TBAfeb23 02-231
Abstract: Running a business requires that strong,
supportable records be kept. Every expense that appears on a tax return might
have to be defended if the IRS decides to audit the return. And failing to
operate in a businesslike manner and keep good records might lead the IRS to
deem the activity a hobby rather than a business. This means expenses may be
limited or disallowed. This article and a sidebar illustrate how the IRS (and
sometimes the courts) view business records, what they’re looking for and what’s
considered acceptable substantiation.
If
you run a business, you know that you need to support expenses with detailed
records. To be deductible, every expense on your tax return might have to be
defended if your company is subject to an audit. Plus, failing to operate in a
businesslike manner, complete with good records, might lead the IRS to deem the activity
a hobby rather than a business — and your expenses may be limited or
disallowed.
While
there’s no one right way to keep business records, some types of expenses do require
more details. For example, records relating to automobile expenses, travel, meals and office-at-home costs are subject to special
requirements or limitations.
To claim deductions, an activity must be
engaged in for profit
For a business expense to be deductible, the taxpayer must
establish that the primary objective of the activity is making a profit. The
expense must also be substantiated and be an “ordinary and necessary” business
expense. In one court case (Gaston v.
IRS, 2021), a taxpayer claimed deductions that created a loss, which she
used to shelter other income from tax.
She engaged in various activities that included acting
in the entertainment industry and selling jewelry. The IRS found her activities
were more like hobbies than businesses engaged in for profit
and it disallowed her deductions.
The taxpayer did, however, have some success when she
took her case to the U.S. Tax Court. The court found that she was engaged in the
business of acting for profit during the years at issue, though not all of the claimed expenses were ordinary and necessary
business expenses. The court allowed deductions for expenses including
headshots, casting agency fees and lessons to enhance the taxpayer’s acting
skills. 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 that 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.
We can
help
Contact
us if you need assistance retaining adequate business records. Taking a
meticulous, proactive approach can protect your deductions and prevent the IRS from
viewing your business as a hobby.
Sidebar:
Proper records are required
In another case, 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.
In U.S. Tax Court, the doctor used charts to
illustrate his expenses but didn’t provide 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. It 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. (Elbasha v. IRS, 2022)
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