Why Do We Keep Vehicle Logs?

  

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.

Don’t Be A Jerk

 

I am looking at a case containing one of my favorite slams so far this year.

Granted, it is 2020 COVID, so the bar is lower than usual.

The case caught my attention as it begins with the following:

The Johnsons brought this suit seeking refunds of $373,316, $192,299, and $114,500 ….”

Why, yes, I would want a refund too.

What is steering this boat?

… the IRS determined that the Johnsons were liable for claimed Schedule E losses related to real estate and to Dr. Johnson’s business investments.”

Got it. The first side of Schedule E is for rental real estate, so I gather the doctor is landlording. The second side reports Schedules K-1 from passthroughs, so the doctor must be invested in a business or two.

There is a certain predictability that comes from reviewing tax cases over the years. We have rental real estate and a doctor.

COMMENT: Me guesses that we have a case involving real estate professional status. Why? Because you can claim losses without the passive activity restrictions if you are a real estate pro.

It is almost impossible to win a real estate professional case if you have a full-time gig outside of real estate.  Why? Because the test involves a couple of hurdles:

·      You have to spend at least 750 hours during the year in real estate activities, and

·      Those hours have to be more than ½ of hours in all activities.

One might make that first one, but one is almost certain to fail the second test if one has a full-time non-real-estate gig. Here we have a doctor, so I am thinking ….

Wait. It is Mrs. Johnson who is claiming real estate professional status.

That might work. Her status would impute to him, being married and all.

What real estate do they own?

They have properties near Big Bear, California.

These were not rented out. Scratch those.

There was another one near Big Bear, but they used a property management company to help manage it. One year they used the property personally.

Problem: how much is there to do if you hired a property management company? You are unlikely to rack-up a lot of hours, assuming that you are even actively involved to begin with.

Then there were properties near Las Vegas, but those also had management companies. For some reason these properties had minimal paperwork trails.

Toss up these softballs and the IRS will likely grind you into the dirt. They will scrutinize your time logs for any and every. Guess what, they found some discrepancies. For example, Mrs. Johnson had counted over 80 hours studying for the real estate exam.

Can’t do that. Those hours might be real-estate related, but the they are not considered operational hours - getting your hands dirty in the garage, so to speak. That hurt. Toss out 80-something hours and …. well, let’s just say she failed the 750-hour test.

No real estate professional status for her.

So much for those losses.

Let’s flip to the second side of the Schedule E, the one where the doctor reported Schedules K-1.

There can be all kinds of tax issues on the second side. The IRS will probably want to see the K-1s. The IRS might next inquire whether you are actually working in the business or just an investor – the distinction means something if there are losses. If there are losses, the IRS might also want to review whether you have enough money tied-up – that is, “basis” - to claim the loss. If you have had losses over several years, they may want to see a calculation whether any of that “basis” remains to absorb the current year loss.

 Let’s start easy, OK? Let’s see the K-1s.

The Johnson’s pointed to a 1000-plus page Freedom of Information request.

Here is the Court:

The Johnsons never provide specific citations to any information within this voluminous exhibit and instead invite the court to peruse it in its entirety to substantiate their arguments.”

Whoa there, guys! Just provide the K-1s. We are not here to make enemies.

Here is the Court:

It behooves litigants, particularly in a case with a record of this magnitude, to resist the temptation to treat judges as if they were pigs sniffing for truffles.”

That was a top-of-the-ropes body slam and one of the best lines of 2020.

The Johnsons lost across the board.

Is there a moral to this story?

Yes. Don’t be a jerk.

Our case this time was Johnson DC-Nevada, No 2:19-CV-674.

A CPA Goes Into Personal Audit

Folks, if you wind up before the Tax Court, please do not say the following:

… petitioner testified that allocating some of the expenses between his personal and business use required more time than he was willing to spend on the activity.”

