The classic deductions such as professional licensing fees, home office, cell phone, internet, and mileage that all business owners salivate over were contested in a recent Tax Court case. Not because the taxpayer took an aggressive position, but because the taxpayer couldn’t support hardly any of the deductions she took.
I have conversations with my clients that usually start off by them asking, “Can I take xyz as a deduction?” to which I generally reply, “Yes, but you need a great record keeping system.” I go on to ask a ridiculous question along the lines of: “Say you deducted your cell phone expenses as a business expense and the IRS audited you. Could you tell them what business conversations you had, with whom, and how many minutes the conversations lasted for the week of June 2-8, 2013?”
Now, I doubt that the IRS would get that picky, but I’m trying to make a point! A good record keeping system will be your saving grace and allow you to answer to the above question with something like, “Well, of course I could! I had a conversation with Bob for 45 minutes, and we spoke about a duplex he wanted to sell at 123 Elm Street. Oh, I also had a long conversation with Tracey. Actually, according to my records, it lasted 2 hours! Tracey was a first-time homebuyer, and I was answering a lot of basic questions. Exhausting, but we later made an acquisition!”
If you don’t have a good record keeping system, your answer will look more like, “Well, I think I spent about 2.5 hours on the phone that week,” and the IRS is going to valiantly attempt to deny your deductions. Did those conversations actually happen? Maybe, but since you don’t have adequate support to substantiate the deductions, the IRS takes the stance that the conversations never occured. And as we found out this year, it seems the Tax Court in Grossnickle vs. Commissioner agrees with the IRS.
In 2010, Sarah Grossnickle, a real estate agent residing in Maryland, did not file a federal tax return, as she believed her income was below the filing requirements. She earned $17,409 in real estate commissions, paid on a 1099 basis, and deducted $10,122 in business-related expenses, leaving her with income under the required amount to file federal taxes. The IRS challenged some of the business deductions Grossnickle took and claimed that without these contested deductions, she would have been required to file a federal tax return.
The business deductions in question were professional licensing fees, home office, phone and internet, and mileage.
As a general rule, the taxpayer bears the burden of proof in taking business deductions, as they are a matter of “legislative grace.” Subsequently, the taxpayer is required to maintain records sufficient to establish and support the amount of each deduction claimed. To deduct the business expenses in question, taxpayers must substantiate the expense with adequate records or by sufficient evidence corroborating the taxpayer’s own statement with the following details:
- The amount of the expense
- The time and place of the expense
- The business purpose of the expense
Additionally, the records should be kept contemporaneously, specifically at the end of each week the expense is being taken.
Professional and Licensing Fees
Grossnickle deducted $654 for professional and licensing fees during 2010. Of that, $564 was for association dues and $90 was for an annual licensing fee. The IRS argued that the petitioner had not adequately substantiated that these expenses were paid. This simply means that it’s now up to the taxpayer to prove she did in fact pay the expenses.
Luckily for Grossnickle, she was able to present itemized invoices and receipts of payment from the third party organizations. However, unluckily for Grossnickle, the “Tax Information” section at the bottom of one of the invoices specifically stated $127 is nondeductible for tax purposes.
The tax court subsequently allowed Grossnickle to write off $527 of her professional and licensing fees rather than the full $654 she had originally deducted.
Home Office and Supplies
Grossnickle deducted $395.26 for office supplies and equipment. She also deducted $470.40 as a home office expense. The IRS argued that she did not provide sufficient information to substantiate her office expenses.
Section 280A(c) allows taxpayers to deduct office expenses and a home office expenses if the portion of the dwelling unit is used exclusively and on a regular basis:
- as the principal place of business;
- as a place of business which is used for meeting clients; OR
- in the case of a separate structure not attached to the dwelling unit, in connection with the taxpayer’s trade or business.
For an expense related to a dwelling unit, whether or not rented by the taxpayer, to fit within the above code, some portion of the dwelling must be used regularly and exclusively for the taxpayer’s trade or business.
