Lost Records / The Cohan Rule

Ten Forty + Quality Tax Preparation & Financial Services 281-397-7777 Fax 281-397-7443 Tax Tip LOST RECORDS Share Lost Tax Records Destroy Both Your Time and Your Tax Deductions What happens if you lose your tax records? Let’s say that your house burns down and your tax records go up in flames. What happens? Your tax life could become very miserable. Protect your tax records so that they will not go up in flames should your house burn down. This may seem like a bit much. But if the IRS came looking for your tax records, you would absolutely wish you had protected them. Pain! Reg. Section 1.274­5T(c)(5) addresses your loss of tax records due to circumstances beyond your control. The regulation states: Where the taxpayer establishes that the failure to produce adequate records is due to the loss of such records through circumstances beyond the taxpayer’s control, such as destruction by fire, flood, earthquake, or other casualty, the taxpayer shall have a right to substantiate a deduction by reasonable reconstruction of his expenditures or use. How painful will your reconstruction of your tax records be? How long will it take? Whom do you know who can testify on your behalf? Let’s face it. You are going to spend a lot of time and effort in trying to make a reconstruction. It’s pretty likely that you will get tired of reconstruction and just go with what you have when you reach that “I’m too tired” point. Reason 2 Cash! Let’s say you do a great reconstruction. Even so, it’s unlikely that you will get your original deductions. The courts don’t have a history of making taxpayers whole when they have to reconstruct. So the bottom line is that this loss of records through no fault of your own is going to cost you some money. How much lost cash depends on how many deductions you’re going to lose. Further, if it appears to the court that your lack of records is your fault, either because you were careless or you did not do a good faith reconstruction, you are going to face penalties on top of the taxes and interest. Example 1 David E. Christensen probably hoped for some mercy when he arrived in court with no records to prove his deductions. He explained that his records were either destroyed in “hard disk crashes” or were lost while moving. the court explained to Mr. Christensen that when you lose your tax records for any reason—including floods, theft, hurricanes, and earthquakes—you have the right to substantiate your deductions using a reasonable reconstruction of those records. Mr. Christensen testified on his own behalf in court, but the court found the testimony deficient, noting that Mr. Christensen contradicted himself, admitted to errors in his Schedule C expenses, and, in some instances, could not recall what he claimed the expenses for. The court ruled that Mr. Christensen did not make a good­faith effort to reconstruct his expenses, did not provide documentation, and did not provide corroborating evidence to bolster the credibility of his testimony. On the basis of Mr. Christensen’s failure to produce records, the court disallowed all of his Schedule C expenses —$46,669, $44,451, $44,063, and $39,135—in the four years under consideration.3 Example 2 Suppose you failed to file tax returns for a number of years and that you misplaced and lost many of your records. This is a major problem. Are you doing a decent job keeping your tax records? If so, why not protect your time and money by protecting your tax records? That’s easier today than ever. With computers and scanners, you can have a paperless office that’s backed up online for very little money. In this situation, a fire or flood would be a major problem, but it would not destroy any of your tax records. Further, as you know, some of those thermal paper receipts allow the ink to disappear from the receipt. To protect the receipts, you need to either photocopy or scan them. If you are doing this, you are on your way to a paperless office. If paperless is not your thing, then an investment in file cabinets that are fireproof and waterproof makes sense, especially when compared to the pain and suffering of re­creating the records and then losing cash too. However, don’t forget the Chohan Rule “Receipts are critical to good book-keeping and tax returns. But if you can’t find one, contrary to popular belief, you are not out of luck. Remember the Cohan Rule, from a still good today tax case called Cohan v. Commissioner. George M. Cohan was a Broadway pioneer with hits like “Give My Regards to Broadway” and “Yankee Doodle Boy.” His statue still commands Times Square if you look amid all the hubbub. In the 1920s, the IRS disallowed Cohan’s (very large) travel and entertainment expenses for lack of receipts. He was a flashy guy and tended to pay in cash. And he wasn't going to take no for an answer. So when the IRS denied all his deductions, he took the IRS to court. Receipts being the stock in trade of the tax system, the trial court upheld the IRS. Again, Mr. Cohan wouldn't take no for an answer and appealed to the Second Circuit. In 1930, the Appeals Court rocked the IRS back on its heels with the Cohan Rule. To this day, it is as an exception to stringent IRS record-keeping requirements. It allows taxpayers to prove by “other credible evidence” they actually incurred deductible expenses. Mr. Cohan testified that he paid in cash, and others too remembered big dinners. Of course, this is a tough way to prove expenses. Not surprisingly, the Cohan Rule often doesn’t impress the IRS. You may have to go to court, and the argument doesn’t always work there either. Still, the IRS or a court may be convinced by oral or written statements or other supporting evidence. If you get over that hurdle and can make a reasonable approximation of the expenses, you may be OK despite your lack of documentation. Even charitable contributions have been allowed under the Cohan Rule, though not in cases subject to special strict substantiation requirements. Remember the IRS computer crashes and the hunt for those long destroyed or lost emails of Lois Lerner? Rep. Steve Stockman of Texas introduced a bill he called the “The Dog Ate My Tax Receipts Act,” to allow us all to try out some excuses. Rep. Stockman said, “Taxpayers should be allowed to offer the same flimsy, obviously made-up excuses the Obama administration uses.” The bill would allow taxpayers who do not provide documents requested by the IRS to claim one of the following reasons: 1. The dog ate my tax receipts. 2. Convenient, unexplained, miscellaneous computer malfunction. 3. Traded documents for five terrorists. 4. Burned for warmth while lost in the Yukon. 5. Left on table in Hillary’s Book Room. 6. Received water damage in the trunk of Ted Kennedy’s car. 7. Forgot in gun case sold to Mexican drug lords. 8. Forced to recycle by municipal Green Czar. 9. Was short on toilet paper while camping. 10. At this point, what difference does it make? The resolution says that the “IRS must allow taxpayers the same lame excuses for missing documentation that the IRS itself is currently proffering.” Every taxpayer has looked for receipts. Seinfeld fans may remember an episode called the ‘‘The Truth,’’ which aired Sept. 25, 1991. The IRS questioned Jerry about a $50 charitable contribution to the people of Krakatoa. The IRS normally doesn’t require extra substantiation of charitable donations less than $250, so Jerry’s check or bank statement would have sufficed. But as this show revealed, worrying about an IRS audit isn't fun. Trying to prove expenses isn't either. The best advice? Save those receipts so you never have to argue the Cohan Rule.”1 Tax season is here. Go to www.tenfortyplus.com and complete your online organizer (under forms and documents). Make your appointment using our online appointment system. Call 281-397-7777 and get a user id with password set up so you Regards, Joseph C Becker EA www.tenfortyplus.com 281-397-7777, Fax 281-397-7443 joeb@tenfortyplus.com Contact Us There are many events that occur during the year that can affect your tax situation. Preparation of your tax return involves summarizing transactions and events that occurred during the prior year. In most situations, treatment is firmly established at the time the transaction occurs. However, negative tax effects can be avoided by proper planning. Please contact us in advance if you have questions about the tax effects of a transaction or event, including the following: • Pension or IRA distributions. • Retirement. • Significant change in income or • Notice from IRS or other deductions. Revenue department. • Job change. • Divorce or separation. • Marriage. • Self-employment. • Attainment of age 59½ or 70½. • Charitable contributions • Sale/purchase of a business property in excess of $5,000 • Sale or purchase of a residence or other real estate.