Our protagonist this time is Ivan Levine, a retired CPA who was trying to get a financial service as well as a marketing business going. He worked from home. He used personal credit cards and bank accounts, as well as a family cellular plan. He also drove two vehicles – a Porsche 911 and a Chevrolet Suburban – for both personal and business reasons. All pretty standard stuff.

The IRS came down like a sack of bricks on his 2011 return. They challenged the following:

(1) Advertising

(2) Vehicle expenses

(3) Depreciation, including the vehicles

(4) Insurance (other than health)

(5) Professional fees

(6) Office expenses

(7) Supplies

(8) Utilities

(9) Cell phone

(10)       Office-in-home

Whoa! It seems to me that some of these expenses are straight-forward – advertising, for example. You show a check, hopefully an invoice and you are done. Same for professional fees, office expenses and supplies. How hard can it be?

It turns out that he was deducting the same expense in two categories. He was also confusing tax years – currently deducting payments made in the preceding year.

The office-in-home brings some strict requirements. One of them is that an office-in-home deduction cannot cause or increase an operating loss. If that happens, the offending deductions carryover to the subsequent year. It happens a lot.

It happened to Mr. Irvine. He had a carryover from 2010 to 2011, the year under audit. The IRS requested a copy of Form 8829 (that is, the office-in-home form) from 2010. They also requested documentation for the 2010 expenses.

COMMENT: Why would the IRS request a copy of a form? They have your complete tax return already, right? This occurs because the IRS machinery is awkward and cumbersome and it is easier for the revenue agent to get a copy from you.

Mr. Irvine refused to do either. The decision does not state why, but I suspect he thought the carryover was safe, as the IRS was auditing 2011 and not 2010. That is not so. Since the carryover is “live” in 2011, the IRS can lookback to the year the carryover was created. Dig in your heels and the IRS will disallow the carryover altogether.

The vehicles introduce a different tax technicality. There are certain expenses that Congress felt were too easily subject to abuse. For those, Congress required a certain level of documentation before allowing any deduction. Meals and entertainment are one of those, as are vehicle expenses.

Trust me on this, go into audit without backup for vehicle expenses and the IRS will just goose-egg you. You do not need to keep a meticulous log, but you need something. I have gotten the IRS to allow vehicle expenses when the taxpayer drives a repeating route; all we had to do was document one route. I have gotten the IRS to accept reconstructions from Outlook or Google calendar. The calendar itself is “contemporaneous,” a requirement for this type of deduction.

BTW the tricky thing about using Outlook this way is remembering to back-up Outlook at year-end. I am just saying.

You know Mr. Irvine did not do any of this.

Why?

Because it would have required “… more time than he was willing to spend on the activity.”

This from a CPA?

Being a CPA does not mean that one practices tax, or practices it extensively. I work tax exclusively, but down the hall is a CPA who has careered in auditing. He can exclaim about myriad issues surrounding financial statements, but do not ask him to do a tax return. There are also nouveau practice niches, such as forensic accountants or valuation specialists. One is still within the CPA tent, but likely far away from its tax corner.

Although a CPA, Mr. Irvine could have used a good tax practitioner. 

How To Lose All Of Your Auto Deduction

I am not a fan of dumb.

And I am reading big dumb.

The IRS wanted over $22 thousand in taxes and $4,000 in penalties. There were several issues, but there was one that racked up the money.

What do you need if you want to claim auto expenses on your tax return?

Answer: some kind of record, like a log.

There is a reason for this. It is not random, chaotic or unfathomable.

The reason has two parts:

(1)  There was a very famous case decided in the 1930s concerning George Cohan. George was a playwright, a composer, a singer, actor, dancer and producer. He was very famous. He was also a terrible record keeper. Given his day job, he spent a ton of money schmoozing people. He deducted some of those expenses on his tax return, as he had to wine and dine to maintain his recognition, connections and earning power. Problem was: he kept lousy records. One had to – essentially – take his word for the expenses.

The Court, knowing who he was, thought it believable that he had incurred significant entertainment expenses. The Court simply estimated what they were and allowed him a deduction.

