Taxpayer’s Responsibility to Substantiate the Numbers on Their Federal Tax Return

By Coleman Jackson, Attorney and Certified Public Accountant

October 11, 2022

As a general rule a taxpayer is allowed a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business.  This basic tax rule is set forth in Internal Revenue Code Section 162.  The particular tax return that a taxpayer’s file depends upon how the business is structured under applicable state business organizational law and certain timely tax elections that the business owners make.  That sounds wonderful; but don’t move too fast because the Internal Revenue Service is not going to simply take the taxpayer’s word for it.  Generally, taxpayers are required to keep records in sufficient quality to establish the amounts, dates and business purpose of the items recorded on their tax return. Taxpayers generally bear the burden to show that they are entitled to deduct an expense on their tax return.  See Internal Revenue Regulation Section 1.6001.  Sometimes taxpayers can establish that an expense has occurred during a tax period, but cannot establish the exact amount.  When this occurs, the taxpayer must produce sufficient evidence to permit an estimation of the amount deductible on the tax return.  See Vanicek v Commissioner, 85 T.C. 731, 743 (1985).

Internal Revenue Code Section 274 sets forth detailed substantiation requirements to which taxpayers must adhere.  Treasury Regulation 1.274(d) sets out several categories of expenses that require enhanced substantiation.  Generally, the taxpayer substantiates their tax deductions by either adequate records or sufficient probative evidence that corroborates the taxpayer’s statements and opinions concerning the deductibility of the expense.  The substantiation burden only requires that the taxpayer maintain sufficient records and documentary evidence to establish the date, amount and business purpose or use of the expenditure.  The taxpayer’s words alone; however, are insufficient substantiation.  But the taxpayer’s written or oral words are sufficient to substantiate the deductibility of the expenditure if it is supported by credible corroborative evidence sufficiently establishing the deductibility of the expense.  As stated before, the burden to show that expenditures are deductible belongs to the taxpayer at all times. The United States Supreme Court has established this burden issue long ago in a case called New Colonial Ice Co. v Helvering, 292 U.S. 435, 440 (1934).  Yes, that means the taxpayer must prove that the expense is deductible in the first place.  In other words, the taxpayer must always prove deductibility of an expense upon challenge by the IRS.  Moreover, see also Internal Revenue Regulation 1.274. (d) regarding the enhanced substantiation requirements on certain categories of expenses.

For the non-tax lawyer and non-tax professional, this might all seem very esoterically complicated.  Like lifting weights—start with a weight that you can easily lift and graduate to more and more weight until you have achieved your goal.  Our goal here is to explain this in layman’s terms; so that, layman can understand the tax concepts of deductibility, substantiation and burden as these terms apply to their tax return.  Let’s try to explain substantiation in layman’s terms:  to be deductible on the taxpayer’s tax return all expenditures must meet three requirements, and possibly four as follows:

  1. Be incurred in pursuit of a trade or business (this means personal expenses don’t count);
  2. Be an ordinary and necessary expense (this means expenditures common to the taxpayer’s trade, group or industry);
  3. Be substantiated by sufficient records or documentation, which can include the taxpayer’s corroborated written and oral statements; and for some expense categories;
  4. Be subject to enhanced or stricter substantiation, such as, contemporaneous logs, charts, and diaries.

Looking at someone play sports is not the same as actually participating in sports.  Neither is reading about tax substantiation in a blog the same as actually running a trade or business in real time and sufficiently substantiating tax expenditures in preparation for the day when the Internal Revenue Service Auditor knocks on the door.  Like locks on our doors are preparatory; the expenditure substantiating taxpayer don’t expect the auditor’s knock, but is prepared if it comes.  It’s kind of like being prepared when a thief comes by having locks, alarms and even attack dogs.  What might these preparatory things look like?

