Burden of proof: The shoebox method and 9-martini lunch

Editors: Brian Hagene, CPA, CGMA, and Mark G. Cook, CPA, CGMA

If a business client questions how detailed their recordkeeping should be, this can be a great time to discuss the burden of proof. Tax professionals often preach recordkeeping and document retention to clients. Using their records to distinguish business expenses under Sec. 162(a) is important. However, the client also needs to be prepared to substantiate these expenses if questioned in Tax Court.

Tax Court Rule 142(a) states that “[t]he burden of proof shall be upon the petitioner, except as otherwise provided by statute or determined by the Court.” Under Sec. 7491(a) (1), the burden of proof shifts to the IRS when the taxpayer “introduces credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer.”

In Wright, T.C. Summ. 2024-9, the Tax Court held that the taxpayers did not meet their burden of proof with respect to expenses that were disallowed by the IRS. The case involved adjustments made to expenses for 2014 and 2015 claimed by Steve Wright and his spouse on Schedule E, Supplemental Income and Loss, for an S corporation and expenses deducted on Schedule C, Profit or Loss From Business, for a café owned by the couple for tax years 2014, 2015, and 2016.

The Tax Court determined that the Wrights had not met their burden of proof for both the Schedule E and Schedule C expenses because they had not provided evidence in Tax Court to substantiate the expenses.

Records and evidence: The ‘shoebox method’ is unacceptable

The court’s opinion pointed out that oral testimony by itself is not enough to meet substantiation requirements (Tokarski, 87 T.C. 74 (1986)). The court noted that for expenses, including those for travel, meals, and entertainment, a taxpayer’s substantiation must include records and evidence to support “(1) the amount of the expenditure or use based on the appropriate measure; (2) the time and place of the expenditure or use; (3) the business purpose of the expenditure or use; and (4) in the case of entertainment, the business relationship to the taxpayer of each person entertained” (Wright, at *10, citing Sec. 274(d)).

The court provided guidance to the taxpayers on how to respond during briefing, advising them to attach a spreadsheet addressing each adjustment at issue. This would help the court find the exact item of support for each deduction rather than if the taxpayers had supplied vast amounts of documentation.

The taxpayers did provide a spreadsheet for meals and entertainment but not for the other adjustments in question. The taxpayers submitted evidence to support each adjustment in question by supplying 1,882 pages of photocopied bills, receipts, and other items, including some with handwritten notes.

The court was not pleased with this large amount of documentation. It referred to the taxpayers’ approach as the “shoebox method” of submitting evidence. This shoebox method was determined to be unacceptable in Patterson, T.C. Memo. 1979-362 (defining it as “attaching photocopies of numerous cash register tapes and of similar bits of paper to [the taxpayer’s] returns, without making any effort on the returns or on brief, and only a slight effort in oral testimony, to link any item to a deductible trade or business expense transaction.”). The court refused to sort through the Wrights’ evidence and held that they did not meet the burden of proof related to the contested adjustments.

Substantiating expenses requires credible evidence

Although the taxpayers’ spreadsheet provided a guide to the adjustments for meal expenses, the court determined the information was not reliable or credible. On further examination, it appeared that, in some instances, a restaurant check and credit card receipt for the same meal were counted as separate meals. One spreadsheet showed 28 pairs of checks and credit card receipts from the same restaurant, with each pair on the same date and for the same charge. Of those 28 pairs, 25 showed the same number on the check and the receipt, and for the other three pairs, the check number was illegible. However, the check and receipt for each pair showed different business purposes and attendees, along with different tip amounts.

For an explanation of why the checks and the receipts were from the same day and restaurant, Wright claimed that he had multiple business meetings that day. However, the times listed on the checks and the receipts were so close together that the Tax Court did not accept this argument. The Tax Court concluded that each check and credit card receipt was for the same meal and that Wright was attempting to double-count each deduction.

In addition to the lack of support for the expenses, the Tax Court also questioned whether these meals were business meals at all. Six of the receipts showed one “Chicken Caesar Salad” each, along with seven, six, six, seven, six, and nine “gins,” respectively. The six receipts noted that for four of the meals, the attendees were the Wrights. Wright testified at the trial that he would drink gin at a meal and his spouse would drink wine. Based on these circumstances, the Tax Court decided that only Wright was present at these four meals and that they did not serve any business purpose. The court was also not persuaded that anyone other than Wright was at the other two meals or that they had a business purpose.

The Tax Court concluded that the taxpayers provided fabricated evidence. The court followed the holding in Brown, T.C. Memo. 1985-269: “[W]here it becomes apparent that some evidence tendered by [the taxpayers] is not trustworthy, we must regard [the taxpayers’] credibility as so damaged that their uncorroborated testimony is insufficient on any other issue as to which they bear the burden of proof.”

The next time a client asks about detailed recordkeeping for business expenses, practitioners should address the burden of proof. If a taxpayer’s case makes it all the way to Tax Court, the court will require the taxpayer to provide substantiating evidence for expenses challenged by the IRS. As Wright demonstrates, properly maintained expense records make substantiating expenses significantly easier.

Editor Notes

Brian Hagene, CPA, CGMA, is partner/owner at Mathieson, Moyski, Austin & Co. LLP in Lisle, Ill., with CPAmerica. Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact thetaxadviser@aicpa.org.

Contributors are members of or associated with CPAmerica or SingerLewak LLP.