Ever since, that guesstimate has been referred to in taxation as the “Cohan rule.”

Problem was: everything can be abused. What started out as common sense and mitigation for George Cohan became a loophole for many others.

(2)  Congress got a bit miffed about this, especially when it came to travel, transportation and entertainment expenses. These expenses can be “soft” to begin with, and the Cohan rule made them gelatinous. Congress eventually said “enough” and passed Code Section 274(d), which overrides the Cohan rule for this category of expenses.

BTW, “transportation” is just a fancy tax-word for mileage.

The tax-tao now is: no records = no mileage deduction. Forget any Cohan rule.

Now, you do not need to record every jot and tittle as soon as you get in the car. Records can include your Outlook calendar, for example. You could extend the appointment by mileage from MapQuest and (probably) have the IRS consider it adequate. The point is that you created some record, at or near the time you racked up the mileage, and that record can be reasonably translated into support for your deduction.

Enter Gary Roy.

He was a consultant in Los Angeles. He worked out of his home and drove all over the place for business. He must have made a couple of bucks, as he purchased an Aston Martin Vantage.

This is not a car you see every day. Chances are the last time you saw an Aston Martin was in a James Bond movie.

You know he deducted that car on his tax return.

There are multiple issues in the case, but the one we want to talk about is his car. Roy appeared before the Court and straight-facedly claimed that he kept a mileage record for the Aston. He presented a sheet of paper showing mileage at the beginning of the year and mileage at the end of the year. He helpfully added the description “business use” so the Court would know what they were looking at.

As far as he was concerned, this was all the record-keeping he needed, as the car was 100% business use.

I want to be sympathetic, I really do. I suppose it is possible that he did not understand the rules, but I read in the decision that he used a tax preparer. 

COMMENT: To whom he paid $250. Given that there were complexities in his tax return – the business and a gazillion-dollar car, for goodness’ sake – he really, really should have upgraded on his tax preparer selection.

Roy had no chance. That stretch of tax highway has a million miles on it, and he missed the pavement completely.

Without the Cohan rule, the Court was not going to spot him anything. He just got a big zero. That is what Section 274(d) says. 

And is what Congress wanted back when.

Worst case scenario for Mr. Roy.

Sometimes the IRS Just Doesn't Believe You

I was reading the following recently, and we will use it as a springboard for our discussion today:

In its continued assault on real estate investors, the Court held in Jafarpour and Prang v. Commissioner, …, the taxpayers were not actively involved in a real estate trade or business nor was she a real estate professional ….

Prang is just one more taxpayer to fall under the IRS’s aggressive assault on real estate investors.

That writer and I do not agree on Jafarpour and Prang (“Prang”).

We are talking today about the taxation of real estate activities. Ever since 1986 we have had the passive activity rules, which Congress used to address the problem of tax shelters. The overall concept is simple: if an activity is considered to be passive, then losses from the activity cannot be subtracted from income considered nonpassive. Here is an example: you will not be allowed to claim losses or tax credits from an Alpaca investment against your W-2 income and bonus.

There are exceptions for real estate activities. This is not surprising, considering how significant real estate is to the national economy. The exception that Prang wanted was the “real estate professional” exception. If she could attain that, then her real estate activities would be nonpassive. She could subtract losses to her heart’s content.

There are two basic requirements to being a real estate pro:

(1)   More than one-half of your work hours have to be real-estate related, and

(2)   You have to work more than 750 hours in real estate

We have several real estate pro clients. A builder or broker qualifies, for example. These guys work real estate full-time, so they are easy to identify. What if you mix real estate with non-real estate activities? Further, what if the total hours are close?  You had better keep good records. That gets us to Prang.

Jafarpour was the husband. He sold stock options in 2006.

Prang was the wife. She was a chiropractor. Unfortunately she got injured and sold her practice during the middle of 2006.

So Prang and her husband came into cash and were looking for something to do. They have some experience in real estate. They have rented a former residence in California for a decade, for example. She attended seminars on real estate investing, including a course at the community college. The community college instructor explained the additional depreciation available for Katrina-affected areas (referred to as the GO Zone).

