2008 was a bad year for my client, “Jackson.” His condo in Missouri burned to the ground in February while he was on vacation in Hawaii. All he had left was the beach attire he’d brought with him. Then, he got a notice from the IRS requesting documentation for his 2007 Schedule C income and expenses.
Fortunately for Jackson,since I hadn’t gotten around to returning them, his business records were still in a box in my office. Brent Katusha, however, as this recent U.S. tax court case describes, wasn’t so lucky.
Mr. Katusha, a part-time professional automobile racing mechanic, agreed that he had omitted $10,081 of self-employment income on his 2014 tax return. Although his timely-filed Schedule C reported $61,399 in income and $13,146 in expenses, he claimed that he’d also left off $7,355 in additional expenses – chiefly meals, entertainment, travel, and gift expenses related to his work at various Indy races. However, before he could assemble documentation for those additional expenses, his CPA’s home, where his business records were located, was destroyed in a wildfire.
Reconstruction of lost or missing records is allowed
Fortunately, the IRS has procedures for situations where records are lost “through circumstances beyond the taxpayer’s control, such as destruction by fire, flood, earthquake, or other casualty.” When this happens, taxpayers can perform a “reasonable reconstruction,” that includes substantiation through secondary evidence.
This procedure, also known as the “Cohan rule,” originated in a 1930 case involving a traveling entertainer who kept no documentation of his expenses. But, because the exclusion of those expenses was seen as unfair, he was allowed to use estimates of those expenses to compute his taxable income.
Higher burden for travel, entertainment, and gifts
However, Section 274(d) expenses, which covers expenses for meals, travel, entertainment, gifts, and the use of listed property, have a higher burden for substantiation. For these expenses, taxpayers need to provide the amount, time and place, business purpose, and business relationship for the deduction, whether it’s from original or reconstructed records.
Bank statements and credit card statements may be used as documentation of the time and amount of the expense, but secondary evidence, such as account books, diaries, trip logs, or other contemporaneously prepared documents, is required to corroborate the place, names of persons involved, and business purpose for these kinds of expenses.
Because Mr. Katusha no longer had his original records, he provided the tax court with 49 pages of bank statements with handwritten notations for his business expenses. He also provided official Indy race schedules for the 2014 season.
However, Mr. Katusha was vague and unsure about exact details of the expenses in his bank statements, which apparently included personal and business expenses. Race dates from the schedule were not consistent with his handwritten notes of business meals and expenses. He also didn’t explain why the additional expenses had been left off his original Schedule C, and did not describe the records he’d lost in the fire at his CPA’s home, or the methods he used to track his racing expenses.
Since he didn’t meet the burden of proof for substantiating his expenses, the tax court had no choice but to deny his request to include the additional expenses in his tax return.
Best practices for reconstructing records
Losing tax records can happen to anyone, so here are some best practices to help your clients in this situation.
- Backup records in multiple places. This is actually a pre-step, but with today’s cloud accounting software, there’s no reason not to have documents stored in the cloud.
- Document the disaster that caused the loss of records. Did your client file an insurance claim or pay for repairs? Are there pictures to back up the damage?
- Ask vendors for duplicate invoices. For many clients, this may go a long way in reconstructing lost records.
- Match secondary proof to events in another source. Events in calendars, mileage logs, meeting notes, or diaries must be consistent with data from bank and credit card statements.
- Include specific details for expenses. Section 274(d) expenses will need the who, what, when, where, and why of the expense.
- Reconstruct records as soon as possible. Even if your client’s tax return has already been filed, this will support the data in case of an audit.
Reconstructing records after a disaster can be time consuming and tedious, but can also be a way to shine as a true hero for your clients in their time of need!