“Ordinarily, documentary evidence will be considered adequate to support an expenditure if it includes sufficient information to establish the amount, date, place, and the essential character of the expenditure.  For example, a hotel receipt is sufficient to support expenditures for business travel if it contains the following: name, location, date, and separate amounts for charges such as for lodging, meals, and telephone.  Similarly, a restaurant receipt is sufficient to support an expenditure for a business meal if it contains the following:  name and location of the restaurant, the date and amount of the expenditure, the number of people served, and, if a charge is made for an item other than meals and beverages, and indication that such is the case.  A document may be indicative of only one (or part of one) element of an expenditure.  Thus, a cancelled check, together with a bill from the payee, ordinarily would establish the element of cost.  In contrast, a canceled check payable to a named payee would not by itself support a business expenditure without other evidence showing that a check was used for certain business purpose.”  See Internal Revenue Code 274.

If a taxpayer with a canceled check payable to a named payee is struggling to lift the substantiation weight, one can only imagine the plight of the taxpayer who conducts its business in cash.  Cash is a completely inappropriate way to conduct business.  But many foreign immigrants came from societies and cultures where business is routinely conducted in cash.    Cash cannot be substantiated and an IRS auditor is very likely to deny any and all expenditures paid in cash unless the taxpayer has serious corroborating evidence to back up their written or oral word.  When paying contract labor and other expenses by cash, the taxpayer voluntarily places onto themselves and their company’s enormous weight because Internal Revenue Code Section 6663(a) states that if any part of any underpayment of tax required to be shown on a tax return is due to fraud, there shall be added to the tax an amount equal to 75 percent of the portion of the underpayment which is attributable to fraud.  See Tax Court case styled, Petzoldt v. Commissioner92 T.C. 661, 699 (1989).  Construction companies and other taxpayers must be sure to substantiate their contract labor or other labor costs by obtaining accurate and complete Form W-9 from all workers who are independent contractors and Form W-4 for workers who are employees, by filing all Form 1099 Miscellaneous with the Internal Revenue Service for all independent contractors or file Form W-2 for employees, withholding the proper tax amounts when required by law, by paying all workers by check and documenting the labor transactions in their books and records.  Numerous federal courts have stated that dealing in excessive amounts of cash is an indicia of tax fraud.  Courts have said that other indicia of tax fraud are (1) substantial understatement of income, (2) maintenance of inadequate records; and 3) implausible or inconsistent explanations of behavior.  See Bradford v Commissioner, 796 F.2d 303, 307 (9th Cir. 1986).  Taxpayer’s demonstrating two or more of these characteristics are all but certain to be charged with the tax fraud penalty and possibly referral to the IRS Criminal Investigations Unit.  See Otsuki v Commissioner, 53 T.C. 96, 106 (1969) and Solomon v. Commissioner, 732 F.2d 1459, 1461 (6th Cir. 1984).

And for expenses, such as, car and truck expenses, taxpayers must comply with the weightier substantiation requirements of Internal Revenue Code Section 274(d) which requires the taxpayer to substantiate vehicle, entertainment, travel and certain other listed expenses by sufficient evidence corroborating the taxpayer’s own statements.  Under the stricter substantiation rules taxpayers must maintain adequate records, such as, account books, diaries, logs, statements of expense, trip sheets, or similar records prepared contemporaneously with the use or incurrence of the expenditure and documentary evidence such as receipts or bills.  See Jijun Chen and Xiujing Gu v. Commissioner (T.C. Memo 2015-167) a recent Tax Court case dealing with disallowance of personal car and truck expenses.  The IRC 274(d) enhanced substantiation requirements are set forth in Internal Revenue Regulations Section 1.274-5T.  Remember that locks, alarms and attack dogs are to prepare for the thief or robber.  Taxpayers are responsible for substantiating the numbers on their tax returns, and knowing and properly implementing these taxpayer substantiation requirements are preparatory in the event the tax auditor comes knocking.

This law blog is written by the Taxation | Litigation | Immigration Law Firm of Coleman Jackson, P.C. for educational purposes; it does not create an attorney-client relationship between this law firm and its reader.  You should consult with legal counsel in your geographical area with respect to any legal issues impacting you, your family or business.

Coleman Jackson, P.C. | Taxation, Litigation, Immigration Law Firm | English (214) 599-0431 | Spanish (214) 599-0432

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