ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – THE OLD RULES ARE ALIVE AND WELL WHEN IT COMES TO DEDUCTING BUSINESS-RELATED EXPENSES
By Robert S. Schriebman
There has been a continuous controversy between taxpayers, the IRS and the FTB that has been going on non-stop since 1954 and even back as far as 1930! When it comes to the deductibility of business-related expenses, the IRS, FTB, and the courts have been wrestling with the basic laws since 1954. And those old 1954 tax statutes have also been influenced by the federal courts since the 1930s. There have been many changes in the Internal Revenue Code since 1954. In fact, the new Code is known as the 1986 Code. All these revisions are enough to make you dizzy. I don’t think there is a living soul who knows all these tax laws. However, when it comes to what it takes to pass muster, and get your deductions accepted, you have to go back to the basic rules set forth in the 1954 code.
These basic rules, enacted in 1954, govern how the FTB allows or disallows business-related expenses that are either set forth on Schedule C of Form 1040, or deducted as non-reimbursed employee business expenses, or the deductions taken by both corporations and LLCs. These old rules also impact the questions of deductibility decided by the Office of Tax Appeals (OTA)
On February 6, 2020, the OTA decided the Appeal of Gladis Morales-Collins, in this article I will review her case and set forth the modern version of these old, but still valid rules. OTA Case No. 19054756, February 6, 2020.
The Case of Gladis Morales-Colins (Gladis)
First Let’s Look at the Facts
Gladis and her husband, whose name was never mentioned, timely filed their 2012 personal income tax return with the FTB. They claimed deductions for unreimbursed employee business expenses per Schedule A. The list of expenses was extensive and the deductions quite large. Gladis listed her occupation as a “legal document preparer” for a small law office. Her husband worked for Verizon and also claimed unreimbursed employee business expenses on Schedule A.
The FTB disallowed all claimed deductions because the couple failed to provide substantiation for the expenses when requested by the FTB. A Notice of Proposed Assessment (NPA) was issued by the FTB. Gladis and her husband timely filed a Protest. They were given an informal hearing.
Gladis and her husband realized that they should not have filed a Schedule A because they each had outside independent businesses. During the informal hearing, the couple filed two Schedule Cs by amending their personal income tax return and filing an amended return Form 540X.
On her Schedule C, Gladis stated that she was a consultant, legal document preparer, and a paralegal. She listed her business expenses as follows:
• Car and truck expenses
• Office expenses
• Training expenses
• Business attire and upkeep.
On his Schedule C, Gladis’ husband stated that he was a telephone technician providing internet and telephone connecting services. He listed his business expenses as follows:
• Car and truck expenses
• Training expenses
He also provided a letter from his supervisor at Verizon stating that he was required to purchase and maintain his uniform, as well as, an option to purchase his own safety gear, tools, and supplies.
The OTA’s Decision
Deducting Schedule C Expenses
This matter involves the deductibility of business-related expenses that are allowed pursuant to IRC § § 162 and 274. These federal code sections have been incorporated into R&TC §§ 17071 and 17201. These sections, generally speaking, allow deductions for ordinary, necessary, and reasonable expenses paid and incurred during the taxable year to carry on any trade or business. (Roberts v. Commissioner, T.C. Memo. 2012-197.) In contrast, personal living expenses are not deductible. For example: we all must wear clothes when we go to work. But the cost of this clothing is not deductible unless your clothing is unique to your job, such as a uniform. You must meet specific substantiation requirements to be allowed a deduction for business-related expenses.
If you wish to deduct business-related entertainment expenses, under IRC § 274, you must also provide adequate records for such things as travel expenses, including meals and lodging away from home, and expenses relating to the nature of entertainment, amusement, or recreation.
These rules and issues go all the way back to 1930 when a case called Cohan allowed the courts the discretion to estimate expenses when the taxpayer is unable to fully substantiate them. This rule, named after the famous Broadway composer, George M. Cohan, can be summarized as follows: If a taxpayer establishes that he or she paid or incurred a deductible business expense but does not establish the amount, a court may approximate the amount of the allowable deduction – but courts are instructed to be tough. Cohan v. Commissioner (2d Cir. 1930) 39 F.2d 540.
Deducting Unreimbursed Employee Business Expenses
If you are a W2 wage earner, and you have unreimbursed employee business expenses, you cannot use Schedule C; you must use Schedule A. However, Schedule A deductions are subject to various limitations. Deductions are only allowed if the employer has a policy of not reimbursing the employee. There is also a limit to the amount of deductions based upon adjusted gross income. For general guidelines see Richards v. Commissioner T.C. Memo 2014-88.
Neither Gladis nor her husband offered any documentary evidence establishing any of their deductions. They simply stood before the OTA and stated what was on the tax return. This is a common error people make when trying to convince any taxing agency that they have allowable business-related deductions. Paper proof is still the king! You must produce copies of bills and invoices. If you are self-employed you should have a business license. If you are using part of your home for business, take pictures of the area devoted to your work.
Is It OK to Reconstruct or Reproduce Business Records?
One of the most common errors people make, is the failure to keep contemporaneous logs of mileage and business-related entertainment expenses. These logs, journals, etc., can legally be reproduced from memory during an audit or hearing, but they must be labeled “reproduction” or “reconstruction.” Never pass off a second-hand accounting as the original journal or diary by attempting to back-date anything. Back-dating can get you into serious trouble. Auditors, judges, and hearing officers are willing to entertain and even accept reconstructed records so long as they are clearly labeled as such.
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 40 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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