You have to keep records.
Depending
upon, this can be easy. Say that you have a job and a money market account –
two sources of income. At year-end you receive a W-2 and a 1099-INT. File them
with your individual tax return and you have kept records.
Dial this up
to business level and the recordkeeping requirement can be more substantial.
Maybe you do
not need a bookkeeper or accountant, but you can open a separate business bank
account, running all deposit and disbursements through it. You can buy an
expanding file – one with a pocket for each month – and keep invoices and receipts
throughout the year. That might not be sufficient were you a regional
contractor, with equipment and employees and whatnot, but it may be more than
enough for what you do.
Why do this?
Because of
taxes.
There is a
repetitive phrase in tax cases - I have read it a thousand times:
Deductions are a matter of legislative grace, and the
taxpayer must prove his or her entitlement to deductions.”
To phrase it
another way:
Everything is taxable and nothing is deductible unless we say
it is deductible.
One of the
things the IRS says is that you must keep records. You can extrapolate what the
IRS can do to you concerning deductions if you do not.
“But they
can’t eat me, right, CTG?” you ask.
No, but here is what they can do.
Sam Fagenboym
was a 50% owner of Alcor Electric, which provided electrical installation for
midsize commercial projects. Alcor was a sub to a general contractor. Alcor in
turn had suppliers and its own subs.
With the
possible exception of the second round of subs, this is pretty routine stuff.
Alcor was an
S corporation. It allocated Fagenboym a loss of approximately $110,000 on his 2015
Schedule K-1.
The IRS
examined Alcor’s 2015 business return.
Alcor could
not document over a quarter million dollars of purchases from a supplier.
Half of that
audit adjustment went to Fagenboym, as he was a 50% owner.
The IRS next
looked at Fagenboym’s personal return.
So much for
the loss he had claimed from Alcor.
Fagenboym went
to Tax Court. He went pro se, generally meaning that he was without tax
representation. As we have discussed
before, that technically is not correct, as I could represent someone in Tax
Court and they would be considered pro se.
Fagenboym argued
for Cohan treatment of Alcor’s business expenses.
COMMENT: I would have expected Alcor to fight this issue during its business audit, but here is Fagenboym doing the fighting during his individual audit.
Cohan is old tax case, going back to 1930
and involving someone who was known for entertaining but not for keeping receipts
and records. The Court considered his situation, reasoning there was no doubt that
Cohan had incurred expenses. It would be inequitable to disallow all expenses,
so the question became: how much to allow?
Cohan has triggered tax changes ever since.
It was responsible for the hyper-technical rules concerning meals and
entertainment, for example, as well as business use of a vehicle.
Fagenboym wanted
some of that Cohan.
I presume there
truly were no records. There is no way that I would lead with Cohan if I
had any other argument.
Why?
Think about
it from the Court’s perspective.
(1) The Court will require a rational basis
to estimate the expenses, and
(2) The Court will consider the taxpayer’s
culpability in creating this situation.
Perhaps if
there were extenuating circumstances: illness of a key employee, a data loss, a
pandemic, something that compromised the taxpayer. The more one is responsible for causing the
mess, the less likely the Court will be to clean-up the mess.
Fagenboym
tried. He presented the Court with estimates of job profitability. He then
subtracted labor and other known expenses to arrive at what the missing purchases
should have been. He submitted four pages of handwritten analysis, but he did
not or could not support it with business bank statements or other records,
such as an accounts payable history for the supplier in question. Despite how
earnest he seemed and how well he understood the business, there were no
records backing him up.
Fagenboym
could not overcome the two factors above. Even if the Court allowed some
leniency on his culpability, it decided it could not independently arrive at a
reasonable estimate of the costs involved.
No Cohan.
No tax deduction. Bad day in Court for Fagenboym.
