COMPENSATION TO RELATIVES
Compensation paid to a child or other relative can qualify as a business deduction if it’s reasonable for the services legitimately provided and there’s sufficient documentation. Wolpert issued checks to his three children and a grandchild for work as “assistants” for his business. He claimed deductions for payments in excess of $50,000 over two years, which he considered compensation for services rendered to his consulting business.
There was no evidence such as timecards or pay stubs or any other records to document the services. Copies of a few negotiated checks were provided, but the checks didn’t include any notation stating the purpose of the payment.
Most of the payments were made to Wolpert’s daughter. She testified at trial regarding her general involvement in the business, which included preparing flyers, taking photographs, and conducting research. Yet none of the flyers, photographs, or research were offered into evidence. The court didn’t find her to be a credible witness and stated her testimony didn’t establish the specific services she performed.
VEHICLE AND TRAVEL
If a taxpayer is unable to substantiate the amount of a deduction, the court may choose to allow some portion of it under the Cohan rule (see Cohan v. Commissioner of Internal Revenue) if there’s sufficient evidence. The Cohan rule says that a business may rely on reasonable estimates when unable to produce records of actual expenditures, provided there’s some factual basis for it. Yet the Cohan rule can’t be applied to deductions subject to the strict substantiation requirements of IRC §274(d) such as vehicle and travel expenses.
Vehicle expenses. Under the substantiation requirements that apply to passenger vehicles, a taxpayer must document the (1) amount of each expense, (2) mileage for each business use of the vehicle and total mileage for all use of the vehicle during the year, (3) date of each business use, and (4) purpose of each business use. To substantiate these expenses, a taxpayer must generally maintain a contemporaneous log, trip sheet, or similar records, as well as corroborating documentary evidence that establishes each element.
If choosing to use the standard mileage rate method, the taxpayer must still substantiate the (1) mileage for each business use and total mileage for all use of the vehicle during the year, (2) date of each business use, and (3) purpose of each business use.
Using the standard mileage rate, Wolpert claimed vehicle expenses totaling more than $10,000 for two years, but he didn’t maintain adequate records. The mileage logs appeared to be printouts from a computer-generated spreadsheet rather than the original log the taxpayer allegedly kept in the vehicle and made no mention of the business purpose of each trip or the total mileage of the vehicle for the year. The only corroborative evidence was his general testimony regarding mileage logs and calendars, which the court found was insufficient to meet the requirements to justify a vehicle expense deduction.
Travel expenses. Under the substantiation requirements for travel expenses, taxpayers must provide the (1) amount of each expenditure for traveling away from home, (2) date of departure and return for each trip, and number of days spent on business, (3) destination, and (4) business reason for travel. Similar to the requirement for vehicle expenses, the taxpayer must substantiate each element through adequate records or sufficient corroborating evidence.
Wolpert provided credit card statements, but the statements didn’t substantiate the date of travel, number of days spent on business, destination of each trip, and the business purpose of each trip. He alleged in general terms that he took business trips to several different states for meetings with government and other officials to discuss projects during the years at issue. In denying his deduction, the court determined that his testimony lacked the specificity and detail needed under the substantiation requirements.
Wolpert also claimed expenses for internet and cell phone services but offered no bills or invoices from the cable company providing the bundled internet and cellular phone services. The only evidence offered were credit card statements reflecting charges from the cable company, but that didn’t provide the identity of the payee or the services covered. In disallowing the deductions, the court noted that these payments could have included charges for cable television, which would be a nondeductible personal expense.
POTENTIAL PENALTY
The one bright spot for Wolpert was that he wasn’t assessed an accuracy penalty. The IRS attempted to assess the IRC §6662 accuracy penalty, which could be 20% of the underpayment amount for negligence or intentional disregard of the rules or regulations. The court held that Wolpert wasn’t liable for the accuracy penalty because the IRS didn’t comply with the procedural requirement that it seek written supervisory approval for the assessment of the penalty.
This case should put taxpayers on notice that if the IRS follows all its procedural requirements in future cases, they risk being subject to this penalty in addition to back taxes and interest.
© 2022 A.P. Curatola
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