It is elementary that receipts should be kept for any tax deductions you are claiming. However, what happens if they are not available? The examples below provide two possible answers.
In a recent case the IRS conducted an audit of a taxpayer’s return. After the audit they denied deductions and assessed additional taxes. The reason for the denial was because there was no backup for the deductions.
The taxpayer maintained that his house was flooded, and the water destroyed his paperwork. He argued that the deductions should be allowed based solely on his testament and other evidence.
The court ruled mostly for the IRS. In their opinion they stated that the taxpayer had not furnished an insurance claim or any other evidence other than his own testimony to substantiate the deductions. They emphasized that when documents are unavailable due to a reason beyond the taxpayer’s control the burden is still on the taxpayer to show why the deductions should be taken.
It did, however, state that deductions not subject to the requirements of Section 274 (i.e. T&C, auto expenses, etc.) may be substantiated by a reasonable reconstruction of expenses to the extent possible. As an example they suggested one possible way is to provide statements from others acknowledging receipt of payment and/or provision of services or goods. They did, however, indicate that all of the required information must be substantiated.
For the reasons stated above the court allowed a few deductions for expenses not subject to Section 274. It is important to note that the court only allowed minimum amounts since the taxpayer made no effort to reconstruct the information. His testimony was not enough evidence to permit the deductions.
In a similar case a taxpayer claimed that she had maintained complete and accurate records, including all documentation Section 274 requires for travel and entertainment expenses, but lost them when she moved.
Unlike in the previous example she furnished the court with three separate spreadsheets that detailed her deductions. She had originally produced it as a way to organize data in order to prepare her tax return. She went even further and provided bank statements and similar documents to prove that payments were indeed made to certain businesses for certain amounts. Even the CPA who prepared her tax returns testified that she had presented the original documents to him for all the items recorded on the spreadsheets which, consequently, he found to be accurate and complete.
The court found (mostly) for the taxpayer. By using her spreadsheets and other documents it was able to verify estimates of a number of expenses. Thus, the deductions were allowed.
However, the court also ruled that not all expenses could be verified this way. They went on to say that estimates do not meet the strict requirements that Section 274 requires. While her bank accounts and other documents proved what she had spent on various items the court stated that they did not meet the requirement of Section 274. All of those deductions were therefore disallowed.
The court also denied deductions for office supplies and certain other expenses. It explained that, while she proved that she made payments to third parties in the amount she was deducting, she failed to document what each item was for and how it related to her business.
As these two differing opinions illustrate there are some proactive steps you can take to help substantiate deductions when paperwork is unavailable. However, it is (at best) somewhat of a crap shoot as to whether or not the deductions will be allowed.
The best strategy is to have a strong offence by ensuring that your documents are safely secured in a place where they cannot be destroyed or lost. That is the most effective way of making sure your deductions are allowed.
Information provided by The General Ledger, Vol. 31, No. 9 September 2014.