Tax Court in Brief | Ayria v. Comm’r | Substantiation for Schedule C Deductions (lodging, vehicle, entertainment, gifts, dry cleaning, etc.))

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The Tax Court in Brief – December 19th – December 23rd, 2022

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Tax Litigation:  The Week of December 19th, 2022, through December 23rd, 2022

Ayria v Commissioner, T.C. Memo. 2022-123 | December 19, 2022 | Lauber, J.| Dkt. No. 13745-20

Short Summary: This case involves the disallowance of taxpayer’s business expenses reported on Schedule C, Profit or Loss from Business for not meeting substantiation requirements and the assessment of an accuracy-related penalty. In the 2017 tax return, Ayria reported wages income received as an employee of Honda. Additionally, he included in his tax return a Schedule C where he described his sole proprietorship as “consulting”, where he reported gross receipts and claimed several deductions. All the expenses reported were incurred in connection with his work as manager of Honda. The expenses incurred were vehicle expenses, meals, and entertainment, gifts, telephone and Internet Charges, and Dry Cleaning. The IRS disallowed all the deductions claimed under Schedule C. The Tax Court determined that expenses shall be “ordinary and necessary” business expenses to be deductible under Section 26 U.S.C. § 162. The tax Court disallowed all the deductions made by Ayria under Schedule C, for the following reasons: (1) Lodging expenses – Ayria incurred hotel expenses that were not essential to carry out his business, but merely a substitution of his daily commuting from his home to his job. (2) Vehicle expenses – Ayria did not maintain any odometer readings to keep track of his mileage nor records for his business travel related. (3) Entertainment expenses – Ayria did not provide any evidence to support that entertainment expenses were for business purposes not personal. (4) Gifts – Ayria could not identify in his bank statements any entries linked to business gifts, or additional tax requirements. (5) Telephone and Internet expenses – Ayria did not provide any substantiation, to determine which portion was used for business and which portion was used for his personal use. (6) Dry cleaning expenses – the Tax Court determined that purchasing and maintaining clothes are not deductible merely because those clothes are worn to the office. The Tax Court did not assess any penalty under Section 26 U.S.C. § 6662 to Ayria regarding all the expenses except for Lodging, as it determined that due to his background education, this error is not chargeable to the petitioner. However, regarding Lodging expenses, the tax Court decided not to assess him with the penalty under 26 U.S.C. § 6662 as he genuinely believed that his lodging expenses were required to hold on to his job as a manager of Honda.

Key Issues:

  • Whether, pursuant to 26 U.S.C. § 274(d) (substantiation requirements), Ayria present sufficient substantiation to evidence entitlement to the business deductions claimed under Schedule C as related to his consulting services?
  • Whether, pursuant to section 6662 Ayria is subject to a 20% penalty upon the portion of any underpayment that is an attributable substantial understatement of income tax?

Primary Holdings:

  • Ayria failed to keep detailed evidence to support the deductions reported under Schedule C were related to his business purpose and not with his activity as an employee or with his personal expenses. Consequently, he failed to meet the higher substantiation requirements to be entitled to deduct the business expenses claimed under Schedule C.
  • No, for the most. He was not considered liable for the error taking those deductions upon his background education. Yes, regarding lodging expenses because he had comprehensive and accurate documentation on those expenses. However, he truly believes those expenses incurred were required to carry out his managerial job.

Key Points of Law:

  • Section 7491(a) the burden of proof may shift to the ISR if a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer. However, if a taxpayer fails to provide such evidence, thus the taxpayer bears the burden of evidence he is entitled to any deduction and the IRS is wrong. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).
  • Section 26 U.S.C. § 162(a)(3) allows a taxpayer to deduct the ordinary and necessary expenses paid required to carry out any trade or business or made within a taxable year. The taxpayer must comply with the tax requirements to consider the expenses as deductible. See Commissioner v. Lincoln Sav. & Loan Ass’n, 403 U.S. 345, 352 (1971).
  • Taxpayers are required to maintain books and records sufficient to establish income and deductions. See 26 U.S.C. § 6001; Treas. Reg. § 1.6001-1(a), (e).
  • If the taxpayer is unable to substantiate the precise amount that he considers deductible, the Tax Court may estimate the amount of deductible expenses (Cohan rule). See Cohan v. Commissioner, 39 F.2d 540, 543–44 (2d Cir. 1930).
  • 26 U.S.C. Section 274(d) overrides the Cohan rule for certain expenses. It provides that, the taxpayer to deduct certain expenses under section 162, including expenses for the use of listed property such as passenger automobiles must meet stricter substantiation requirements. See 26 U.S.C. section 280F(d)(4)).
  • The taxpayer must substantiate by adequate records or by sufficient evidence corroborating the taxpayer’s own statement: (1) the amount of the expense or other item, (2) the time and place of the expense or the date and description, (3) the business purpose of the expense or use, and (4) the business relationship. See 26 U.S.C. Section 274(d), Treas. Reg. § 1.274-5T(a).
  • The taxpayer shall maintain an accountbook, diary, log, statement of expense, trip sheets, or similar record, and documentary evidence sufficient to establish each element of an expenditure or use specified in paragraph (b) of this section. See Reg. § 1.274-5T(a).

Insights:  This case involves the disallowance of deductions made by the taxpayer regarding certain business expenses under Schedule C for not presenting enough support documentation to meet the higher substantiation requirements of 26 U.S.C. Section 274 and related Treasury Regulations. If a taxpayer fails to duly record and register the information and documentation that will allow him or her to substantiate a deduction made, this will imply that the higher substantiation requirements will not be met. It is advisable to record any expense made, considering the requirements set forth in 26 U.S.C. Section 274 to avoid the disallowance of taxpayer’s deductions by the IRS. For additional information on 26 U.S.C. Section 274(d) (substantiation requirements), please see Freeman Law blog:

Patitz, Moody v. Commissioner (September 27, 2022)

Valentine v. Commissioner Tax Court Brief (April 29th, 2022).

Elbasha v. Commissioner (January 12, 2022)

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