Expenses that could have been substantiated not allowed

The Tax Court would not accept journals and registers as evidence of payment of certain expenses on Schedule C, Profit or Loss From Business, and Schedule E, Supplemental Income and Loss, and refused to estimate the amount of the expenses under the Cohan rule where the taxpayers could have substantiated the expenses with underlying documents.

Background

Patricia and Anthony Anderson were self-employed and involved in company management, commercial real estate, and the medical industry. They carried on their business activities through six limited liability companies that were owned by a limited partnership. For 2010 through 2015, the years at issue in their case, they did not file income tax returns. Because they had not filed returns, the IRS prepared substitutes for returns for both of them for those years, based on a bank-deposits analysis.

The Andersons filed petitions with the Tax Court, and during the proceedings in their case, they filed returns using the status married filing jointly. The IRS did not process those returns. In each of the returns for each year, the Andersons included two to four Schedules C and a Schedule E. On the Schedules C and E, the Andersons claimed deductions for expenses incurred for a variety of business items, including insurance, mortgage interest, legal and professional fees, rent, taxes and licenses, utilities, wages, telephone, computer support services, postage and mail, gasoline and oil, and management fees. In Tax Court, to substantiate the expenses, the Andersons submitted a binder of accounting ledgers for their seven entities.

The cash disbursements journals and the account registers in the binder provided the details of each entity’s alleged expenses. The cash disbursements journals listed expenses day by day, referencing a date, a check number or account number, the payee, a description, and an amount. The account registers showed cash disbursements by payee, grouping the year’s disbursements to the payee.

The record also contained bank statements for the entities. Other than what indicia of payment by bank check or electronic funds transfer could be found in the bank statements, however, the record contained no documentary evidence of payment of any of the reported Schedule C and E expenses on the Andersons’ returns, nor did it contain any loan document, contract, or other evidence of an obligation to pay any expense.

At trial, Anthony Anderson explained that the relevant documents were in “so many boxes” that he “wouldn’t be able to bring [them] into th[e] courtroom.” Later in the trial, he claimed that the bank statements and records that would substantiate the expenditures recorded in the cash disbursements journal were in storage, and he did not have access to them because of another pending legal matter. Despite this, he also claimed that the couple would offer sufficient accounting records to support their actual income for the years that were audited.

To give the Andersons a chance to cure their failure to show where in the bank statements support for the register or journal entries could be found, the court ordered them to file a supplemental brief identifying those expenses reported on any of the Schedules C or E that were traceable to bank statements in the record and to identify the page in the record of the bank statement entry. It ordered the IRS to file a supplemental briefing answering the Andersons’ proposed findings of fact.

Based on the parties’ briefings, the court was able to come up with tables of the Andersons’ Schedule C and Schedule E expenses (table expenses) to which the IRS had no objection. This left the court to address whether expenses claimed by the Andersons on their returns other than the table expenses were deductible.

The law

In general, a taxpayer may deduct the expenses of carrying on a trade or business. However, the taxpayer has the burden of substantiating the amount and purpose of a claimed deduction and is required to maintain records that are sufficient to enable the IRS to determine the correct tax liability. A taxpayer can establish the fact (payment) of an expenditure by producing canceled checks, invoices, receipts, or credit card statements. Statements in briefs do not constitute evidence, and they cannot supplement the record.

If a taxpayer’s records have been destroyed or lost due to circumstances beyond their control, generally, the taxpayer is allowed to substantiate the deductions through secondary evidence. Also, under the Cohan rule (from Cohan, 39 F.2d 540 (2d Cir. 1930)), where the taxpayer has failed to keep records of deductible expenditures, the Tax Court has the discretion in appropriate circumstances to estimate those expenditures where there is evidence that deductible expenses were incurred. Nonetheless, where the evidence presented in a Tax Court trial is insufficient to support the deductibility of a particular expense, the court is obligated to sustain the IRS’s determinations and disallow the deduction.

The Tax Court’s decision

The Tax Court held that it would not accept the journals and registers for the entities as evidence that the expenses the Andersons claimed were actually paid. It further held that it would not estimate the amounts of the expenses under the Cohan rule.

Although the Andersons provided the cash disbursements journals and the account registers for each of their entities, they did not provide any of the underlying documents, such as canceled checks, invoices, receipts, or credit card statements, for the entries in the journals and registers. As an excuse for the lack of substantiating documents, at trial, Anthony Anderson testified that he and his wife were either (1) unwilling to provide them because of the sheer volume of documents or (2) unable to provide them due to other litigation.

The Tax Court found that the Andersons’ first excuse described their choice on how to present their case, not a circumstance beyond their control. Their second excuse, according to the Tax Court, lacked “particulars that might convince [the court] that the stored records are unavailable because of circumstances beyond [the Andersons’] control.” The court also noted that in other cases where a taxpayer had presented the court with accounting documents merely containing lists of categories and amounts of expenses without the introduction of any source documents underlying the figures, it treated the documents as argument rather than evidence, and, accordingly, it would do so in the Andersons’ case. Therefore, the Tax Court found that, other than the journals and registers, the record lacked evidence of the outlays underlying the Andersons’ Schedule C and E expenses.

The Andersons also invoked the court’s discretion under the Cohan rule to estimate acknowledged expenses that a taxpayer cannot fully substantiate. The IRS argued that the court lacked this discretion because no evidentiary basis existed upon which the court could make an estimate.

The Tax Court, however, found another reason not to make an estimate under the Cohan rule. It explained that in Cohan, the Second Circuit found that not only did the taxpayer fail to keep account of his travel expenses, but also that he probably could not have done so. Thus, the Tax Court has previously determined, in Joseph, T.C. Memo. 2020-65, that estimating unsubstantiated expenses under the Cohan rule would be inappropriate when proper recordkeeping is feasible and can reasonably be expected. The court also noted that the Seventh Circuit has recognized this limitation, finding that the Cohan rule cannot be applied where the claimed but unsubstantiated deductions are of a sort for which the taxpayer could have and should have maintained the necessary records (Lerch, 877 F.2d 624 (7th Cir. 1989) , aff’g T.C. Memo. 1987-295).

Because the Andersons had averred that they possessed and would offer at trial sufficient evidence of their actual income, and the Tax Court was not persuaded by their excuses for not doing so, the court found that it was feasible for the Andersons to have maintained records that would substantiate the expenses at issue and that they actually did maintain these records. Thus, the court would not estimate any of those expenses under the Cohan rule and allowed only the table expenses.

Reflections

Besides claiming the table expenses and the disallowed expenses, the Andersons claimed a net operating loss (NOL) carryover on their 2010 return based on an NOL carryover from 2005, increased by NOLs from 2006 through 2009, which led to NOL carryovers to the years 2011 through 2013. They also claimed an NOL in 2014 that was included in the NOL carryover to 2015. However, the Andersons did not show that the NOL carryover from 2005 was not used in 2006 through 2009 or that they had an NOL for 2014. Thus, the court also found that the NOL deductions the Andersons claimed must be disallowed because the NOL carryover amounts were not substantiated and the court had no basis to estimate the NOL carryover amounts.

Anderson, T.C. Memo. 2024-95

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.