Written by Guy Schmitz J.D., LL.M.
We all recognize the importance of substantiating expenses, but it still helps to remind ourselves of that importance (from time to time) so we can remind our clients. Clients bemoan the complexity of the Code, and they are right. A review, however, of any of the daily or weekly tax rags reveals an extraordinary number of cases which have nothing to do with the complexity of the Code and everything to do with substantiation. A case in point is Edgar Flores, Sr., et ux. v. Commissioner, TC Memo 2015-9 (Flores), which nicely illustrates the rules of substantiation.
Code §469 and Substantiation
Code §469, that horror of a Code section which pretty much ended tax shelters for the middle class, denies, of course, passive losses to taxpayers, in a maze of complexity, unless they can prove material participation in a given business venture. In Flores, the taxpayers owed rental real property in 2011 (the year before the Court) and took a rental real estate loss deduction of $10,000 for such year. Under Code §469(c)(2), rental activity is per se passive unless a taxpayer is a real estate professional under Code §469(c)(7). Only if a taxpayer “passes” the real estate professional test does the taxpayer have the pleasure of proving material participation.
Assume, for the sake of brevity, that Mr. Flores had to prove that he spent 1295 hours on his real estate property in 2011 to prove he was a real estate professional. (There was no allegation that Mrs. Flores was a real estate professional.) Mr. Flores introduced a calendar and a summary of work into evidence that revealed 799 hours of work on his real property. Mr. Flores also introduced a log into evidence. According to the Court, Mr. Flores’s testimony was contradictory, unclear, and uncorroborated. The Court stated that even if the 799 hours were justified, there was no way to prove the additional 496 hours of work (1295 - 799 = 496). Result: Losses disallowed.
Code §162 and Substantiation
Code §162 is far less complicated than Code §469. As you know, Code §162 permits a taxpayer to deduct ordinary and necessary expenses paid or incurred in a taxable year in carrying on a trade or business. Mr. and Mrs. Flores had certain unreimbursed employee business expenses. There are different substantiation tests depending on the expense in question. Generally, if a taxpayer cannot substantiate the precise amount of a deduction, a court may estimate such amount (Cohan v. Commissioner, 39 F. 2d 540 (2d Cir. 1930)). There is a carve-out for certain deductions, such as vehicle and computer expenses, requiring strict substantiation (Code §274). In order for a taxpayer to prove substantiation under Code §274, there must be an account book, log, or similar record and documentary evidence such as receipts, paid bills, or similar evidence (Regs. §1.274-5T(c) (2)(i) and (iii)). In Flores, the taxpayers failed the strict substantiation tests of Code §274. The taxpayers couldn’t even pass the Cohan test, that gift of the Second Circuit Court of Appeals, because taxpayers did not provide sufficient evidence for the Court to make the Cohan estimate. Result: Unreimbursed employee business expenses disallowed.
Code §170 and Substantiation
The Code allows for charitable deductions, of course, for charitable donations and unreimbursed out-of-pocket expenses for transportation and other expenses necessarily incurred in providing donated services. The taxpayers could not provide any substantiation. Result: Charitable deductions disallowed.
The Tax Court imposed a 20-percent accuracy penalty on the taxpayers under Code §6662(a) because of their trifecta of lack of substantiation (Code §§469, 162, 170). Oddly enough, the taxpayers hired a CPA to do their 2011 Form 1040 but did not call the CPA to testify.
Practitioners know the law, but clients must provide the substantiation. Perhaps the best idea is to profile a new client to determine the client’s usual deductions. If the client has only charitable deductions, provide a pre-prepared written guide of what the client needs in order to substantiate a charitable deduction (for example, a written acknowledgement from a charitable entity for charitable gifts of $250 or more). If the client has passive losses, provide a guide if there is a possibility of showing material participation. If the client has business expenses—well, you know.
If the client arrives the next year with insubstantial substantiation, you can remind the client of the written guide. Such clients cannot blame you. They should blame themselves.