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.

The EV Tax Credit

I was reading an article recently that approximately 40% of Americans have not heard about the EV tax credits.

EVs are battery powered cars. We used to have hybrids, which sometimes used a motor and other times a battery. EVs by contrast are 100% battery powered.

If you are thinking about buying one for personal use, here are a few markers to keep in mind:

(1)   There was an OLD tax credit and now there is a NEW tax credit.

a.     The OLD credit went through April 18, 2023.

b.    The NEW credit of course is after April 18, 2023.

Both credits can get up to $7,500, so what changed was the measuring stick.

Before April 19, the EV had to be assembled in North America.

After April 18, one test became two tests:

·       The battery itself has to be manufactured in North America, and

·       Then critical minerals in the battery (cobalt and lithium, for example) must be extracted or processed in the U.S. or in a country with which the U.S. has a free trade agreement.

Notice that OLD $7,500 credit (assembled in North America) has become two NEW credits of $3,750 each. You can get to $7,500, but along a different route.

It matters. For example, the new Ford Mustang Mach-E only qualifies for one of the credits – only $3,750 – because its battery comes from abroad.

Some – like the Genesis GV70 – used to qualify for the old $7,500 credit but no longer qualify for anything under the new rules.

If you are considering an EV, please double check whether the vehicle qualifies. Here is the Department of Energy’s website:

https://fueleconomy.gov/feg/tax2023.shtml

(2)   Congress included some price caps on qualifying vehicles. These things are expensive, and Congress was trying to exert downward pressure.

To qualify,

·       A van, SUV or pickup truck must cost $80 grand or less.

·       Any other vehicle (a sedan, for example) must cost $55 grand or less.  

(3)   Starting in 2024, you will have the option of using the credit immediately when you purchase the vehicle. It would make for an easy down payment, I suppose.  

The heavy lifting is done behind the scenes, as the dealerships will register on a new website to initiate and receive the credits. If you are curious, that website is: 

https://www.irs.gov/credits-deductions/register-your-dealership-to-enable-credits-for-clean-vehicle-buyers  

(4)   For the first time, used EVs will qualify for a credit. This credit will not be as large as the one for new EVs, but it is not insignificant either. Here are the ropes:

·       The price must be $25 grand or less.

·       The car must be at least two years old.

·       The car qualifies only once in its lifetime.

·       The credit is up to $4 grand, limited to 30% of the price.

·       You can claim the used EV credit once every three years.  

(5)   There are income limits on both the new EV and used EV credits. Make too much money and you will not qualify.  

For example:

New EV

           Married        income < $300,00

                                       Single          income < $150,000

                            Used EV

                                        Married       income < $150,000

                                        Single         income < $75,000  

You can test for income either in the year of purchase or the immediately preceding year. I am thinking – to be safe – that one should generally go with the preceding year. It would be no fun to apply a $7,500 credit against the purchase of an EV and then give it back because you reported too much income on your 2024 tax return.  

(6)   Up to now, we have been talking about buying an EV for personal use. There is a similar credit if you lease rather than buy, but some rules are different.

·       Since the leasing company (and not you) owns the vehicle, the income test does not apply.

·       The credit requires the EV be manufactured by a “qualified manufacturer” rather than the two-step qualification discussed above for a purchased vehicle. This should result in a wider selection.

·       Mind you, the leasing company is not required to pass (all or any of) this credit on to you. Education is important here - and expect negotiation.  

The reason the rules are different is that this second credit is designed for businesses – rather than individuals – buying an EV. By bringing in a leasing company, we flipped from the first to the second credit.  

I am not in the market for a car myself.  If I were, though, I would go in a very different direction.

Failing To Take A Paycheck

I am looking at a case involving numerous issues. The one that caught my attention was imputed wage income from a controlled company in the following amounts:

2004                    $198,740

2005                    $209,200

2006                    $220,210

2007                    $231,800

2008                    $244,000

Imputed wage income means that someone should have received a paycheck but did not.

