Small business owners need to establish a bookkeeping system and retain proper documentation for each year to substantiate items of income and expense. Otherwise, IRS encounters may be expensive.
David Laudon, a chiropractor licensed in Minnesota, had this point driven home in a recent U.S. Tax Court case (David William Laudon v. Commissioner, U.S. Tax Court, T.C. Summary Opinion 2015-54, Sept. 8, 2015).
Basically, Laudon did not have a bookkeeping system in place. The IRS audited his business returns for the 2007 through 2009 tax years and found numerous issues.
Laudon had established a checking account for his chiropractic business. From 2007 through 2009, he made $290,000 worth of bank deposits. But during this same period, he reported only $210,000 in gross receipts on his income tax returns.
Because Laudon did not keep records regarding his income, the IRS was allowed to reconstruct his income using any rational method that separates taxable income from nontaxable income. A bank deposits analysis is considered to be an acceptable method.
For the Tax Court to have allowed the bank deposits method, the IRS had to show that Laudon had operated an income-producing business for the tax years at issue and had made regular deposits into the business’s checking accounts. The IRS then could compute taxable income by distinguishing between taxable deposits and nontaxable deposits.
Because the IRS used the bank deposits method, which is an acceptable method for reconstructing income, Laudon had the burden of proving that the IRS had made some type of mistake in reconstructing his income.
Laudon claimed that many of the deposits listed as taxable income by the IRS were actually nontaxable items. Unfortunately, Laudon was unable to provide any evidence to back up his statements. Therefore, he failed to meet his burden of proof. The court accepted the IRS’s reconstructed income amount and added an additional $78,991 to Laudon’s revenue for the three-year period at issue.
Next under consideration were Laudon’s various business expenses.
The court disallowed all of Laudon’s extensive car and truck expenses because his records did not substantiate them. Section 274 of the Internal Revenue Code has strict mileage record-keeping requirements that obliged Laudon to keep a detailed mileage log. While he kept some sort of log, it fell far short of the IRS requirements.
Laudon lost his home business use deductions as well because he was unable to convince the court that he had used portions of his home exclusively for business. His own testimony in court was used against him since he admitted using these areas for activities other than running his chiropractic business.
In addition to losing all of his car and truck expense deductions and home office deduction, most of Laudon’s other business expenses were severely limited due to lack of substantiation. Laudon was unable to produce receipts, invoices and statements to back up most of his business expense claims.
By not keeping proper accounting records, Laudon’s gross receipts were increased by almost $79,000, and he lost over $200,000 in expense deductions.