If you operate a business or are starting a new one, you must keep records of your income and expenses. Specifically, you should carefully record your expenses to claim all the tax deductions you’re entitled to. And you want to ensure you can defend the amounts reported on your tax returns in case the IRS ever audits you or you wind up in the U.S. Tax Court.

Of course, there’s no one way to keep business records. However, there are strict rules regarding keeping records and proving expenses are legitimate for tax purposes. Certain expenses — such as vehicle, travel, meals, and home-office costs — require special attention because they’re subject to special recordkeeping requirements or limitations. Here are two recent cases from the U.S. Tax Court to illustrate some issues.

Case 1: Profit motive is paramount

A business expense can be deducted only if the taxpayer can establish that the primary objective of the related activity was making a profit. The amount must also be substantiated and definable as an “ordinary and necessary business expense.”

In one case, a taxpayer claimed deductions that created a loss, which she used to shelter other income from tax. She engaged in various activities, including acting in the entertainment industry and selling jewelry. The IRS found that her activities weren’t for profit and disallowed her deductions.

The taxpayer took her case to the U.S. Tax Court, where she found some success. The court found that she was engaged in the business of acting during the years in question. However, she didn’t prove that all claimed expenses were ordinary and necessary business expenses. The court did allow deductions for some expenses — including headshots, casting agency fees, lessons to enhance the taxpayer’s acting skills, and part of the compensation for a personal assistant. However, 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 the taxpayer didn’t prove that she engaged in her jewelry sales for profit. She didn’t operate it businesslike, spend sufficient time on it or seek out expertise in the jewelry industry. Therefore, all deductions related to that activity were disallowed. (TC Memo 2021-107)

Case 2: Substantiation must be sufficient

A taxpayer worked as a contract emergency room doctor at a medical center and started a business providing 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.

The doctor took his case to the U.S. Tax Court, where he showed charts listing his expenses but didn’t provide receipts or other substantiation showing the costs were paid. He also failed to account for the portion of expenses attributable to personal activity.

The 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. (TC Memo 2022-1)

Mind the details

Documenting your company’s income and expenses meticulously and proactively is critical to defending your tax deductions if necessary. Work closely with your tax advisor to ensure you remember all the details.

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