From the Desk of Lauran Corcoran
It’s a Write-off, Right? Business Deduction Requirements and Rules, Part 2
As discussed previously, a business expense is valid deduction against business income when the expense is necessary and ordinary to the production of business income. However, the “ordinary” prong to this test implicates substantiation issues and these substantiation issues are also the basis for the accuracy related penalties under IRC §§ 6662(b)(1) and (2).
To be “ordinary,” the business deduction must be substantiated and verifiable. This means that the business expense must have a record at the time the expense occurs. Generally speaking, the IRS does not require any specific kinds of records, the taxpayer can choose any type of recordkeeping system suitable to their business that clearly reports the allowable expense. This means that the records must provide the answer to the “What? Why? When? Who? And How much?” standard for every single business expense. Additionally, the records must also include supporting documents like invoices, receipts and cancelled checks are required in order to substantiate deductions.
You might be thinking, “I know! This is what you wrote about last week!” And you would be correct, but it bears repeating in order to understand how the accuracy related penalties will be assessed. If audited, the very first thing the IRS will ask for are the records and supporting documents for the business deductions taken against the income. If the taxpayer cannot provide these records, the “ordinary” and “necessary” test won’t even be considered because business deductions without substantiation are disallowed. Period. The IRS will consider this to be negligence and a disregard for the rules and regulations. (As a side note, the tax geek in me wants to point out there are very rare situations where it is possible to get around this requirement under the philosophy of the Taxpayer Bill of Rights but that is a discussion for a different post.)
The amount of an accuracy-related penalty equals twenty percent of the portion of the underpayment attributable to the taxpayer’s negligence or disregard of rules or regulations or to a substantial understatement. Pursuant to IRC Section 6662(d)(1)(A), for Individuals, the “understatement” of tax is “substantial” if it exceeds the greater of $5,000 or Ten percent (10%) of the tax that must be shown on the return. Pursuant to IRC Section 6662(d)(1)B), for Corporations (other than S corporations or personal holding companies), an “understatement” is “substantial” if it exceeds the lesser of ten percent (10%) of the tax required to be shown on the return (or, if greater, $10,000), or $10,000,000.
The IRS will impose the IRC § 6662(b)(1) negligence penalty if it concludes that a taxpayer’s negligence or disregard of the rules or regulations caused the underpayment. Negligence is defined to include “any failure to make a reasonable attempt to comply with the provisions of this title, and the term ‘disregard’ includes any careless, reckless, or intentional disregard. The most common type of negligence is the failure to keep adequate books and records or to substantiate items that gave rise to the underpayment.
The bottom line is that if there are obvious legitimate business expenses taken against business income without verifiable records and supporting documents, all business expenses will be disallowed and a penalty will be assessed.