Here’s the scene: you go to the mailbox, and inside is a letter from the IRS. They want more information about your 2008 tax return, specifically some deductions on your Schedule A. Problem is, those records got lost when you moved last month, and you’re not sure you can prove all of your expenses. Is all lost?
Some may be, but not necessarily all.
What can be saved? Well, to answer that, you need to look at some tax court cases, a section or two of code, and cross your fingers. Chocolate and/or whiskey might help, too. For you. Not the agent.
In general, once the IRS issues a notice of deficiency, that notice is presumed correct, and you’re on the hook to prove that it’s not. (See, e.g., Rule 142(a), Welch v. Helvering, 290 U.S. 111, 115 (1933), Lang v. Commissioner, T.C. Memo 2010-152, at 4 (2010)). Often, in a tax court case, a taxpayer will attempt to circumvent this general rule by citing to Section 7491, a provision of the code which shifts the burden of proof to the IRS. Does it work? Not really.
Here’s why: in order to shift the burden of proof, you, the taxpayer, must comply with certain rules. In reality, if you do, your case is not likely to get as far as Tax (or Federal District) Court in the first place. Furthermore, the burden of proof issue is only determinative when there is an evidentiary tie (See, Knudson v. Commissioner, 131 T.C. 185, 189 (2008), Lang v. Commissioner, T.C. Memo 2010-152 at 8). Still want to try to use 7491? Then take a look at the way Section 7491 is worded:
(a) Burden shifts where taxpayer produces credible evidence
(1) General rule
If, in any court proceeding, a taxpayer introduces credible
evidence with respect to any factual issue relevant to
ascertaining the liability of the taxpayer for any tax imposed by
subtitle A or B, the Secretary shall have the burden of proof
with respect to such issue.
(2) Limitations
Paragraph (1) shall apply with respect to an issue only if -
(A) the taxpayer has complied with the requirements under
this title to substantiate any item;
(B) the taxpayer has maintained all records required under
this title and has cooperated with reasonable requests by the
Secretary for witnesses, information, documents, meetings, and
Interviews; []
The first thing that stands out is the phrase ‘credible evidence.’ While not specifically defined, paragraph 2(B) provides a strong indication of what that might mean – producing the records required to substantiate the expense.
The second point to be made is what one colleague calls the ‘cooperate fully’ provision – you comply with all reasonable requests made by the IRS. This means that if they ask for your employer’s reimbursement policy, you provide it, or a reason why it cannot be provided (if your employer does not have a reimbursement policy, you’ll need to have them say so in a letter. Agents don’t have to, and likely won’t, rely upon your oral statements only). “Reasonable request” gives the IRS pretty wide latitude, too. As long as the IRS can provide a plausible explanation why the record is needed, you’ll need to ante up the document. You can certainly challenge it later, if needed, but that fight isn’t particularly advised at the early stages of an audit (unless you know you’re on shaky ground. If you are, damage control is your best option).
If, for some reason, you do not have proof of an expense, you can – under what is known as the Cohan rule – estimate the expense. Cohan refers to composer George M. Cohan (of “Yankee Doodle” fame) who was audited by the IRS in 1930[1]. Cohan had certain entertainment and business-related expenses that he couldn’t provide receipts for, but which he alleged were business-related. Based solely upon testimony he provided, the court (in an opinion written by the great jurist Learned Hand) agreed, and overruled the IRS’ denial of all expenses. In his opinion, Judge Hand stated,
“… the Board should make as close an approximation as it can, bearing heavily if it chooses upon the taxpayer whose inexactitude is of his own making. But to allow nothing at all appears to us inconsistent with saying that something was spent. True, we do not know how many trips Cohan made, nor how large his entertainments were; yet there was obviously some basis for computation, if necessary by drawing upon the Board's personal estimates of the minimum of such expenses. The amount may be trivial and unsatisfactory, but there was basis for some allowance, and it was wrong to refuse any, even though it were the travelling expenses of a single trip. It is not fatal that the result will inevitably be speculative; many important decisions must be such. We think that the Board was in error as to this and must reconsider the evidence.”
