For the owner of a closely-held business, and especially one with a limited support staff, it can be easy to drift into carelessness or, worse, neglect, when it comes to maintaining detailed records of the business’s expenses. However, as one taxpayer recently learned the hard way, such inattention to detail can come back to haunt you when it comes time to file your tax returns.
In Nguyen v. Commissioner, tax deficiencies were assessed upon the taxpayer, an owner of a hardwood floor installation business (the “Taxpayer”), for the years 2009 and 2010. The IRS also determined accuracy-related penalties for the same period. The crux of the case turned on the Taxpayer’s lack of substantiation for the amounts claimed for cost of goods sold as well as for supplies.
In conducting his business, Taxpayer generally purchased the flooring necessary for each job as he was hired, rather than maintaining an inventory of flooring materials. At times, Taxpayer also installed flooring already purchased by his customers. In addition to purchasing flooring materials, Taxpayer purchased supplies in connection with the business, including wood, paper, glue, and nails. He made these purchases using his debit card, checks, and cash.
Taxpayer’s practice for both 2009 and 2010 was to keep business bank statements in the drawer of his desk, and receipts for business expenses in a bag in his basement. However, due to a flood in Taxpayer’s home in 2009, some of the receipts for that year were destroyed. (At least the dog didn’t chew his homework.)
The 2009 and 2010 Returns
Taxpayer’s returns for 2009 and 2010 were prepared by two different tax professionals. The preparer for the 2009 return reviewed Taxpayer’s bank statements and the receipts that remained after the flood over the course of an hour-long meeting. The IRS determined that about 40% of the cost of goods sold claimed on Taxpayer’s Schedule C had been substantiated, and asked for an explanation of the discrepancy. A review of additional documents provided by the Taxpayer only substantiated a small portion for cost of goods sold.
Taxpayer’s 2010 return was prepared by a different tax professional, who was given the 2009 return as a guide but no other documentation. On the 2010 return, $39,894 was claimed as a deduction for supplies, which the IRS determined had been about 60% substantiated. A review of additional documents provided by the Taxpayer substantiated an additional $178.26.
In its analysis, the Court highlighted the fact that “[d]eductions are a matter of legislative grace, and taxpayers bear the burden of establishing entitlement to any claimed deduction.” In this instance, in addition to the limited documentation provided by the Taxpayer to substantiate the claimed deductions for cost of goods sold and supplies, Taxpayer failed to provide any testimony regarding specific expenditures related to flooring jobs for which deductions should be allowed but were denied, or for supply expenses in excess of the amount determined as allowable, in either 2009 or 2010. As a result of his inability to back up the amounts on his returns, Taxpayer was not entitled to any more deductions, for either cost of goods sold or supplies, than the IRS had already determined as allowable.
The Court also found in favor of the IRS in upholding the accuracy-related penalty of 20% under Code § 6662, which penalty applies, among other things, to the portion of an underpayment attributable to negligence. For purposes of this rule, negligence includes any failure to keep adequate books and records or to substantiate items properly. The burden is on the IRS to produce evidence of such negligence, and was met in this case with the showing that the Taxpayer lacked adequate records to substantiate fully the amounts claimed.
Although there is a good faith exception to the § 6662 penalty under Code § 6664 if the Taxpayer can establish that there was reasonable cause for the underpayment and that the Taxpayer acted in good faith, the Taxpayer provided no evidence that he fell within this exception. Therefore, the accuracy-related penalty was upheld.
For all businesses, but especially for a business that routinely purchases goods and supplies, it is critical to keep meticulous records of purchases throughout the year. While many of these purchases may seem insignificant at the time—in the instance of the Taxpayer here, for example, purchases of glue and nails—in the aggregate, if documented correctly, they are likely to result in a significant tax benefit and thus be well worth the headache of cataloging them along the way.
Small, closely-held businesses must especially be diligent if they are to reduce their tax liability and avoid penalties. The tax savings will warrant the cost of recordkeeping.