Recordkeeping is an important part of running any small business. In fact, keeping good records helps business owners make sure their business stays successful. Good recordkeeping is the key to proving tax deductions and painless IRS audits.
If you operate a business or start a new one, you need to maintain a system that records your income and expenses.
Good records will help business owners:
- Monitor the progress of their business
- Prepare financial statements
- Identify income sources
- Keep track of expenses, and
- Prepare tax returns and support items reported on tax returns
The documentation you retain to support tax return income and expenses is very important in defending the amounts in the event you’re ever audited by the IRS. The responsibility to validate information on tax returns is known as the burden of proof. Small business owners must be able to prove expenses to deduct them.
Be aware that there’s no one particular way to keep business records. But there are strict rules when it comes to keeping records and proving that expenses are legitimate for tax purposes. Certain types of expenses, such as automobile, travel, meals, and home office costs require special attention because they’re subject to special recordkeeping requirements and more contemporaneous reporting procedures.
Here are two recent court cases to illustrate some of the issues.
Case 1: To claim deductions, an activity must be engaged in for profit
A business expense can be deducted if a taxpayer can establish that the primary objective of the activity is making a profit. The expense must also be substantiated and should be an “ordinary and necessary” business expense. In one case, a taxpayer claimed deductions that created a loss, which she used to shelter other income from tax.
She engaged in various activities including acting in the entertainment industry and selling jewelry. The IRS found her activities weren’t engaged in for profit and it disallowed her deductions.
The taxpayer took her case to the U.S. Tax Court, where she found some success. The court found that she was engaged in the business of acting during the years in issue. However, she couldn’t prove that all claimed expenses were “ordinary and necessary” business expenses. The court did allow deductions for expenses including headshots, casting agency fees, lessons to enhance the taxpayer’s acting skills and part of the compensation for a personal assistant. But the court disallowed other deductions because it found insufficient evidence “to firmly establish a connection” between the expenses and the business.
In addition, the court found that the taxpayer didn’t prove that she engaged in her jewelry sales activity for profit. She didn’t operate it in a businesslike manner, spend sufficient time on it or seek out expertise in the jewelry industry. Therefore, all deductions related to that activity were disallowed. (TC Memo 2021-107).
OBSERVATION: While the Taxpayer in these court cases were not successful, the decision provides a strategy to those starting a business and likely not profitable at the start. Seeking out the advice of industry professionals is an indication of an intent to make a profit. Also operate in a businesslike manner! This means have separate business bank accounts; have a written business plan.
Case 2: A business must substantiate claimed deductions with records
A taxpayer worked as a contract emergency room doctor at a medical center. He also started a business to provide emergency room physicians overseas. On Schedule C of his tax return, he deducted expenses related to his home office, travel, driving, continuing education, cost of goods sold and interest. The IRS disallowed most of the deductions.
As evidence in Tax Court, the doctor showed charts listing his expenses but he didn’t provide any receipts or other substantiation showing the expenses were actually paid. He also failed to account for the portion of expenses attributable to personal activity.
The Court disallowed the deductions stating that his charts weren’t enough and didn’t substantiate that the expenses were ordinary and necessary in his business. The Court noted that “even an otherwise deductible expense may be denied without sufficient substantiation.” The doctor also didn’t qualify to take home office deductions because he didn’t prove it was his principal place of business. (TC Memo 2022-1)
Please contact your advisor at Wegner CPAs if you need guidance related to retaining appropriate business records. Taking a meticulous, proactive upfront approach can protect your tax deductions and help make an audit much more manageable.