If you’re a self-employed individual, you can deduct your “ordinary and necessary” business expenses, just like the corporate giants do. However, you’re also held to the same strict substantiation rules. A taxpayer in a new case, Kalk TC Memo 2024-82, 9/4/24, failed to live up to her end of the bargain.
Background: Under Section 162 of the tax code, a business can deduct ordinary and necessary expenses that are common and accepted in its industry or profession. For an expense to be deductible, it must be both helpful and appropriate for the trade or business. Other special rules and limits may apply to certain business expenses such as vehicles and other types of “listed property.”
Furthermore, you must meet substantiation rules to qualify for most business expense deductions. Typically, these records will indicate the amount, time, and place of travel and meals, the business purpose, the identities of the parties involved, and their relationship to the businessperson.
These rules have tripped up more than one taxpayer. In the new case, a self-employed individual was an expert at computers, but not recordkeeping.
Key facts: After completing just one year of college, the taxpayer became proficient in computer programming. In 2006, she formed her own consulting company providing software installation and training services on a contract-for-contract basis, often as a subcontractor.
During 2011 and 2012, the taxpayer supplied the bulk of her subcontractor services to a client with more than 120,000 employees. Her services allegedly included installation of software and training employees in its use. But she supplied no statement of work or other document that detailed the services she was expected to perform. The record includes some of her invoices, but these simply delineate the hours worked, with no description of any services performed.
The taxpayer contends that she incurred numerous other expenses in her software consulting business, including commuting expenses, vehicle license fees, vehicle insurance, daily parking, and the cost of “working lunches.” The taxpayer operated exclusively out of 900-square-foot condo in Indiana and claimed home office expenses. For the tax years in question, she showed a total of about $274,000 in expenses, resulting in roughly $6,000 and $2,000, respectively, in taxable income for two years. The IRS assessed deficiencies.
The Tax Court commented that the taxpayer didn’t provide “a shred of documentary evidence” to corroborate her testimony relating to her business expenses. She failed to provide any receipts, credit card statements or other substantiation for the costs of computer and software she purportedly purchased for clients, nor any documentation of office supplies, legal and professional services, etc.
Bottom line: The Tax Court sided with the IRS. The taxpayer didn’t provide adequate substantiation, so the business expense deductions are denied. (However, the taxpayer was able to use certain gambling losses to offset gambling winnings on the tax returns in question.)
The moral of the story is relatively simple. Keep contemporaneous records of the ordinary and necessary expenses incurred by a business. Meet all the requirements for each category of expense.
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