If you run a business, you know that you need to support expenses with detailed records. To be deductible, every expense on your tax return might have to be defended if your company is subject to an audit. Plus, failing to operate in a businesslike manner, complete with good records, might lead the IRS to deem the activity a hobby rather than a business, in which case your deductions may be limited or disallowed.
While there’s no one right way to keep business records, some types of expenses do require more details. For example, records relating to automobile, travel, meal and home-office costs are subject to special requirements or limitations.
An activity must be engaged in for profit
For a business expense to be deductible, the taxpayer must establish that the primary objective of the activity is making a profit. The expense must also be substantiated and be an “ordinary and necessary” business expense. In one court case (Gaston v. IRS, 2021), a taxpayer claimed deductions that created a loss, which she used to shelter other income from tax.
She engaged in various activities that included acting in the entertainment industry and selling jewelry. The IRS found her activities were more like hobbies than businesses engaged in for profit, and it disallowed her deductions.
The taxpayer did, however, have some success when she took her case to the U.S. Tax Court. The court found that she was engaged in the business of acting for profit during the years at issue, though not all of the claimed expenses were ordinary and necessary business expenses. The court allowed deductions for expenses including headshots, casting agency fees and lessons to enhance the taxpayer’s acting skills. But the court disallowed other deductions because it found insufficient evidence “to firmly establish a connection” between the expenses and the business.
In addition, the court found that that taxpayer didn’t prove that she engaged in her jewelry sales activity for profit. She didn’t operate it in a businesslike manner, spend sufficient time on it or seek out expertise in the jewelry industry. Therefore, all deductions related to that activity were disallowed.
Proper records are required
In another case (Elbasha v. IRS, 2022), a taxpayer worked as a contract emergency room doctor at a medical center. He also started a business to provide emergency room physicians overseas. On Schedule C of his tax return, he deducted expenses related to his home office, travel, driving, continuing education, cost of goods sold and interest. The IRS disallowed most of the deductions.
In court, the doctor used charts to illustrate his expenses but didn’t provide receipts or other substantiation showing the expenses were actually paid. He also failed to account for the portion of expenses attributable to personal activity.
The U.S. Tax Court disallowed the deductions, stating that his charts weren’t enough and didn’t substantiate that the expenses were ordinary and necessary in his business. It noted that “even an otherwise deductible expense may be denied without sufficient substantiation.” The doctor also didn’t qualify to take home office deductions because he didn’t prove it was his principal place of business.
We can help
Contact us if you need assistance determining how to maintain adequate business records. Taking a meticulous, proactive approach can protect your deductions and prevent the IRS from viewing your business as a hobby.