In Heinbockel v. Commissioner, T.C. Memo. 2013-125, the U.S. Tax Court considered a routine substantiation case and disallowed business expense deductions for a fashion clothing retailer. This case presents an opportunity to consider how to present routine substantiation cases to the IRS and to the courts.
Facts & Procedural History
Mrs. Heinbockel was in the fashion industry. She was an accomplished model from her late teens to her late twenties.
She started in business as an LA sales rep for Pierre Fabre, a French pharmaceutical company with a cosmetics line.
In 1997-1998, she got married and bought a home in San Luis Obispo.
Mrs. Heinbockel was well aware that her new home was far away from the big cities that she enjoyed, but she sensed an opportunity in the dearth of quality clothing that she saw there.
Mrs. Heinbockel created Lydia’s World (also known as Lydia’s Personal Shopping Services) offering designer lines with a personal touch to “very upscale women.” She would buy (or obtain on consignment) clothes from about a dozen internationally known designers, and bring those collections to trunk shows that she advertised in email invites.
She had no storefront, but started with three trunk shows a year that lasted a week or two each (spring, fall, and holiday), and soon the business expanded into an “all-year-round, all-the-time business” where she would hold trunk shows at various times throughout the year in many of her clients’ homes.
During any given in-home show, Mrs. Heinbockel would spend a few hours with “two or three girlfriends” personally outfitting them, while treating them to champagne and appetizers.
Mrs. Heinbockel ability to market her brands to a loyal customer base brought in gross sales of between $65,000 and $135,000 during 2005 through 2007.
The business expense deductions for Lyndia’s World were at issue in the case. The court described the issue as follows: “The disputes over some of the expenses are nothing more than routine substantiation.” The court went on to disallow the taxpayer’s business deductions.
The IRS proposes adjustments in tens of thousands of audits just like this one. The U.S. Tax Court has considered hundreds, if not thousands, of cases just like this one. Many of the cases with this issue are not decided in the taxpayer’s favor.
The raises the question as to how “routine substantiation” issues can be presented persuasively, with the aim of being one of the few cases in which the deductions are allowed on audit or in court. This article provides a few pointers.
Focus on presenting the case in a different or novel way
From the IRS audit and the court’s perspective, generally, much of the work of the government is this type of repetitive ho-hum work that just has to be done. Routine substantiation tax cases fall into this category.
To make the case interesting or at least more challenging for the government to dispose of unfavorably on audit or in court, the issue should be presented as different or novel. There are a number of ways to do this.
For example, you may be able to find recent court case opinions (preferably from the same court and judge) that have less favorable or pro-government facts. The less favorable or pro-government position the better. Then you can use those cases as the basis for arguing that your records, facts, etc. are better than the other cases and, as such, your deductions should be allowed.
Another example would be finding a way to categorize or describe the expense that is different while still being a correct description. For example, a dress that is purchased and worn for work but could also be worn outside of work, might be described as a uniform, a prototype, inventory, etc. Thus, the argument for this uniform, prototype, inventory, etc. was sufficiently different than the dresses in the other cases in which the court had previously disallowed the expense deductions.
Focus on presenting the records
With substantiation cases, it is important to focus on the records and what was known at the time the expense was incurred and what the records actually say.
This is particularly important when presenting testimonial evidence where the records are incomplete. The focus should be on what was known at the time. The testimonial evidence should be corroborated by records.
It should not be presented the other way around–i.e, that you found some record that is not entirely sufficient (as it is incomplete in some way) and it jogs your memory. This presentation is not as strong. It raises doubts as to whether the records are sufficient and whether your memory is correct.
When presenting documentary evidence, the details matter. Pointing out that dates, transaction codes that have some meaning (even if they are cryptic and require explanation), or the order or completeness of the records helps. These details are often overlooked or forgotten if not pointed out. This also entails finding and submitting the best records possible.
For example, a monthly credit card statement is different than the online version of the same record from the credit card company website that auto categorizes expenses, as these categories add a contemporaneous description in the record. This detailed credit card records with descriptions can be categorized as being more than merely presenting a monthly credit card statement. They are detailed credit card records with contemporaneous descriptions. Similarly, a single monthly bank statement is not just a bank statement when it is presented for every month in the tax year–it is a complete set of bank records.
These facts and descriptions should be pointed out every time the records are described–even though repeating this may be awkward or seem forced.