Sec. 162(a) authorizes business entities to deduct all ordinary and necessary expenses that are paid or incurred during the tax year. This seems simple and straightforward and leads many companies to claim deductions for expenses that they believe are related to their business operation, only to find that the expenses are not deductible because the companies did not keep the proper records to substantiate them.
Sec. 6001 and Regs. Sec. 1.6001-1 require taxpayers to maintain accurate and complete records to support the information presented in tax returns. Thus, all business entities should be able to demonstrate that the deductions they claim are allowable through records or statements that substantiate the expenses. In Greatest Common Factor, T.C. Memo. 2023-39 (opinion issued in March 2023), the Tax Court emphasized the importance of substantiation in claiming business deductions.
In this case, Glenn Fyfe and his ex-wife each held 50% shares of a C corporation, Greatest Common Factor (GCF). Fyfe, through GCF, worked as a subcontractor for Kinsey Technical Services, a company that provided engineering services for the U.S. military. GCF had gross receipts of $274,448 in 2013 and $265,126 in 2014 from Fyfe’s work for Kinsey.
Fyfe filed Forms 1120, U.S. Corporation Income Tax Return, for GCF and claimed various expenses on its tax returns for tax years 2013 and 2014. In the returns, the corporation reported home office expenses of $13,747 in 2013 and $13,615 in 2014. The corporation also reported car and truck expenses of $17,785 in 2013 and $16,412 in 2014, a portion of which were for Fyfe’s commuting between his home and his job location on an Air Force base. GCF’s returns also reported auto depreciation expenses of $8,558 in 2013 and $67,706 in 2014.
The IRS examined GCF’s returns for 2013 and 2014, which resulted in its issuing a notice of deficiency dated March 30, 2021. In the notice, the IRS disallowed the deductions for home office expenses, the car and truck expenses, and the depreciation expenses. The IRS also assessed accuracy-related penalties under Sec. 6662(a). GCF challenged the IRS’s determination in Tax Court.
With regard to the home office deduction, the Tax Court found that GCF could possibly claim the deduction under Sec. 162 because the corporation was not subject to the limitations of the Sec. 280A home office deduction rules, which apply only to individuals and S corporations. Under Sec. 162, a C corporation may deduct payments to an employee to lease home office space, but the lease expense must be an ordinary and necessary expense and directly related to a corporation’s trade or business.
To prove entitlement to such a deduction, a taxpayer must provide evidence, such as a rental agreement, that shows there was a rental payment related to the corporation’s business operation. In this case, GCF could not provide any rental agreement to show there were payments for business use. Also, the corporation could not produce any evidence that it expended any funds maintaining Fyfe’s alleged home office. Thus, the court found that GCF could not deduct the home office expenses.
The Tax Court noted that Fyfe’s car and truck expenses for which GCF claimed a deduction were passenger automobile expenses that are subject to strict substantiation requirements under Sec. 274(d) for expenses related to listed property (as defined in Sec. 280F(d)(4)), which includes a passenger automobile. To meet the substantiation requirement for passenger automobile expenses, a taxpayer must provide three essential pieces of information that substantiate the expenses by adequate records or by sufficient evidence that backs up the taxpayer’s own statement. Adequate records consist of an account book, a log or a similar record, and documentary evidence, which together are sufficient to establish each element of an expenditure.
First, the taxpayer must provide the amount of the expense incurred for the automobile. This could be an account book or log, invoices, and other documents that clearly state the costs, according to Regs. Sec. 1.274-5. Second, they must provide the time and place the expense was incurred, such as in a mileage log. Third, taxpayers must demonstrate the business purpose of the expense or item.
In this case, the court disallowed GCF’s deduction for Fyfe’s car and truck expenses, despite Fyfe’s providing mileage logs and receipts. The court found that this evidence failed to demonstrate a direct connection between the car and truck expenses and his business activities that established a business purpose for the expenses. Furthermore, the court explained that, because where a taxpayer lives is a personal choice, case law and Regs. Sec. 1.162-2 do not allow a deduction for commuting expenses. Thus, the court found that the car and truck expenses that were for commuting were not deductible as such.
Besides the operating expenses of the three vehicles Fyfe used during 2013 and 2014, GCF also sought to claim depreciation expenses for the vehicles. Sec. 167 allows taxpayers to deduct depreciation for reasonable exhaustion and wear and tear of property used in a business. However, as with other deductions, depreciation deductions must be substantiated.
Under Tax Court precedent, to substantiate eligibility for a depreciation deduction, a taxpayer must provide adequate supporting evidence for the property’s depreciable basis by showing its cost basis, useful life, and accumulated depreciation. Because a passenger automobile is listed property, the depreciation deduction is subject to the enhanced substantiation requirements of Sec. 274(d). Thus, a taxpayer is obligated to provide evidence substantiating the business purpose of the property being depreciated.
GCF, however, was unable to provide any supporting documentation demonstrating the cost of the three vehicles Fyfe used or the corporation’s ownership of the vehicles. Also, it did not provide evidence sufficient to establish the extent of any business-related use of the vehicles. As a result, the court disallowed all of GCF’s depreciation deductions for the vehicles.
Taxpayers who have an underpayment of tax due to expense deductions that are disallowed because they are not properly substantiated are potentially subject to accuracy-related penalties under Sec. 6662(a). Underpayments of tax covered by Sec. 6662(a) include those due to “negligence or disregard of rules or regulations.” The penalty amount is 20% of the portion of any underpaid taxes resulting from taxpayers’ negligence and disregard. Per Regs. Sec. 1.6662-3(b)(1), negligence includes a taxpayer’s failure to keep adequate books and records or to substantiate items shown on a return properly. Under Sec. 6664(c)(1), though, the accuracy-related penalty does not apply to any portion of the underpayment for which the taxpayer shows reasonable cause and good faith.
In GCF’s case, the Tax Court held that the IRS had correctly determined that the corporation had not properly substantiated the expenses it disallowed in its notice of deficiency. It also found GCF had not shown reasonable cause for not properly substantiating the expenses. Therefore, the court held that GCF was liable for the accuracy-related penalty.
This case shows the importance of proper substantiation and compliance with tax laws when claiming deductions. It reminds tax professionals that they play an influential role in assisting clients to be well prepared and minimize the risk of deduction disallowance. It is essential to emphasize the importance of substantiation to clients and to make sure they understand the substantiation requirements and to educate clients on how to maintain accurate recordkeeping and to record transactions in real time or as close as possible to when transactions incur. Tax professionals can do this by providing clear guidelines, such as a checklist, to clients to help them organize and gather necessary documents throughout the year.