During 2010, Grossnickle testified that she rented a 500 sqft room from her sister and dedicated “50 to 100 sqft” of the rented space to her home office. Her $470.40 deduction was based on estimated square footage. To support the deduction, she offered into evidence two Google aerial view photographs of the residential structure with handwritten notations.
She failed to produce documentation, receipts, and canceled checks that would have substantiated the rental agreement with her sister. She also failed to offer sufficient evidence to prove that the “50 to 100 sqft” of space was used regularly and exclusively for her real estate business.
The Tax Court ruled that because Grossnickle had not proven that she rented a dwelling unit or that a portion of it was regularly and exclusively used for business purposes, they could not allow her any deduction attributable to a home office. Therefore, her $865.66 deduction was reversed.
Phone and Internet Expenses
While the IRS allowed Grossnickle to take roughly $900 in communications deductions, Grossnickle argued that she is entitled to additional deductions for various phone and Internet expenses incurred in carrying on her real estate business in 2010, including:
- $107 to Verizon Wireless in March 2010 for business phone/Internet,
- $315 to Verizon Wireless for three months of estimated business phone expenses, and
- $360 to her sister, consisting of $30 per month for internet use in the purported home office.
The IRS argued that Grossnickle had not substantiated any of these expenses. Grossnickle offered into evidence a Verizon Wireless bill providing that $107 was due on the account by March 1, 2010. However, she did not provide any documentation, receipts, or corresponding credit card charges to substantiate that this bill was actually paid or that it was for business purposes.
Additionally, Grossnickle did not offer any documentation to substantiate that she incurred or paid $315 for a business phone expense in 2010. She also testified that she paid her sister $30 per month for internet access to “research, upload, download, and update listings, and email clients.” However, she failed to provide any documentation, bills, or receipts to show that she incurred or paid this expense.
Accordingly, the court ruled that Grossnickle failed to substantiate the claimed phone and internet expenses in excess of the amounts already allowed by the IRS. Therefore she was unable to claim the three extra expenses mentioned above.
Grossnickle deducted $1,040 for car and truck expenses in 2010. The IRS argued that she did not provide sufficient information to substantiate her office expenses.
Grossnickle contended that she lost her original mileage calendar “during her move in November and December of 2014.” Thus, to substantiate her claimed mileage, petitioner offered into evidence at trial a typewritten statement that showed only total business miles and the total dollar amount claimed. According to Grossnickle, this statement provides “extremely conservative estimates” and a “guesstimate” of miles she drove (1) from her home to RE/MAX and (2) while “showing properties.”
Unfortunately, “extremely conservative guesstimates” do not fly with the IRS, folks. The record keeping needs to substantiate the expense with adequate records. “Adequate records” include: (1) the business mileage; (2) the time and place; and (3) the business purpose.
The log also needs to be prepared contemporaneously with the use of the vehicle. “Contemporaneous records” means maintaining an account book, a diary, a log, a statement of expense, trip sheets, or similar records on a weekly basis.
Grossnickle tried to offer a more substantial log into evidence, but her methodology in its preparation was not adequately explained, and the log was deemed not credible since it was prepared over four years after the fact.
As you can expect, the deduction was not allowed.
Due to the reversal of these business deductions, Grossnickle had to go back and pay 2010 taxes. On top of that, she was assessed penalties and interest. All of this could have been avoided if she simply spent an hour a week entering data into logs prepared by her CPA for her recordkeeping.
But here’s the catch: I doubt she had a CPA, and if she did, that CPA didn’t understand business and/or real estate. So folks, make sure you are using a CPA who understands business and real estate deductions and the record keeping that comes with them.
Disclaimer: This article does not constitute legal advice. As always, consult your CPA or accountant before implementing any tax strategies to ensure that these methods fit with your particular situation.
How do you keep your records detailed, accurate, and organized?
Leave your comments below!