Perhaps they used the company to pay personal expenses, I think to myself, and the IRS is treating those expenses as additional W-2 income. Then I see that the IRS is also assessing constructive dividends in the following amounts:

2004                    $594,170

2005                    $446,782

2006                    $375,246

2007                    $327,503

2008                    $319,854 

The constructive dividends would be those personal expenses.

What happened here?

Let’s look at the Hacker case.

Barry and Celeste Hacker owned and were the sole shareholders of Blossom Day Care Centers, Inc., an Oklahoma corporation that operated daycare centers throughout Tulsa. Mr. Hacker also worked as an electrician, and the two were also the sole shareholders of another company - Hacker Corp (HC).

The Hackers were Blossom’s only corporate officers. Mrs. Hacker oversaw the workforce and directed the curriculum, for example, and Mr. Hacker was responsible for accounting and finance functions.

Got it. She sounds like the president of the company, and he sounds like the treasurer.

For the years at issue, the Hackers did not take a paycheck from Blossom.

COMMENT: In isolation, this does not have to be fatal.

Rather than pay the Hackers directly, Blossom made payments to HC, which in turn paid wages to the Hackers.

This strikes me as odd. Whereas it is not unusual to select one company out of several (related companies) to be a common paymaster, generally ALL payroll is paid through the paymaster. That is not what happened here. Blossom paid its employees directly, except for Mr. and Mrs. Hacker.

I am trying to put my finger on why I would do this. I see that Blossom is a C corporation (meaning it pays its own tax), whereas HC is an S corporation (meaning its income is included on its shareholders’ tax return). Maybe they were doing FICA arbitrage. Maybe they did not want anyone at Blossom to see how much they made.  Maybe they were misadvised.

Meanwhile, the audit was going south. Here are few issues the IRS identified:

(1)  The Hackers used Blossom credit cards to pay for personal expenses, including jewelry, vacations, and other luxury items. The kids got on board too, although they were not Blossom employees.

(2)  HC paid for vehicles it did not own used by employees it did not have. We saw a Lexus, Hummer, BMW, and Cadillac Escalade.

(3) Blossom hired a CPA in 2007 to prepare tax returns. The Hackers gave him access to the bank statements but failed to provide information about undeposited cash payments received from Blossom parents.

NOTE: Folks, you NEVER want to have “undeposited” business income. This is an indicium of fraud, and you do not want to be in that neighborhood.

(4)  The Hackers also gave the CPA the credit card statements, but they made no effort to identify what was business and what was family and personal. The CPA did what he could, separating the obvious into a “Note Receivable Officer” account. The Hackers – zero surprise at this point in the story - made no effort to repay the “Receivable” to Blossom.  

(5) Blossom paid for a family member’s wedding. Mr. Hacker called it a Blossom-oriented “celebration.”  

(6) In that vein, the various trips to the Bahamas, Europe, Hawaii, Las Vegas, and New Orleans were also business- related, as they allowed the family to “not be distracted” as they pursued the sacred work of Blossom.

There commonly is a certain amount of give and take during an audit. Not every expense may be perfectly documented. A disbursement might be coded to the wrong account. The company may not have charged someone for personal use of a company-owned vehicle. It happens. What you do not want to do, however, is keep piling on. If you do – and I have seen it happen – the IRS will stop believing you.

The IRS stopped believing the Hackers.

Frankly, so did I.

The difference is, the IRS can retaliate.

How?

Easy.

The Hackers were officers of Blossom.

Did you know that all corporate officers are deemed to be employees for payroll tax purposes? The IRS opened a worker classification audit, found them to be statutory employees, and then went looking for compensation.

COMMENT: Well, that big “Note Receivable Officer” is now low hanging fruit, isn’t it?

Whoa, said the Hackers. There is a management agreement. Blossom pays HC and HC pays us.

OK, said the IRS: show us the management agreement.

There was not one, of course.

These are related companies, the Hackers replied. This is not the same as P&G or Alphabet or Tesla. Our arrangements are more informal.

Remember what I said above?

The IRS will stop believing you.

