Whether one likes it or not, the federal government is their business partner. The tax code is often compared to a partnership agreement that sets out the share of the income that belongs to the federal government. Continuing the analogy, the records the business keeps are the support for making the allocation between the taxpayer and the federal government.
This is where the analogy differs when it comes to the federal government as the partner. With a partnership and allocations between partners, records have to be kept according to accounting standards for the industry, a partner who wishes to challenge the records can do so and can resort to litigation, and the partner challenging the records has the burden to prove that the records are deficient. The courts will usually apply a reasonableness standard in reviewing the records.
When it comes to the federal government as a partner, the federal government does not have to agree with the books and records, it does not have to accept records kept according to accounting standards, it can assert that they are deficient, and it can push the taxpayer into a court process where the burden is on the taxpayer to prove that their records are sufficient. The court will apply the tax law rather than a reasonableness standard.
There are rules that allow for accounting records to be used in tax court litigation. The recent Amundsen v. Commissioner, T.C. Memo. 2023-26, case provides an example of this, and an opportunity to consider how these records can be used.
Facts & Procedural History
The taxpayer was a CPA. His practice was operated from his house in Pennslyvania and he made frequent trips to New York City and New Jersey. Presumably, most of his clients were located in New York City and New Jersey.
On his 2017 return, the taxpayer reported gross receipts that were nearly the same as the amount of his expenses for the business. Both amounts were around $50,000 for the year. The court opinion does not specify whether this was an unusual year for the taxpayer, such as if his practice was in transition or he was having some other issue that impacted his income or expenses for the year.
The taxpayer’s return was pulled for audit by the IRS, the IRS concluded that his records were deficient, and it proposed assessments. Presumably, the case was forwarded to the IRS Office of Appeals and not settled in appeals, before the case went on to the U.S. Tax Court for the court to decide.
Tax Recordkeeping Rules
We have addressed the recordkeeping rules in numerous articles on this site. Most tax cases are at some level, a dispute over records. Whether it is a truck driver trying to establish expenses or a business trying to document a research tax credit, the concepts are the same.
The recordkeeping rules start with Section 6001 which says that taxpayers have to keep records as the IRS prescribes:
Every person liable for any tax imposed by this title, or for the collection thereof, shall keep such records, render such statements, make such returns, and comply with such rules and regulations as the Secretary may from time to time prescribe.
When it comes to rules and regulations, the IRS has generally not prescribed any. There are some revenue procedures, revenue rulings, and a handful of regulations. There is a plethora of lesser guidance such as publications, forms, and notices, however.
And there are the Section 274 rules that provide higher substantiation requirements for travel, meal, and other various expenses.
Accounting Recordkeeping Rules
The rules above differ from accounting rules. The accounting rules vary widely from jurisdiction to jurisdiction. The accounting rules usually apply an industry-standard analysis. This looks at what is common practice from industry to industry to determine what records should be kept.
Most accounting standards say that receipts and invoices need to be kept. They go on to say that electronic data from receipts and invoices can be accepted as a substitute for the original paper documents, provided that certain conditions are met. The criteria usually involve making sure that there are controls in place to confirm that the electronic data accurately reflects what was in the original paper documents.
This usually entails keeping records according to GAAP or some similar standard. GAAP (“Generally Accepted Accounting Principles”) provides guidelines for recordkeeping for businesses. GAAP generally requires that a business maintain an audit trail for all financial transactions. This concept is found in various standards and rules. For example, ASC 606-10-25-15 discusses the importance of maintaining a detailed audit trail for revenue transactions and providing supporting documentation to verify the accuracy of the recorded amounts. Similarly, the AICPA’s Statement on Auditing Standards No. 99 (SAS 99) requires auditors to obtain sufficient evidence to support the financial statements and assess the risk of material misstatement. This means that the business should be able to provide supporting documentation, such as invoices and receipts, for all recorded transactions if the electronic data is questioned.
Reconciling Accounting Records & the Tax Return
In the present case, the court describes the taxpayer’s records as follows:
a profit and loss statement, a revenue and expenses statement, a depreciation schedule, a 2017 accounting fee list, a general ledger comprising numerous entries for both personal and purported business expenditures, and a tax diary where petitioner logged his business travels. Petitioner also produced a canceled check relating to the refinancing of his home and personal USAA bank statements that reflect the names of various vendors and the outflow of funds.
One might think that these would be the standard records that an accountant would keep. After all, they are in the business of compiling and keeping records by generating these reports.
The court was not satisfied with these records. It noted that the taxpayer “did not provide any receipts corresponding to the expenses listed in his documents or details of the purchases listed on his bank statements.” It went on to say that:
Petitioner also introduced numerous documents he prepared, including a voluminous general ledger. While the general ledger does have headings (e.g., date, name, category, etc.) under which the expenses are cataloged, it, and the other documents in the record, provide little to no clarity as to the expenses themselves.
The court concluded that these records were insufficient as the court was not going to “undertake the work of sorting through every piece of evidence that the petitioner has provided in an attempt to find support for his reported expenses.” In accounting terms, it sounds like the court was hoping for a reconciliation from the general ledger to the tax return.
Accounting Records as Evidence
Federal Rule of Evidence 1006 addresses this:
The proponent may use a summary, chart, or calculation to prove the content of voluminous writings, recordings, or photographs that cannot be conveniently examined in court. The proponent must make the originals or duplicates available for examination or copying, or both, by other parties at a reasonable time and place. And the court may order the proponent to produce them in court.
This rule allows the proponent to use the records, but, absent more, cannot admit the records into evidence as stand-alone evidence.
While this rule would seem to allow the use of summaries, it should be noted that IRS Counsel typically objects to this type of this evidence and the court often refuses to consider it as admissible evidence. For example, in Kohout v. Commissioner, No. 11958-17 (U.S.T.C. 2022), the court concluded that summaries of bank statements could not be admitted into evidence as each exhibit provided a summary of bank statements that were under 60 pages in length. The court struck the summaries from the record.
In the present case, it is not clear from the records, but it would seem that $50,000 of expenses would be more than 60 pages in length. It would also seem that the court could have ordered the parties to produce a reconciliation to aid the court if this was needed. The court did not do this, likely because, as noted in a footnote in the court opinion, the expenses appeared to include some personal expenses. What the court was actually saying is that it would not go through the categories in the general ledger and determine which expenses were business expenses and which were personal expenses. With that said, the court did do this analysis for some of the checks. The court identified three checks that it found to be for deductible expenses, and it allowed those expenses.
The lesson from this case is that parties to litigation in the tax court have to provide a reconciliation for the court. The reconciliation should compare the accounting summaries to the tax return line items. One should expect to have to spend quite some time putting together records and exhibits for this reconciliation for trial. The reconciliation should be offered to the court and, if it refuses to admit the reconciliation into evidence, it may at least use the reconciliation to work through the evidence that is presented. Also, small business taxpayers who do not have underlying receipts and invoices should also take steps to ensure that the reconciliation excludes or segregates any seemingly personal expenses so that they can be easily identified and explained separately. This may help avoid the outcome in the present case.