Mrs. Prang liked the idea and they snapped up three properties in Louisiana and Alabama. They almost immediately signed contracts with management companies to handle the properties. After all, they live almost 2,000 miles away. They returned to California.

They claimed over $271,000 in real estate losses on their 2006 tax return. Surprisingly, this caught the IRS’ attention. They were audited.

Jafapour immediately admitted that he was not a real estate pro for 2006. Not a problem, as Mrs. Prang claimed that she was the real estate pro. The IRS said: let’s go through the math: how many hours did you work and how many hours were in real estate?

The way to prove this is to show a record or log, preferably kept contemporaneously, showing what you did and how long it took. Mrs. Prang had an appointment book at the chiropractic office, so that should establish the chiropractic hours. The IRS looked at it and had questions. Daily visits were often illegible. There were daily totals, but the IRS was unable to determine what the totals represented. The totals frequently did not coincide with the number of patients filled-in for the day or the hours Mrs. Prang was supposedly working. Prang deepened the hole by attesting that she left the practice after selling in June. However there were e-mails and notations that she was still involved.

The IRS moved over to the real estate logs. The log was divided into sections. Immediately they were curious because she wrote her activities in pen but the number of hours in pencil. Mrs. Prang explained that she did this so she could cross-reference her time with phone records and make adjustments. Flipping through, the IRS saw several times the same task recorded in multiple sections. More than once the amount of time seemed excessive for the task. For example, Prang noted that she spent one hour on November 8, 2006 reading the following e-mail:

Hi Lecia, I'm your loan processor and will be your main contact person from this point on. I received the FedEx package you sent back. I will review it and prepare the file for my underwriter to review. I will update you with the status within 3 business days."

So she was a slow reader. The IRS pressed on. They spotted several days where she said he worked 17 or more hours, which was impressive. Problem is that she noted the same tasks on more than one day. She described doing something while she was actually on a plane back to California, which would have been a Copperfield-worthy trick. Some of the e-mails she claimed to have sent were from her husband’s e-mail account - and electronically signed by her husband.

The IRS came to the conclusion that she manufactured the logs after-the-fact, which greatly weakened their credibility. She worked the logs to get the answer she wanted. The IRS trusted none of it, denied her real estate professional status and disallowed her loss.

Prang went to Tax Court. Here is the Court:

We would have to engage in complete guesswork to determine how much time Ms. Prang spent at her chiropractic business on a particular day during 2006, let alone the entire year. We decline to engage in such dubious speculation.”

We are not convinced that Ms. Prang contemporaneously recorded her actions in the real estate log. Petitioners' unreasonable assertions are so pervasive that the entire log is tainted with incredibility. Moreover, petitioners' appointment book is frequently illegible and generally ambiguous. While Ms. Prang may have invested a considerable amount of time in real estate activities during 2006, petitioners' records are simply too unreliable for us to draw any sound conclusion.”

The Tax Court found the logs unreliable. With them she couldn’t prove her real estate pro status. Without that status she could not claim losses. Without the losses she owed the IRS a lot of money. And she owed a big penalty.

My Take:  I have had a real estate pro audit before, and the IRS challenged the logs directly. I was younger and working under a partner at another firm. In that case, I felt that the examining agent and supervisor were being unreasonable. The client had maintained but had not assembled the data into a usable, calendar form.  The agent felt that fact impugned the log, whereas my argument was that the log was little more than an administrative compilation of existing data. The agent disallowed pro status, the group manager sided with the agent, we appealed and won in Appeals. Quite a hassle - and we had better facts than Prang. For all that the client fired us. It did not go as smoothly as he would have liked. I wasn’t too thrilled about it either.

