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	Scott Wrigley

December 2011

Beware the Tax Perils – and Penalties – of Poor Recordkeeping

Failure to document your deductions can result in a “substantial understatement” penalty, one of the most commonly assessed and expensive federal income tax penalties

The importance of keeping thorough and accurate records cannot be over-emphasized. If you have incomplete or missing records and get audited by the IRS, it can result in the loss of valuable deductions and the assessment of penalties and interest. One recent Tax Court case illustrates the potential pitfalls facing some taxpayers.

Background. Adan Sucilla operated a sole proprietorship providing farm labor services in California. He claimed deductions for various business expenses in 2007 and 2008, including travel and entertainment, car and truck expenses, repairs, maintenance, supplies, taxes and insurance. Unfortunately for Mr. Sucilla, he did not keep separate books for his business operation; instead, he relied on bank statements, subcontractor checks, and receipts to account for the expenses. He did, however, hire an accountant to prepare his federal tax returns for the years in question.

The IRS agent who examined the returns for 2007 and 2008 found that, while all of Mr. Sucilla’s business income was accurately reported, some expenses were not substantiated because Mr. Sucilla had either lost or misplaced the receipts. For 2007, out of a total of nearly $2.3 million in expenses, the IRS found that $165,400 was unsubstantiated. Similarly, for 2008, $36,000 of his $1.3 million in reported expenses lacked documentation.

Tax Outcome. Mr. Sucilla challenged the IRS’s disallowance of his unsubstantiated deductions. Citing a lack of information concerning the deductions claimed on the tax returns, the Tax Court agreed with the IRS. Other than the deductions conceded, the court stated, the taxpayer “failed to provide receipts, logs, books or any other kind of documentation to substantiate the deductions.”

In his challenge, Mr. Sucilla, invoked the Cohan rule (discussed below), which allows estimates of expenses without complete documentation. However, the Tax Court ruled that Cohan did not apply in this case.

In defeat, Mr. Sucilla could take some solace in the Court’s ruling that he acted with reasonable cause and in good faith and was not liable for accuracy-related penalties for substantially understating income (Sucilla, TC Memo 2011-197).

Penalty Exception. The substantial understatement penalty is one of the most commonly assessed federal income tax penalties. It can also be one of the most expensive: The penalty equals 20% of any tax underpayment caused by a substantial understatement of income tax liability on a federal return.

However, as we learned in the Sucilla ruling, there is an important penalty exception when the taxpayer (a) had reasonable cause for taking the tax position that caused the understatement, and (b) acted in good faith.

One of the ways to demonstrate reasonable cause and good faith is to give a competent, independent tax professional all the relevant information and then rely on his or her advice and tax preparation efforts.

Recordkeeping Methods. On its website, the IRS states that “you may choose any recordkeeping system suited to your business that clearly shows your income and expenses.” However, in a few cases, the law does impose certain requirements. For example, with respect to travel, entertainment, gifts and listed property expenses, a taxpayer must generally substantiate with records (a) the amount of the expense, (b) the time and place the expense was incurred, (c) the business purpose, (d) the business relationship, and (e) for listed property, the amount of business use and the amount of total use.

Conclusion. The moral of the Sucilla case is pretty simple: Don’t leave the important matter of documentation to chance. With guidance from your tax adviser, you can prepare tax return records that will stand up to close scrutiny from the IRS.

Cohan Rule Offers a Tax Fall-Back Position

In a landmark case decided more than 80 years ago, the legendary entertainer George M. Cohan was allowed to deduct various expenses he could not substantiate. The court reasoned that he had provided credible evidence that some expenses had been incurred, so it permitted deductions on a limited basis (Cohan, 39 F.2d 540, 2d Cir., 1930).

As the Tax Court explained in the Sucilla case: “In these instances, the court is permitted to make as close an approximation of the allowable expense as it can, bearing heavily against the taxpayer whose inexactitude is of his or her own making.” (In some cases, the Cohan rule is allowed when records are lost for reasons beyond a taxpayer’s control, such as a fire or natural disaster.) Cohan does not apply to travel and entertainment expenses.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.