Leon and Margaret Daniels owned nine vehicles back in 2005 and 2006 and they used them in connection with their business, A1 Carpet Cleaning, an unincorporated business. A1 Carpet Cleaning, as the name suggests, cleaned carpet and upholstery. The nine vehicles consisted of a 1988 Jeep, a 1986 Cadillac, a 1975 Chevrolet Nova, a 1994 Lincoln Continental, four vans and a 1965 Ford pickup truck.
Are you protecting yourself from an automobile deduction disaster?
Most business owners understand that the Internal Revenue Code allows the deduction of automobile and truck expenses when incurred in connection with business. However the Daniels were audited by the Internal Revenue Service and the IRS disallowed the expenses incurred for use of four of the vehicles used in the business in 2005 and 2006. Apparently the Daniels felt the IRS was wrong so they exercised their right to take the matter to the U.S. Tax Court. They told their story to the U.S. Tax Court, but the Tax Court agreed with the IRS and upheld the disallowance of the deduction and told the Daniels to pay the $30,427 of additional taxes and penalties due the U.S. Treasury because of the IRS adjustment to their income taxes. So what went wrong for the Daniels?
In addition to business use, the Daniels used the Jeep, the Cadillac, the Nova and the Lincoln for some personal use. Their fatal mistake was they did not keep a mileage log to document the business use of the four vehicles nor did they keep receipts for the vehicle expenses.
There is a long standing rule, the Cohan Rule, which states that when a taxpayer establishes that he or she paid or incurred a deductible expense but does not establish the amount of the expense, an estimate of the expense can be used. However, there must be sufficient evidence in the record to permit the IRS or the court that the taxpayer incurred the expense in at least the amount allowed.
The problem with vehicle expenses is that there is a pesky Internal Revenue Code section, Section 274(d), which makes the Cohan Rule inapplicable for certain classes of expenses. Expenses falling under the rules of Section 274(d) have stricter requirements for documentation than other types of expense. The types of expense ruled by Section 274(d) are traveling, entertainment or recreation, gifts and listed property. Listed property includes passenger automobiles.
In the exact words of the Internal Revenue Code’s Section 274(d), “No deduction or credit shall be allowed…unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating the taxpayer’s own statement (A) the amount of such expense or other item, (B) the time and place of the travel, entertainment, amusement, recreation, or use of the facility or property, or the date and description of the gift, (C) the business purpose of the expense or other items, and (D) the business relationship to the taxpayer of persons entertained, using the facility or property, or receiving the gift.”
The Tax Court wrote in their opinion, “Petitioners did not comply with the strict substantiation requirements of section 274(d). They [the Daniels] did not maintain a contemporaneous diary, calendar or mileage log of their business travel and have failed to prove that they otherwise made a record of the alleged business use of each vehicle at or near the time of the use. The did not retain receipts for the expense reported, did not otherwise produce documentary evidence of the expense reported, and did not establish the total business miles driven during the years at issue. Instead, petitioners [the Daniels] offered general and uncorroborated testimony, along with a handwritten summary sheet of expense and an estimate of the business use of each vehicle. Such evidence does not have the high degree of probative value necessary to elevate it to the credibility of a contemporaneous log. Accordingly, we conclude that petitioners have failed to substantiate their claimed vehicle expense deductions under section 274(d)….”
The Potts paraphrase of this code section and the lesson to be learned is that if you want to make sure you can deduct your business expenses for travel, entertainment, gifts and most passenger automobiles, then you had better document in some way the amount, time, place, business purpose and, if applicable, the business relationship of any person you spent money on in order to get your deduction. Documentation usually requires some form of ink and some type of paper or digital equivalent.
The other five vehicles? It doesn’t say, but they either did not fall under the definition of “listed property” and therefore did not have to meet as strict requirements as the four passenger vehicles of which the expenses were disallowed or they had records to substantiate their expenses.
Source: Daniels v Commissioner, U.S. Tax Court, 5828-12S, February 24, 2014, Unpublished, T.C. Summary Opinion 2014-16