November proved to be an interesting month here at Galactic
Command. Everything changes; we have changed; there is sadness about the change.
We may talk about this someday, but for today let’s keep our discussion to
matters of tax.
Here is an easy one, but many get it wrong: can you
estimate your auto expenses?
The use of estimates in accounting is prevalent: a bad
debt reserve, an inventory write-down, even something as prosaic as
depreciation. It has to be this way,
otherwise you could not get financial results out in time to be useful. For
example, say you have a warranty program on a newer – and significant – product
line. You may want to accrue a warranty reserve on this product line, but the
line does not have sufficient track record to be statistically reliable. I suppose you could skip a reserve altogether
(not a good answer) or wait until there is enough history before issuing
financials (also not a good answer).
Tax returns also use these numbers. Mind you, a tax
return has a separate purpose from financial accounting - the purpose of a tax
return being to separate you from your money. Depending upon, the IRS may flat-out
tell you what accounting method to use. In most cases, though, tax and financial
accounting coexist well enough.
There was a case in the 1930s that many tax advisors have
studied: Cohan.
George Cohan was a famous Broadway star, producer and manager
in the early part of the 1900s. He was known for his over-the-top entertaining
of both fans and critics, and entertainment was a significant part of his
business expenses. What George was not good at, though, was keeping receipts
and records. He got audited, and the IRS proposed to disallow a raft of deductions
because Cohan could not substantiate them. The IRS won before the Tax Board of
Appeals (think the predecessor to today’s Tax Court).
Cohan had no intention of rolling over. He appealed.
And he won on his appeal.
The Court reasoned that approximating his expenses may
be unsatisfactory, but an outright denial of his expenses was erroneous.
So, the Court estimated what his expenses would be.
Mind you, there were some guardrails, such as the proving a right to deduct the
expenses and providing some basis for the deduction (restaurant booking
registers, for example), such that an independent person could agree that an
expense was incurred and when.
This estimating of expenses has since been known as
the Cohan rule.
But you know who did not like the rule? Congress. They
wrote the following into the tax Code:
Section 274(d)
(d) Substantiation
required
No deduction or
credit shall be allowed—
(1) under section 162 or 212 for
any traveling expense (including meals and lodging while away from home),
(2) for any expense for gifts, or
(3) with respect to any listed property
(as defined in section 280F(d)(4)),
unless the taxpayer
substantiates by adequate records or by sufficient evidence corroborating the
taxpayer’s own statement (A) the amount of such expense or other item, (B) the
time and place of the travel or the date and description of the gift, (C) the business purpose of the expense
or other item, and (D) the business relationship to the taxpayer of the person
receiving the benefit. The Secretary may by regulations provide that some or
all of the requirements of the preceding sentence shall not apply in the case
of an expense which does not exceed an amount prescribed pursuant to such
regulations. This subsection shall not apply to any qualified nonpersonal use vehicle (as
defined in subsection (i)).
Yes, it reads like gobbledygook but note the phrase “unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating the taxpayer’s own statement.” Congress was saying that – for certain expenses – Cohan would be insufficient to save the day. One of those expenses was “listed property” which normal people refer to as a car or truck.
The Cohan rule will not save you when
it comes to car and truck expenses. You have to keep records, such as a log or something
similar for the business use of the vehicle.
Lisa Nkonoki deducted $22,936 for vehicle expenses on
her 2009 federal tax return. Most of it was for the use of her Mercedes, but
there were also rental cars during the year. She did not have a fixed office,
meaning that she travelled – a lot.
The IRS wanted that mileage log.
Lisa refused. Off to Court they went.
Now the Court wanted the log.
Lisa told the Court that she had provided the log to the
accountant who prepared her return, but the accountant failed to return it to
her.
This placed the Court in a tough spot.
Her word alone was insufficient to substantiate the
deduction. The Court knew that her work
involved travel – meaning that vehicle expenses were to be expected – but Section
274(d) would not let the Court estimate those expenses.
The Court disallowed her vehicle expenses.
I am curious why Nkonoki did not provide an
alternative:
Using her e-mail, telephone and credit card records, could she have recreated an alternate log of her travel, including clients, dates and distances? We think of a log as being created at the moment (“contemporaneous”), but the Courts have noted that is not the correct meaning. Contemporaneous also encompasses other information (think e-mails) created at or near the time the expenses were incurred. Perhaps one transcribes that information into more usable form at a later time (such as a Tax Court hearing), but the information underlying such transcription was created at or near the time – that is, it was contemporaneous.
Our case this time was Nkonoki v Commissioner,
T.C. Memo 2016-93.
