otherwise, is a critical component of substantiating the expense. Cash payments can be especially problematic for recordkeeping if not documented contemporaneously. Business owners dealing in cash must be cautious to record their transactions as soon as possible and not wait until tax time to meet the requirements of proper substantiation.
The Tax Court has given a clear message to business owners: The IRS will disallow business expenses lacking substantiation. Documenting business expenditures has become easier in the age of smartphones and apps, but an app’s effectiveness depends on the user’s commitment. CPAs advising business owners on substantiation and digital recordkeeping of business expenses will help them improve their documentation and, ultimately, create a more efficient tax return preparation process for their practices.
Key questions to ask business owners
- What type of expenses will you be documenting?
- What is your comfort level using apps and sharing your location?
- What level of integration do you want your expense recordkeeping to have with your accounting system?
- What is your budget for documenting expenses?
- What amount of time can you commit to reviewing and verifying expenses?
About the authors
Kaitlin Newkirk, CPA, MST, M.Acc., is an assistant professor in the Williams College of Business at Xavier University in Cincinnati. Sarah Webber, CPA, J.D., LL.M., is an associate professor at the University of Dayton in Dayton, Ohio.To comment on this article or to suggest an idea for another article, contact Paul Bonner at Paul.Bonner@aicpa-cima.com.
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“Card-Carrying Ways to Automate Expense Reports,” JofA, Jan. 2022
“Proving Employee Business Expense Deductions,” The Tax Adviser, Nov. 2021
“Dropping the Curtain on Entertainment Deductions,” JofA, March 2021
“IFP Essentials: Gig Economy Guidance and Tools,” AICPA Insights, Aug. 11, 2021
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