Business Management

What a Recent Tax Court Case Can Teach Business Owners About Surviving an IRS Audit

Expertise: Business Management, Landlording & Rental Properties, Personal Finance, Personal Development
65 Articles Written

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.

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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.

The Facts

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.

Related: How an Investor Missed a $100K+ Tax Deduction (& How You Can Avoid This Costly Error!)

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:

  1. as the principal place of business;
  2. as a place of business which is used for meeting clients; OR
  3. 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:

  1. $107 to Verizon Wireless in March 2010 for business phone/Internet,
  2. $315 to Verizon Wireless for three months of estimated business phone expenses, and
  3. $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.

Business Mileage

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.

Related: A CPA Answers: How Can Investors Maximize Car-Related Tax Deductions?

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.

How do you keep your records detailed, accurate, and organized?

Leave your comments below!

Brandon Hall is a CPA and owner of The Real Estate CPA. Brandon assists investors with Tax Strategy through customized planning and
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    Joe Harper Landlord and Appraiser from Bartow, Florida
    Replied almost 5 years ago
    Wow this is a good read despite with mundane tax issues. For my vehicle expense, I just titled the truck into my llc and had planned on deducting 100% of expenses like gas and insurance. Reading the above nuances makes me question my defensibility. I’m also curious who paid for the defendant’s attorney fees and why she would fight so hard for such a small tax bill. Great post, man. Put the fear of the G man back in me
    Brandon Hall CPA from Raleigh, NC
    Replied almost 5 years ago
    Hey Joe – if the entity owns the vehicle, you will be able to deduct the actual business expenses the vehicle incurs. Things like gas, insurance, repairs, etc. But if the vehicle is used for personal purposes, you cannot deduct the personal portion of the expenses. The defendant was fighting hard because she would have to go back and file a tax return, subjecting herself to a tax bill likely around the $2k range if not higher. I also believe she was representing herself as a tax attorney would have had better evidence in place 🙂
    David Roberts from Brownstown, Michigan
    Replied almost 5 years ago
    How much did she have to pay in penalties? Just wondering if the penalty was worth all that weekly effort and risk of getting audited. Just curious. It sounds simple to keep records like that, but i find it extremely difficult. Probably just bed to form good habits.
    Brandon Hall CPA from Raleigh, NC
    Replied almost 5 years ago
    It wasn’t disclosed but I’m guesstimating her total bill came out to be around $2k. It is difficult to learn the habits, but once you are over that learning curve it will become second nature. Also, check out various recordkeeping apps to further automate the process.
    Gloria Almendares from Kailua, Hawaii
    Replied almost 5 years ago
    Hi Brandon: Great post, something we should all be concerned with. Can you please recommend a few recordkeeping applications? I’m not good at documenting my mileage and phone calls. I talk a minimum of 3,000+ minutes per month. Who has time to keep track of all of this? I am sure that’s what the IRS is counting on. What a waste of time and energy!
    Mindy Jensen BiggerPockets Community Manager from Longmont, CO
    Replied almost 5 years ago
    I have a real estate license, and use a Google Spreadsheet to enter my mileage every day after I am finished showing houses. I enter the mileage from Google maps. I have a separate credit card for business only, and use it to pay for parking, continuing education classes, membership dues, etc. If you do it every day, it takes minutes. Thanks for a great article, Brandon.
    Brandon Hall CPA from Raleigh, NC
    Replied almost 5 years ago
    Awesome Mindy – keep up the great work!
    Jerome Hanson from Sierra Vista, Arizona
    Replied almost 5 years ago
    This is a really great article which expounds on something we’re all afraid of. I’m just starting up but have definitely already been thinking about this heavily. After reading this I’ll be delving much more deeply into finding a qualified CPA.
    Brandon Hall CPA from Raleigh, NC
    Replied almost 5 years ago
    Thanks Jerome for reading and commenting. It’s little things like this that a CPA will keep you on top of.
    Karen Rittenhouse Flipper/Rehabber from Greensboro, NC
    Replied almost 5 years ago
    Such a great article. Yes, it is IMPERATIVE that we all have CPAs who understand real estate! It is such a unique business with unique deductions and allowances that most CPAs are completely unaware of. You not only need to keep vigilant track of everything you can deduct, but you also need to know what those allowances are so you can track them! Thanks for the important post.
    Brandon Hall CPA from Raleigh, NC
    Replied almost 5 years ago
    Thanks for reading and commenting Karen. A real estate savvy CPA will significantly improve a real estate investor’s tax and financial position. It’s the little things that investors are too busy to think about 🙂
    Chi Cheung Investor from Brooklyn, New York
    Replied almost 5 years ago
