Substantiating business expenses for your taxes is an essential part of financial management. When it comes to deducting business expenses, if they are not adequately substantiated, the expenses may be disallowed, and your taxable income and tax liability will increase. To avoid improper claims, it is necessary to keep thorough records.
The first step to substantiating a tax deduction is to ensure the deduction is both ordinary and necessary to operating your trade or business. An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business.
Substantiation typically requires proof of payment and evidence showing the character and deductibility of the expenditure. Proof of payment can include canceled checks, bank statements, credit card statements with receipts for charges, or invoices marked “paid.” You can establish the character and deductibility of an expense with items such as sales slips, invoices, receipts, payment acknowledgments, and check registers. A canceled check may also suffice if it indicates the nature of the expense.
Each receipt should provide certain information for substantiation, including 1) the date, time, and location the expense was incurred, 2) the person(s) you were with when you incurred the expense (e.g., to whom you provided a meal or gift), and 3) the business topics discussed.
Other examples of records to substantiate business expenses include appointment logs, diaries, account books, trip sheets, and expense statements. Make sure to record the details at the time of the event or soon after. Do not wait until the end of the year or until receiving a notice from the IRS. To help keep records accurate and timely, business owners should require employees to submit expense reports.
Inadequate Records Can Lead to Legal Trouble
Merely paying or incurring an expense is not enough to entitle a taxpayer to a deduction—there must be sufficient records to prove it is a qualified business expense. In particular, deductions claimed for business meals or auto expenses are carefully scrutinized by the IRS. If a business owner cannot fully substantiate an expense, the court can estimate the approximate costs allowed or deduction amounts. This is called the “Cohan Rule.” Cohan v. Commissioner established the use of estimates by a court to determine the amount of expenses allowed when records are incomplete.[1]
Recent tax court cases highlight the dangers of failing to substantiate business expenses and provide adequate records. For example:
- Sherman v. Commissioner: An emergency medicine physician contested the IRS’s rejection of his deductions for various expenses for his medical practice due to a lack of proper documentation. The costs included advertising, insurance, legal fees, office expenses, travel meals, entertainment, and laundry. The court sided with the IRS, highlighting the physician’s failure to demonstrate that the expenses were ordinary and necessary for his practice.[2]
- Wolpert v. Commissioner: The court rejected a consultant’s claim for vehicle and travel expenses because he couldn’t prove these expenses with timely or supporting records. The court highlighted the need for specific details like expense amount, business mileage, travel dates, and reasons for trips. The records provided needed to be clearer on their timeliness and lacked necessary specifics, leading to the disallowance of the deduction.[3]
Keep Adequate Complete Records to be IRS Compliant
To avoid potential issues related to tax deductions, ensure the business has processes in place to substantiate expenses by keeping detailed, accurate, up-to-date records. Taxpayers are required to keep an accounting of income and expenses. However, no specific method of accounting is mandated. Adopting specific forms or systems is subject to the taxpayer’s judgment.
The IRS allows various methods of accounting, including:
- Cash receipts and disbursements: Expenses are recorded when received or paid.
- Accrual method: Expenses can be claimed in the tax year in which they are incurred, regardless of when the actual payment is made.
- Other methods: The crop method, installment method, and other special methods of accounting are described in the tax code.
Mixing methods is okay if they correctly show income and are used consistently.
Final Thoughts
Claiming a tax deduction is not the same as proving a tax deduction. It is critical to retain sufficient detailed records to prove the expense is both ordinary and necessary and meets the proof of payments and character of deduction rules. Failing to have these records can lead to an increase in taxes if a taxing authority questions a deduction for which you do not have adequate support. For help properly substantiating your business expenses, consult with tax experts at RDG+Partners by calling (585) 673-2600.
[1] Cohan v. Commissioner of Internal Revenue, 39 F.2d 540 (2d Cir. 1930)
[2] Sherman v. Commissioner of Internal Revenue, No. 22276-19 (U.S.T.C. May. 17, 2023)
[3] Wolpert v. Commissioner of Internal Revenue, No. 3182-20 (U.S.T.C. Jul. 7, 2022)