I try to be blunter with clients these days about the hazards of tax representation. Lose the examiner’s trust, for example, and you may not convince him/her that the sun came up this morning. Catch the examiner on a pet peeve and he/she may raise the body more often than a Living Dead episode. You may have an examiner too green to realize that classroom examples rarely occur outside the classroom. You may run into a coordinated exam, in which a specialized group – not necessarily the examiner - is calling the shots.  A lot can go wrong.

Was Prang an “aggressive assault” on real estate investors? I do not see it. What I do see is someone gaming the system. They got caught. That’s all.

Another Warning on Deducting Auto Expenses

There is a very recent case concerning tax deductions for business use of a vehicle that I am considering as mandatory reading for many of our clients.

The pattern is repetitive. Either the business provides the car or the employee uses his/her car for business and is not reimbursed. Tax time we ask the following questions: what is your mileage? What do you have as documentation to support that mileage? We review the danger associated with this tax deduction (the IRS will disallow it if you cannot back it up), to which it seems most of the clients roll their eyes and go “yea, yea.”

Well, Jessica Solomon just got schooled. It’s a shame, too, as it sounds like Jessica was trying to do the right thing, but she just didn’t know what that meant. Let’s look at Jessica Solomon v Commissioner.

Jessica Solomon moved from Illinois to Missouri in 2006. First, let me say that I went to the University of Missouri, so I approve of her move. Second, she started work as a commission-only salesperson for seven months – June through December. She was peddling office supplies. Every day she started the morning at the company office in St Louis, and at the end of the day she finished with an evening meeting there. She only made $3,307 in commissions. Considering that she was reimbursed for NOTHING, it sounds to me like this was a waste of her time.

She kept a log in her car. At the start of the day she wrote down her mileage, and at the end she noted her mileage. Unfortunately, there was no other information, such as the towns, prospects or customers she was visiting. It was bare-boned, but it was something.

At the end of the year she went to H&R Block. They deducted her business expenses, including 18,741 business miles.

In January, 2009 the IRS issued a statutory notice disallowing all her mileage and employee expenses for 2006. Jessica, bless her heart, went to Tax Court representing herself (this is called “pro se”). It did not go well for Jessica.

Unfortunately, the court was right. Let’ go through this…

* It is an axiom in tax practice that deductions are a matter of legislative grace. This is fancy way of saying that there is no deduction just because you really, really want there to be one.
* If a taxpayer presents credible evidence on a factual issue concerning tax liability, Code Section 7491(a) shifts the burden of proof to the IRS.
* If Section 7491(a) kicks in, the IRS (or Court) may even estimate the amount of expenses, if the supporting documentation is poor or even nonexistent.
* There are some expenses where the burden of proof does not shift under Section 7491(a).
* A car is one of those expenses. Car expenses are addressed under Section 274(n).
* Section 274(n) says that no deductions are allowed with respect to listed property (think a car) unless very specific documentation requirements are met:

** The amount
** The time and place
** The business purpose
** The taxpayer’s relationship with the persons involved

The Court looked at her log. The court had several problems;

(1) The log noted only the beginning and ending mileage for each day

(2) The log included a 27 mile commute

(3) The log may have included personal trips

So far, I could have worked with this. I would ask Jessica for a Day Runner or some other record of who she visited, where and etc. In fact, had she submitted contact reports to the company, I would ask the company to provide copies for her tax audit. I need corroborating evidence. The evidence does not have to be on the same sheet of paper. In truth, it need not even had been created at the time, although that would of course carry more weight.

Unfortunately Jessica could not do this. Here is the Court:

Petitioner did not present any evidence at trial, such as appointment books, calendars, or maps of her sales territories, to corroborate the bare information contained in the mileage log…”

But the court KNEW that she had to use her car – right? Surely the Court would spot her something.

Although we do not doubt that petitioner used her Chevrolet Cavalier for business between June and December, 2006, we have no choice but to deny in full petitioner’s deduction for mileage expenses. For reasons discussed …, petitioner’s mileage log does not satisfy the adequate records requirement of Section 274(d).”

No mileage deduction for Jessica.

As I said, perhaps this case should be mandatory reading for many of our clients.