Since Cohan was decided, the law has been considerably narrowed. For example, estimation is not acceptable in regard to travel , meals and entertainment (Section 274(d) requires documentation; without documentation, no expense is permitted), and courts have made it clear that when a section of the code requires specific types of documentation, an estimate is unacceptable. Moreover, courts routinely refuse to provide any estimation where insufficient evidence exists in the record to provide a basis for estimation. [2]
While it can be said that alternate means of proof are acceptable substitutes for receipts, that doesn’t mean that alternate means are a cure for what ails you. Again, courts require documentation: "In the absence of adequate records, a taxpayer may alternatively establish an element of an expenditure by “his own statement, whether written or oral, containing specific information in detail as to such element” and by “other corroborative evidence sufficient to establish such element."” Lang, at 7, quoting Larson v. Commissioner. The use of the phrase 'specific information in detail' is vague enough that it gives the IRS latitude in deciding how specific you need to be. Suffice to say that your testimony alone is probably not even close to being enough.
Finally, to add insult to injury, the IRS can, under Section 6662, tack on an accuracy related penalty. Here again, you might be tempted to rely upon Section 7491 burden of proof requirements. Don’t . The Services burden here is ridiculously small. All the IRS has to do is show the greater of two things: either 1) that you understated your tax by more than $5,000.00, or 2) that the amount of understatement is greater than ten percent (10%) of the tax shown on the return. If the Notice of Deficiency does that, the IRS burden of proof has been met, and you’ll be assessed the tax.
Frequently, the Code gives taxpayers and out, and here a safe harbor exists which may allow a taxpayer to avoid the penalty under Section 6662 – as the Court in Lang noted:
The accuracy-related penalty is not imposed with respect to any portion of the underpayment as to which the taxpayer acted with reasonable cause and in good faith. Sec. 6664(c)(1). The decision as to whether the taxpayer acted with reasonable cause and in good faith depends upon all of the pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. Relevant factors include the taxpayer’s efforts to assess his proper tax liability, including the taxpayer’s reasonable and good faith reliance on the advice of a professional such as an accountant. Id. Furthermore, an honest misunderstanding of fact or law that is reasonable in the light of the experience, knowledge, and education of the taxpayer may indicate reasonable cause and good faith. See Remy v. Commissioner, T.C. Memo. 1997-72.
What does that mean? Well, where the taxpayer has been found to have sufficient knowledge, experience or education, or attempted to assess his or her proper tax liability, a penalty has been assessed[3], but where a taxpayer has shown that they have little financial knowledge, the penalty has been waived. So a cleaning lady whose unreimbursed expenses are disallowed will have better luck laying the blame at the tax preparer’s feet (provided it can be shown that they are a competent preparer) than, say, a law professor who teaches tax law. It is very much a fact and circumstance based test, and what works for one taxpayer may not work for another.
In short, just because you do not have, or cannot find a particular receipt does not mean you automatically lose a particular deduction. It does mean that you have a harder row to hoe, and a higher likelihood of disallowance, but don’t start writing a check just yet – hire a professional, and start pushing back.
[1] Cohan v. Commissioner, 39 F2d 540 (2nd, 1930).
[2] See, e.g., Lang, where the Court permitted the taxpayer a $96 deduction for Ross Reports magazine, because the taxpayer 1) provided two receipts showing he’d purchased the magazine for $8, and 2) testified that he bought the magazine monthly. However, the court did not allow a deduction for Backstage magazine, which the taxpayer claimed to buy weekly at $2 a pop, because he could not even produce one receipt showing a purchase.
[3] See Lang, where, in denying relief under 6664, the Court noted, “While a taxpayer’s reliance on the specific advice of a tax return preparer may constitute reasonable cause, petitioner has failed to offer testimony or evidence regarding the qualifications of his tax return preparer. Petitioner’s general statements that he relied on his tax return preparer are not sufficient to prove a reasonable basis, substantial authority, or reasonable cause for his disallowed deductions. Secs. 6662(d)(2)(B), 6664(c)(1).” Lang, at 23.