    If she really used something for her business, how can an invoice state that $127 is nondeductible for tax purposes? Unless, she got a tote bag or some other gift in return for her membership fee?
    Brandon Hall CPA from Raleigh, NC
    Replied almost 5 years ago
    It could have been something like that. I know with the CPA you can order accessories, but I still think most of them would be deductible. Regardless, the case didn’t say what the $127 nondeductible expense was so all we can do is speculate 🙂
    Patrick Moody Investor from Sachse, Texas
    Replied almost 5 years ago
    I will speculate that it was lobbying fees. Our Chamber of Commerce membership includes a few dollars that go towards the legislative lobbying organization in the area and therefore are not deductible.
    Brandon Hall CPA from Raleigh, NC
    Replied almost 5 years ago
    Good speculation. You are probably correct!
    Gloria Almendares from Kailua, Hawaii
    Replied almost 5 years ago
    Yes, that’s exactly what it is (PAC contributions are not tax deductible).
    Cody L. Rental Property Investor from San Diego, Ca
    Replied almost 5 years ago
    This makes me ill. Especially the part about some of her licence fees not being deductible. If there is some fee (or, hell, a fine) I have to pay, it’s a cost of business. Period. How the F can the government just decide ‘you can’t deduct that’. On that note, I hate the fact you have to keep track of various capitalized spending. If I buy a fridge, it’s a cost. I don’t feel like keeping track of that fridge (and 100,000 other items for 100 different properties) on my taxes for 10 years. They’re simply a cost. Period. This is why our tax system needs an overhaul. Taxing based on income, even if it’s a simple flat tax, will always have the problem of “Well what’s income?”. It also allows the government to be in a position where they regulate lending to only allow decisions based on income that are based on tax returns. I know plenty of people who are following the rules, do quite well, but have $0 income. They can’t get a $300 Target credit card yet can write a check to buy their house.
    Robert Steele Investor from Lucas, Texas
    Replied almost 5 years ago
    Wouldn’t it be so much easier if there were no direct taxes at all? That is how the founding fathers framed it in the constitution. No direct taxes. Only indirect taxes like sales taxes. The idea behind this restriction was to maintain privacy. Instead we have to waste so much time and money to account for every damn dime to the federal government who must know everything we are doing all the time. I am sick of it. Repeal the 16th amendment and scrap the IRS.
    Gloria Almendares from Kailua, Hawaii
    Replied almost 5 years ago
    I agree with you Robert 100%!!!
    Deanna Opgenort Rental Property Investor from San Diego, CA
    Replied almost 5 years ago
    I have more than one car. I’ve been wondering if there is any issue if I don’t keep track of which vehicle I drive, since it’s not really provable anyhow. My house is ALWAYS 97 miles from Disneyland no matter which car I drive (and yes, I do sometimes drive there for work. Really.).
    Mary B. Real Estate Investor from Lansdowne, Pennsylvania
    Replied almost 5 years ago
    Good points, Brandon but unfortunately many will still go unheeded. If she would have just filed the return like she was supposed to along with keeping viable records there wouldn’t have been any tax court hearing to attend. This entire ordeal was avoidable from the start. People with these outlandish deductions having no physical documentation to support them is screaming for trouble and no offense but I don’t need a tax attorney, EA or accountant to know better. Delinquent is not filing(even if its a zero tax return) and often its this course of action or the lack thereof that’s taken by a guilty party trying to get away with paying their share. My motto is if I have to file and pay my share so does everyone. Sure there are incidents when someone didn’t make any money during a tax year so that’s why someone else would likely be able to claim them as a dependent. Yet most employed(by way of w2 / 1099) adults have to file a tax return in the event someone else can’t claim them as a form of accountability. True an accountant could have determined ahead of time if there were little or no taxes due(from the business perspective anyway) but again the taxpayer would’ve had to have that consultation, timely that is in order to learn whether or not that was a route to go…. Hopefully this was a harsh lesson learned. Kudos, Mary
    Mary B. Real Estate Investor from Lansdowne, Pennsylvania
    Replied almost 5 years ago
    Additionally, the better route to go is to have a separate phone (pre-paid or plan) for the business if one is to claim a phone expense as a deduction. Trying to figure out which calls were business and which were personal is a losing strategy. Get a tablet or laptop that’s for business only. Its not easy to have a 2nd car for business purposes only but there’s a tax software that can assist on how much mileage and expenses can be claimed. Co-mingling phone usage, computer / internet usage can make it difficult come tax time if those items are going to be included as business deduction. If and when things can be separated for business use only do so. Its obviously worth it. Generally the IRS only comes after those that are tax delinquent, have an unpaid balance due(that the taxpayer isn’t attempting to resolve) or / and attempting to deduct 58% of their income in one tax year. Granted $17,409 isn’t much for a yearly income but trying to deduct over $10 grand wasn’t a smart move here either, especially with next to no supporting documents. Kudos, Mary