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August 3, 2017

The Importance of Substantiation and Documentation


In a U.S. Federal Income tax world that is ever more complicated, it is as important as ever to keep good records, seek appropriate professional tax advice, and be vigilant in using your knowledge and judgment in the application of the law as it pertains to your own personal and business situations.

Over the past few years there have been a number of prominent cases in which taxpayers have been denied deductions because of inadequate documentation which supported their deduction claims on their income tax returns.

In other cases substantiation was missing through inadequate reporting on the return itself. Sloppy or incomplete tax return preparation can result in lost deductions where the amount is challenged, through audit, by the IRS.

Example I: Partnership didn't properly substantiate charitable contribution.

A partnership purchased a remainder interest in a web hosting facility for $2.95 million. The following year, the partnership assigned the remainder interest to the University of Michigan.

On its federal income tax return, the partnership claimed a charitable contribution deduction of approximately $33 million. However, its Form 8283 (Noncash Charitable Contributions) left blank the space for the donor's cost or other adjusted basis of the property.

In light of this, the Tax Court held that the partnership violated the substantiation requirement of Reg. 1.170A-13(c)(4) . In addition, the Court rejected the partnership's argument that it substantially complied with the regulations because omission of the basis amount prevented the appraisal summary from achieving its intended purpose. Therefore, the partnership's charitable contribution deduction was denied in full. Reri Holdings I, LLC, 149 TC No. 1 (Tax Ct.).

Example II: Real estate LLC did not adequately substantiate repair and maintenance days.

According to Sec. 280A(d)(2), (Disallowance of expenses related to business use of home of vacation rental.) a day is not treated as a day of personal use if the taxpayer engages in repairs and maintenance work on the unit substantially full time during the day.

Further, Sec. 280A(a) provides that no deduction can generally be taken related to a dwelling unit that is used by the taxpayer as a residence during the tax year. Property is treated as a residence if a taxpayer uses it for personal purposes for the greater of: more than 14 days or 10% of the days during the year that the property is rented.

Ordinary and necessary expenses incurred in connection with a business or for the production of income are deductible as per Sec. 162(a) and Secs. 212(1) and (2). However, no deductions are allowed for expenses incurred related to activities that are not engaged in for profit.

In the Cooke, T.C. Memo. 2017-74 the Tax Court determined that the taxpayer did not establish that he engaged in repairs and maintenance because the taxpayer's records did not show the time spent on each activity and that the logbooks the taxpayer did maintain, provided no evidence that the property actually needed any repairs nor specific details of the work done to improve the property.

Upon audit, the IRS disallowed the deductions of $134,273 in 2010 and $127,740 in 2011. The Tax Court found that Cooke used the property for personal purposed for more than the allowed number of days, and therefore, disallowed the deductions.

Example III: Compensation is held reasonable and a management fee deduction allowed.

The Tax Court held that officer compensation paid by a corporate taxpayer for two tax years was reasonable and therefore deductible. The court reached that conclusion by applying the five-factor test of Elliotts, Inc., 716 F.2d 1241 (9th Cir. 1983).

The court also held that a $500,000 administrative fee expense paid by the taxpayer to a corporation wholly owned by two of the three shareholder-officers of the taxpayer was deductible because it was normal for the taxpayer's business and helpful to it.

A deduction is allowed for compensation expense if the amount is reasonable and paid only for services rendered. In Elliotts, Inc., the Ninth Circuit (the court to which this case could be appealed) used a five-factor test to determine whether compensation is reasonable: (1) the employee's role in the company, (2) a comparison of compensation paid by similar companies for similar services, (3) the character and condition of the company, (4) potential conflicts of interest, and (5) the internal consistency of compensation arrangements.

After considering all five Elliotts factors, the court held that the compensation paid was reasonable. The court found that all five factors had been met, given the substantiation by the taxpayer, and rejected the arguments made by the IRS to the contrary.

H.W. Johnson, Inc., T.C. Memo. 2016-95

Example IV: Family stock transfer was not a taxable gift.

The Tax Court held that a deceased taxpayer's 1972 transfer of stock to his children's trusts in settlement of a family dispute was not a taxable gift. Evidence indicated that the transfer of stock was made in the ordinary course of business and for full and adequate consideration, even though that consideration was not furnished by his children.

According to Regs. Sec. 25.2511-1(g)(1), gift tax is not applicable to a "transfer for a full and adequate consideration in money or money's worth, or to ordinary business transactions."

A transfer will have occurred "in the ordinary course of business" and therefore will be considered to have been made "for a full and adequate consideration in money or money's worth" if it meets three requirements under Regs. Sec. 25.2512-8: that the transfer be bona fide, at arm's length, and free of donative intent.

The Tax Court held that the transfer of shares to the children's trusts was not a gift because the requirements in Regs. Sec. 25.2512-8 were met. (Proper documentation had been retained that supported the taxpayer's position.)

The court reasoned that the transfer was bona fide because the taxpayer agreement to transfer the stock to the children's trusts was a bona fide settlement of a real dispute.

As the registered owner of the family stock, the male child agreed to the settlement terms to end the dispute with his father and receive payment for his remaining shares. There was no indication that this was a sham transaction to avoid gift tax.

Estate of Redstone, 145 T.C. No. 11 (2015)

In Summary

What can be seen by two of the above examples are instances where things can go wrong with improper substantiation and documentation, and the remaining two cases that show how things can go right with proper substantiation and documentation.

Let us know how our tax, accounting, and consulting services staff may help you with your documentation requirements. Our experts at Smolin are here to provide you with the best advice possible.

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