Merely paying or incurring an expense is not sufficient to entitle a taxpayer to a deduction under Sec. 162(a). The recent Tax Court case Sherman, T.C. Memo. 2023-63, highlights the fact that taxpayers bear the burden of substantiating not only the amount of the deduction but also that the purpose underlying the deduction is ordinary and necessary to operating their trade or business.
Joseph W. Sherman, an emergency medicine physician residing in California and maintaining an apartment in Tacoma, Wash., sought redetermination after the IRS disallowed for lack of documentation or receipts his claimed deductions for expenses of advertising, insurance, legal and professional services, office expense, travel, meals and entertainment, and laundry relating to his medical practice. Ultimately, the court sustained the IRS’s disallowance of the expenses on the grounds that, even if Sherman could document his expenses, he failed to prove that the expenses were ordinary and necessary to his medical practice.
The case provides an opportunity to review the rules surrounding substantiation of business expenses.
Adequate records
All taxpayers are required to keep an accounting of income and expenses under Regs. Sec. 1.446-1. The regulation, not discussed by the court but relevant to the topic here, acknowledges that no uniform method of accounting applies to all taxpayers and leaves the adoption of specific forms and systems to the taxpayer’s judgment.
Though no specific method of accounting is mandated, Regs. Sec. 1.446-1(a)(4) lists the following features as being essential to maintaining records that enable a taxpayer to file a correct return:
(i) Except in the case of a taxpayer qualifying as a small business tax-payer for the taxable year under section 471(c), in all cases in which the production, purchase, or sale of merchandise of any kind is an income-producing factor, merchandise on hand (including finished goods, work in progress, raw materials, and supplies) at the beginning and end of the year shall be taken into account in computing the taxable income of the year. … (ii) Expenditures made during the year shall be properly classified as between capital and expense. For example, expenditures for such items as plant and equipment, which have a useful life extending substantially beyond the taxable year, shall be charged to a capital account and not to an expense account. (iii) In any case in which there is allowable with respect to an asset a deduction for depreciation, amortization, or depletion, any expenditures (other than ordinary repairs) made to restore the asset or prolong its useful life shall be added to the asset account or charged against the appropriate reserve.
Regs. Sec. 1.446-1(c)(1) lists several permissible methods of accounting:
Cash receipts and disbursements method: Under this method of computing taxable income, all items constituting gross income (whether in the form of cash, property, or services) are to be included in the tax year in which they are actually or constructively received. Likewise, expenditures are to be deducted in the year payment is made.
Accrual method: Under this method, income is to be included for the tax year when all the events have occurred that fix the right to receive the income and the income can be determined with reasonable accuracy. Similarly, expenditures are deductible in the tax year in which all events occur that establish the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.
Other permissible methods: These include special methods of accounting, such as the crop method, the installment method, and other methods described in Chapter 1 of the Code and regulations.
Combinations of the above methods: A combination method of accounting is permitted if it clearly reflects income and is consistently used.
Sherman was operating his medical practice under the cash receipts and disbursements method of accounting. Thus, he should have kept canceled checks, invoices, credit card receipts and statements, cash register tapes, or other documents reflecting proof of payment, including the name of the payee, the amount paid, date paid, and a description of the item or service received. The IRS determined that Sherman lacked proper documentation of amounts for many expenses claimed on his Schedule C, Profit or Loss From Business (Sole Proprietorship).
Cohan rule
Often, in cases such as Sherman’s where documentation of expenses is lacking, a court will consider using the Cohan rule to estimate expenses. The landmark case Cohan, 39 F.2d 540 (2d Cir. 1930), established the use of estimates by a court to determine the amount of expenses allowed when records are incomplete.
George M. Cohan, a music composer, deducted significant travel and entertainment expenses, which on audit were disallowed by the IRS in full for lack of complete documentary evidence. The Board of Tax Appeals (BTA) agreed with the IRS that the deductions should not be allowed because Cohan failed to satisfy his burden of proof for the expenses he had incurred. On appeal, the Second Circuit found that complete denial of the expenses was inappropriate and that “the [BTA] should make as close an approximation as it can, bearing heavily if it chooses upon the taxpayer whose inexactitude is of his own making. But to allow nothing at all appears to us inconsistent with saying that something was spent.”
It is important for taxpayers to be aware that use of the Cohan rule is discretionary by the courts, and it is not a substitute for keeping adequate records. For the Cohan rule to apply, a court must first be persuaded that an ordinary and necessary expense was incurred for a business purpose. Even then, it is not obligatory for a court to estimate the amounts. Additionally, the Cohan rule does not apply where specific statutory documentation requirements exist, such as those for travel expenses under Sec. 274(d). Because Sherman had failed to demonstrate his expenses were ordinary and necessary business expenses, the Tax Court held the use of the Cohan rule was inappropriate.
