Tax deductions are a matter of legislative grace, and failure to comply with substantiation requirements can have dire consequences. One family in El Paso discovered this harsh reality after an audit of their 2012 and 2013 taxes. Mrs. Baca is a W-2 employee of a bank in El Paso, Texas, and her husband is self-employed or a partner in the following businesses:
- A multi-level-marketing company;
- A transportation/delivery service company;
- An 18-wheeler mechanic/servicing company;
- A company that moved fracking equipment in the Midland and Odessa regions;
- A partnership employing a “belly dump” truck transporting dirt; and
- An automobile transportation company that moved cars from New York to Mexico.
Mr. and Mrs. Baca filed their 2012 and 2013 joint returns, combining all business income and expenses onto a single Schedule C even though each company should have had its own. Among other items, the Schedule C included approximately $115,000 in depreciation and Section 179 deductions for the belly dump truck, two passenger vehicles, and more. The Bacas also included approximately $50,000 in unreimbursed business expenses on Schedule A related to Mr. Baca’s travel and lodging costs. Further, the Bacas took a home office deduction for each year, but failed to include Form 8829, Expenses for Business Use of Your Home, for either tax year.
After an audit, the IRS disallowed approximately $230,000 worth of expenses and deductions for the 2012 and 2013 tax years. The Bacas then filed a claim in the United States Tax Court seeking relief. For a litany of reasons, the Court found for the IRS on every issue – a harsh result for a taxpayer who certainly incurred some business expenses even if not quite the full amount claimed.
The deduction for the purchase of the belly dump truck was disallowed because it was the partnership, not Mr. Baca personally, that used the truck in business. He instead purchased and contributed it to the partnership, which should have filed a separate 1065 tax return and issued a K-1 to Mr. Baca reflecting his share of depreciation.
Passenger vehicles are “listed property” subject to enhanced substantiation requirementsunder § 274 because they (along with airplanes, yachts, and more) are at a higher risk of non-business use. Deductions for the couple’s Honda Odyssey, which Mr. Baca admitted was for personal use, and a used Chevrolet for which no purchase or use details were provided, were disallowed in full.
A $9,000 deduction for contract labor was disallowed due to lack of substantiation. Mr. Baca testified at trial that he merely handed the contractor a debit card to make cash withdrawals, but submitted no receipts, invoices, or other evidence regarding these withdrawals.
Verbal testimony from Mr. Baca that he spent $42,000 on a storage shed and various equipment wasn’t enough to substantiate the deduction. The judge found his testimony credible generally, but questioned whether one would spend $42,000 on a shed and equipment for a business that earned only a fraction of that amount, and so disallowed this expense entirely.
Finally, two of Mr. Baca’s businesses operated in Midland, Texas, some 300 miles from their home in El Paso. The judge disallowed Mr. Baca’s travel to and from Midland because his work there was not “temporary.” Instead, his “tax home” was in Midland while his wife’s was in El Paso. For a great explanation on the nebulous concept of dual tax homes of husband and wife, read more here.
The end result is a ruling for the IRS on all issues, including inaccuracy penalties – a bitter pill for the Bacas to swallow. This cautionary tale is a reminder to other small business owners to keep receipts, track them carefully in accounting software, and partner with a trusted tax professional for advice.
Andrew Ralls is a business and estate-planning attorney, licensed in both Missouri and Kansas. He can be reached at (913) 744-6589.