If you own a business or are in the process of starting one, it’s essential to maintain accurate records of your income and expenses. This not only ensures you’re capturing every tax deduction you’re entitled to, but also helps you substantiate the figures reported on your tax returns should you ever face an IRS audit.
There’s no one right way to keep business records. The IRS says, “You can choose any recordkeeping system suited to your business that clearly shows your income and expenses.” However, when it comes to claiming deductions, the rules are more specific. Some expenses — such as those related to vehicles, travel, meals and home offices — are subject to additional documentation requirements or limitations on deductibility. These areas require special attention to ensure compliance and maximize your tax benefits.
Business expenses: How much is too much?
To deduct an expense, a taxpayer must establish that the primary objective of the activity is making a profit, and the cost must be “ordinary and necessary.” What does that mean?
A married couple learned a great deal about the definition when the IRS audited them. Both the IRS and later the U.S. Tax Court disallowed most of their business deductions. The reasons: The expenses were found to be personal, and the taxpayers didn’t have adequate records for them.
In this case, the husband was a salaried executive. With his wife, he started a separate business as an S corporation. His sideline business identified new markets for chemical producers and connected them with potential customers. The couple’s two sons began working for the business when they were in high school.
The couple then formed a separate C corporation that engaged in marketing. For some of the years in question, the taxpayers reported the income and expenses of the businesses on their joint tax returns. The businesses conducted meetings at properties the family owned (and resided in) and paid the couple rent for the meetings.
Deductions that didn’t make the cut
The IRS selected the couple’s returns for audit. Among the deductions the IRS and the Tax Court disallowed:
- Travel expenses. The couple submitted reconstructed travel logs to the court, rather than contemporaneous records. The court noted that the couple didn’t provide “any documentary evidence or other direct or circumstantial evidence of the time, location, and business purpose of each reported travel expense.”
- Marketing fees paid by the S corporation to the C corporation. The court found that no marketing or promotion was done. Instead, the funds were used to pay several personal family expenses.
- Rent paid to the couple for the business use of their homes. The court stated the amounts “were unreasonable and something other than rent.”
Deductibility of retirement contributions
The couple did prevail on deductions for contributions to 401(k) accounts for their sons. The IRS contended that the sons weren’t employees during one year in which contributions were made for them. However, the court found that 401(k) plan documents did mention the sons working in the business, and the father “credibly recounted assigning them research tasks and overseeing their work while they were in school.” Thus, the court ruled the taxpayers were entitled to the retirement plan deductions.
Bottom line
As this case illustrates, a business can’t deduct personal expenses. Scrupulous records, kept contemporaneously, are critical. Business bank accounts should be used for business purposes only. Contact us if you have questions about retaining adequate business records.
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