Heightened substantiation for travel and meals and entertainment
Several of Sherman’s claimed medical practice expenses were subject to heightened substantiation requirements under Sec. 274(d), the Tax Court explained. These included expenses related to travel while away from home, such as for meals and lodging. Temp. Regs. Sec. 1.274-5T(b)(2) requires the following elements to be proved to substantiate travel expenses:
(i) Amount. Amount of each separate expenditure for traveling away from home, such as cost of transportation or lodging, except that the daily cost of the traveler’s own breakfast, lunch, and dinner and of expenditures incidental to such travel may be aggregated, if set forth in reasonable categories, such as for meals, for gasoline and oil, and for taxi fares. (ii) Time. Dates of departure and return for each trip away from home, and number of days away from home spent on business. (iii) Place. Destinations or locality of travel, described by name of city or town or other similar designation; and (iv) Business purpose. Business reason for travel or nature of the business benefit derived or expected to be derived as a result of travel.
Temp. Regs. Sec. 1.274-5T(c) outlines best practices for keeping suitable records of travel expenses. Written records are not explicitly required, but far more evidentiary value is given to written versus oral records. Additionally, keeping a record of the necessary elements as close as possible to the time of expenditure has a higher degree of credibility than relying on recall later. A taxpayer relying on recall will need far more corroborative evidence for it to rise to the evidentiary value of a contemporaneous record.
Sherman not only failed to keep a written log of his travel expenses explaining the business reason for travel, but the court found his oral testimony to be generally “self-serving, and, at times, lacking in credibility and candor.” The court sustained the IRS’s disallowance of travel and meal expenses related to Sherman’s medical practice. His claimed deduction for entertainment expenses also failed to meet heightened substantiation requirements.
Ordinary and necessary
Though Sec. 162(a) requires that an expense be ordinary and necessary to a taxpayer’s business to be deductible, the Code section does not define “ordinary and necessary.” The prevailing definition of the terms as they relate to Sec. 162(a) comes from Welch v. Helvering, 290 U.S. 111 (1933).
Thomas Welch, the former secretary of the bankrupt Welch Co., after obtaining a new job in the same industry, decided to pay the debts of the Welch Co. in an effort to solidify goodwill. Welch deducted the payments made to Welch Co.’s creditors as ordinary and necessary business expenses. The IRS determined that the expenses were not ordinary and necessary but rather akin to capital expenditures. After the BTA agreed with the IRS, the taxpayer appealed to the Eighth Circuit, which affirmed. The Supreme Court agreed to hear the case. Although it affirmed the Eighth Circuit’s decision, the Court acknowledged that expenses can sometimes be ordinary for a business in this sense even if infrequent.
Supreme Court Justice Benjamin N. Cardozo wrote for the Court:
Now, what is ordinary, though there must always be a strain of constancy within it, is none the less a variable affected by time and place and circumstance. Ordinary in this context does not mean that the payments must be habitual or normal in the sense that the taxpayer will have to make them often. A lawsuit affecting the safety of a business may happen once in a lifetime. The counsel fees may be so heavy that repetition is unlikely. None the less, the expense is an ordinary one because we know from experience that payments for such a purpose, whether the amount is large or small, are the common and accepted means of defense against attack.
As such, a taxpayer need not incur a particular expense regularly and habitually for that expense to nonetheless be ordinary. In fact, an expense incurred once in an individual taxpayer’s lifetime may still be ordinary. Under the specific facts in Welch, however, the Supreme Court upheld the lower courts’ determination that Thomas Welch’s voluntary debt payments were not ordinary.
While the Welch case turned on the definition of “ordinary,” the Supreme Court also indicated that an expense may be considered “necessary” if it is “appropriate and helpful” for the development of the taxpayer’s business; thus, an expense does not need to be essential to be considered necessary. Heineman, 82 T.C. 538, 543 (1984), further reinforces that so long as a business purpose exists, an expense can be necessary even if it is not required. A reasonable expectation that the business will benefit from an expense is enough for it to be considered necessary within the context of Sec. 162(a).
Returning to the case involving the emergency medicine physician, the Tax Court ultimately found that Sherman failed to offer documentation, testimony, or other evidence to prove the amount or business purposes of his purported medical practice expenses. There was a “pervasive” lack of substantiation of the alleged expenses, the Tax Court said.
The IRS thus prevailed in reducing Sherman’s claimed expenses for his medical practice. (In a separate portion of the opinion, the Tax Court rejected Sherman’s claims for business deductions related to his film production activities, holding that he did not engage in them with the primary motivation of earning a profit.)