Petitioner has submitted no evidence of a management agreement, either written or oral, with Hacker Corp. Likewise, petitioner has submitted no evidence, written or otherwise, as to a service agreement directing the Hackers to perform substantial services on behalf of Hacker Corp to benefit petitioner, or even a service or employment agreement between the Hackers and Hacker Corp.”

Bam! The IRS imputed wage income to the Hackers.

How bad could it be, you ask. The worst is the difference between what Blossom should have paid and what Hacker Corp actually paid, right?

Here is the Court:

Petitioner’s arguments are misguided in that wages paid by Hacker Corp do not offset reasonable compensation requirements for the services provided by petitioner’s corporate officers to petitioner.”

Can it go farther south?

Respondent also determined that petitioner is liable for employment taxes, penalties under section 6656 for failure to deposit tax, and accuracy-elated penalties under section 6662(a) for negligence.”

How much in penalties are we talking about?

2005                    $17,817

2006                    $18,707

2007                    $19,576

2008                    $20,553

I do not believe this is a case about tax law as much as it is a case about someone pushing the boundary too far. Could the IRS have accepted an informal management agreement and passed on the “statutory employee” thing? Of course, and I suspect that most times out of ten they would. But that is not what we have here. Somebody was walking much too close to the boundary - if not walking on the fence itself - and that somebody got punished.

Our case this time was Blossom Day Care Centers, Inc v Commissioner, T.C. Memo 2021-86.

Should I Have A Separate Bank Account For …?

One of the accountants recently told me that a client had asked whether he/she should set-up a separate bank account for their business.

The short answer is: yes.

It is not always about taxes. An attorney might recommend that your corporation have annual meetings and written minutes – or that you memorialize in the minutes deferring a bonus for better cash flow.  It may seem silly when the company is just you and your brother. Fast forward to an IRS audit or unexpected litigation and you will realize (likely belatedly) why the recommendation was made.

I am skimming a case where the taxpayer:

·      Had three jobs

·      Was self-employed providing landscaping and janitorial services (Bass & Co)

·      Owned and operated a nonprofit that collected and distributed clothing and school supplies for disadvantaged individuals (Lend-A-Hand).

The fellow is Duncan Bass, and he sounds like an overachiever.

Since 2013, petitioner, Bass & Co …, and Lend-A-Hand have maintained a single bank account….”

That’s different. I cannot readily remember a nonprofit sharing a bank account in this manner. I anticipated that he blew up his 501(c)(3).

Nope. The Court was looking at his self-employment income.

He claimed over $8 thousand in revenues.

He deducted almost $29 thousand in expenses.

Over $19 thousand was for

·      truck expenses

·      payment to Lend-A-Hand for advertising and rental of a storage unit

He handed the Court invoices from a couple of auto repair shops and a receipt from a vehicle emissions test.

Let’s give him the benefit of the doubt. Maybe he was trying to show mileage near the beginning and end of the year, so as to establish total mileage for the year.

Seems to me he next has to show the business portion of the total mileage.

Maybe he could go through his calendar and deposits and reconstruct where he was on certain days. He would still be at the mercy of the Court, as one is to keep these records contemporaneously.  At least he would field an argument, and the Court might give him the benefit of the doubt.

He gave the Court nothing.

His argument was: I reported income; you know I had to drive to the job to earn the income; spot me something.

True enough, but mileage is one of those deductions where you have to provide some documentation. This happened because people for years abused vehicle expenses. To give the IRS more firepower, Congress tightened-up Code Section 274 to require some level of substantiation in order to claim any vehicle expenses.

And then we get to the $9,360 payment to Lend-A-Hand.

Let’s not dwell on the advertising and storage unit thing.

I have a bigger question:

How do you prove that his business paid the nonprofit anything?

Think about it: there is one checking account. Do you write a check on the account and deposit it back in?

It borders on the unbelievable.

And the Tax Court did not believe him.

I am not saying that the Court would have sustained the deduction had he separated the bank accounts. I am saying that he could at least show a check on one account and a deposit to another.  The IRS could still challenge how much “advertising” a small charity could realistically provide.

As it was, he never got past whether money moved in the first place.

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.