By Robert S. Schriebman
This is Part 2 of a 2 Part series. Are QuickBooks records, standing alone, sufficient to prove deductible business expenses? In the Kouza case, the US District Court, E.D. Michigan, held that deductible business expenses cannot be substantiated by QuickBooks alone.
In this Part 2, I will discuss the Court’s position regarding the legal sufficiency of QuickBooks summaries as the equivalent of original source documentation. I will also set forth the Court’s opinion on how long a taxpayer should keep books and records for tax purposes.
The Kouza Case
US District Court, E.D. Michigan, So. Div., 21-12790, Oct. 30, 2023.
Mr. Kouza was quite an entrepreneur. He had many different businesses. His record keeping left much to be desired. He was audited by the IRS for the years 2013 through 2015. In 2017, he submitted to the IRS a claim for refund for the year 2015 on Form 1040X. The refund claim was based on losses from three businesses in the amount of almost $230,000. During an administrative hearing to attempt to resolve the refund claim, Mr. Kouza testified that his business records were lost or probably dumped because he scraped everything. He could not produce original source documentation such as invoices and cancelled checks. He also testified that he had no personal knowledge concerning how the businesses’ profit and loss and payroll information was prepared. The IRS took the position that Kouza had not produced any original source documentation to substantiate claimed businesses expenses and losses. Rather Kouza’s sole documentation supporting his claim for refund consisted of profit and loss statements produced by the accountant for the three businesses in issue and that these statements were generated by QuickBooks, a software product.
Kouza relied on QuickBooks summaries prepared by the tax return preparer for the three businesses that went under.
Why Are QuickBooks Summaries, Standing Alone, Insufficient to Prove Deductible Business Expenses?
Mr. Kouza testified that he had no personal knowledge of how the QuickBooks summaries were created or on what source records they were based. The tax return preparer testified that he too had no knowledge concerning how the QuickBooks summaries were generated. Presumably, the tax return preparer merely used the summaries to prepare tax for the defunct entities.
The taxpayer always bears the burden of proving by a preponderance of evidence that he/she is entitled to business related deductions. An income tax deduction is a matter of legislative grace and the burden of clearly showing the right to any claimed deduction is always on the taxpayer. Taxpayers bear the burden of demonstrating entitlement to claim a deduction for any ordinary business expense under IRC § 162.
Taxpayers are required to keep such permanent books of accounts or records, including inventories, as sufficient to establish what the IRS looks for in a traditional audit. These include the amount of gross income, deductions, credits, or other matters required to be shown by the taxpayer. According to IRS Regulations, taxpayers are required to retain such records “so long as the contents thereof may become material in the administration of the tax laws.” 26 C.F.R 1.6001-1(e). That is rather vague and not all that helpful.
Mr. Kouza claimed that he provided sufficient substantiation of claimed expenses and losses by producing the QuickBooks summaries prepared by the tax return preparer. To this the Court stated, “… taxpayers are not relieved from the responsibility of retaining the hard copy records from which the computer records were derived, i.e., bills, invoices, etc., received in the ordinary course of business…A taxpayer proves payment of an amount by producing a cancelled check.”
What about Quicken compared to QuickBooks? Are the rules different? Quicken computer records standing alone will not validate claimed business expenses. Rev. Proc. 98-25, 1998 -11 IRB 7 (Mar.16,1998).
A taxpayer should also keep any other documents that are helpful to prove allowable tax deductions such as receipts, sales slips, charged slips, check registers, and images of cancelled checks. Mr. Kouza offered none of this documentation to prove his entitlement to claimed expenses and losses.
Finally, Mr. Kouza argued that the QuickBooks summaries have been used for decades without issue. The Court found this argument unpersuasive. An accountant’s reliance on computer summaries to prepare tax returns is not commensurate with the type of documentary evidence needed to legally substantiate business deductions.
How Long Must You Keep Your Records for Tax Purposes
If you go to the IRS website, you will be told that records should be kept for 3 years. This rule of thumb works well for most small taxpayers. For high income taxpayers, the 3-year rule is not the total answer. If upon an audit, the auditor finds that the taxpayer underreported 25% or more of gross income, the IRS has a right to conduct a 6-year examination. IRC § 6501(e). My standard recommendation is that every taxpayer should keep records for at least 6 prior years plus the current year. See IRS Publication 583, Starting a Business and Keeping Records. This Publication is available at www.irs.gov/pub583.
Mr. Kouza argued that the Court should accept QuickBooks summaries instead of invoices and cancelled checks because the original source documentation was either lost or destroyed when the several businesses went under. There was no objective disaster such as fire, flood or landslide. Unless these tragedies are highly documented and publicly acknowledged, a taxpayer’s word standing alone has little favorable impact on the IRS and even less on the FTB. Keep your records safe and try not to tell your accountant or lawyer that someone broke into your Porsche and stole your documents but left your Porsche in place.
Robert Schriebman has a successful practice in the Rolling Hills Estates area of Los Angeles County serving clients throughout California and the United States. He has successfully dedicated more than 50 years to helping individual taxpayers, business owners, CPAs, Enrolled Agents, and tax attorneys navigate the complicated tax systems of the federal and state governments. Mr. Schriebman is in private practice. He is not affiliated in any way with the EDD, and he is not employed by the EDD or any other agency of the State of California.
Robert Schriebman has written the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House in addition to the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
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