Imagine this common scenario – you own a small business and incur a legitimate expense that you pay and have some record of. Years later the IRS audits and disallows the deduction for lack of receipts or other documentation.
The auditor may request bank statements, which you provide, only to be told those are inadequate. You supply your bookkeeping records, but those too are deemed insufficient. Asked for an invoice, you manage to locate and submit one, yet still the deduction is denied on grounds of self-serving evidence.
What other record could there be for the expense? The answer is, in many cases, none. This is the fundamental problem with IRS audits. The IRS audits several years in arrears. The taxpayer’s words and records are often found to be inadequate, and one cannot turn back time to create and keep records for every penny spent. The consequences are real. They can result in significant amounts of taxes being assessed when they should not be, and, worse yet, significant IRS penalties.
The recent Villa v. Commissioner, T.C. Memo. 2023-155, is an example of this after the fact second-guessing involved in post hoc IRS audits. It also provides an example of how taxpayers can try to minimize the damage, namely, using reasonable estimates to prove business expenses.
Facts & Procedural History
The facts in this case are straightforward. The taxpayer operated a small business installing fences. He would get paid, either by the property owner or in other cases by a general contractor. For his direct jobs, he would buy materials and pay his contract workers. The money left over was his profit.
The IRS audited his tax returns and proposed adjustments to his income and reduced the amount of his expenses that were deducted. The dispute probably headed off to the IRS Office of Appeals for settlement. The case did not settle, and the taxpayer filed a petition with the U.S. Tax Court. The amount of the reduction for cost of goods sold and the accuracy penalty were at issue in the case.
The Typical IRS Audit
This case provides a fairly common example of an IRS income tax audit for a small business.
The IRS agent will start by conducting an “income probe” looking for income that is not reported on the tax returns. This often consists of a review of the accounting records coupled with a bank deposit analysis.
It is common for some unreported income to be found for small businesses. Reasons include failing to properly account for income. Even those with in-house bookkeepers miss items. In some cases, they may also not report income as it originated from an illegal activity.
There are also nontaxable items that the IRS identifies as taxable, but are not taxable. This leaves it to the business to show that the items are nontaxable. This can include any number of items that would appear to be income for the business, but they are not. For example, it can include contributions, gifts, loans, transfers, etc.
Having identified income, the focus will typically shift to expenses. The IRS will typically examine some of the larger expenses on the tax return and several of them are often overstated, such as meal, travel, and entertainment expenses.
Taxpayers will also review their deductions and, frequently, find expenses that they failed to deduct. This is also often attributable to subpar accounting. It can also be due to not knowing what expenses are deductible. In many cases it comes down to the judgment of the IRS auditor as to what types of records are acceptable.
IRS Audits & Business Records
This is the framework for most IRS audits: additional income and overstated expenses versus non-taxable income and missed expenses.
The IRS issues a report for its position and the taxpayer reiterates its position in a written protest asking for a review by the IRS Office of Appeals. The outcome in the adminsitrative appeals process is typically something in the middle and results in a settlement at the appeals office level.
The focus of these disputes is on records–and what records the IRS thinks is acceptable. There are no specific guidelines on what records are adequate. Section 6001 of the tax code just requires taxpayers to keep sufficient records to substantiate income and deductions. Taxpayers are left to guess what is adequate based on the nature of their business, the type of income or expense in question, and what records are available for the item.
Given the absence of any hard rules, courts apply the burden of proof to decide these disputes. The general rule is that the burden starts with the IRS but is met when it issues its notice of deficiency. The notice is presumed correct, and the taxpayer has to show that the IRS notice is incorrect. Thus, the burden really starts and ends with the taxpayer as the IRS can include just about anything in its notice and enjoy the benefit of it being correct.
Cohan Rule & Use of Estimates
For business expenses, if the taxpayer provides testimony that seems credible and honest, the courts will often use the Cohan doctrine to resolve the dispute.
When taxpayers have incomplete or no records, the Cohan rule allows the court to estimate deductible expenses. The courts have applied these in a number of different contexts and types of expenses. This ranges from truck driver expenses to research tax credits.
The Cohan rule has two steps. First, the taxpayer must establish that he or she incurred the expense. Second, the court makes a reasonable estimate based on the available evidence. Although the Cohan rule expressly applies to deductible business expenses, courts have adapted it to estimate cost of goods sold as well.
The first element is usually met by making a minimal showing that the business incurred the type of expense. This step is usually not that difficult for taxpayers to meet. The second step is where many taxpayers are lacking. The reason for this is that absent perfect records, there is often no way for the court to make an estimate–at least that is what the court’s put in their opinions. The court will often decline to make estimates based on its hesitancy to hazard a guess.
This is the very same discretion issue that recordkeeping affords the IRS auditor. The tax court, which answers to the executive branch of the government just as the IRS does, has the discretion to say what records are acceptable and what records are not.
The outcome of these disputes varies. For example, concerning business expenses, some courts have found that credit card and bank statements can suffice. Other courts have said that these records are insufficient. As noted above, the outcome in these cases often comes down to the credibility of taxpayers’ testimony at trial and the reasonableness of their positions.
Using Ratios to Make an Estimate
This is where the ratio in the present case comes in. In this case, the IRS agreed to use the taxpayer’s testimony from one sample project to estimate the cost of goods sold. It did so by taking the ratio of income and expense for this one sample job and applying it to the income from the taxpayer’s other jobs.
So the IRS allowed an estimate based on the taxpayer’s records from one sample job, applying the cost-to-income ratio to other jobs. This reasonable method is unfortunately rare as the IRS typically rejects estimates outright. The ratio approach likely originated from the IRS Appeals process, with the IRS attorney simply accepting it for litigation.
Regardless, the challenge for the taxpayer in this situation is choosing a representative project and calculating the ratio of the cost of goods sold to gross receipts in a way that might be acceptable to the IRS. The burden is on the taxpayer given the current audit framework. Here, using the 73% ratio between his $1,750 in materials and labor against $2,400 in gross receipts on one job, was accepted. It is refreshing to see a case where the IRS allowed this type of estimate to reduce litigation costs and the burden on the taxpayer, but this case is not the norm. It is far from it, unfortunately.
It should be noted that taxpayers have occasionally also convinced the IRS to accept third party statistics or data to prove expenses. This data, like ratios, can be a viable way to minimize the adjustments and penalties when records are imperfect.
This case provides an example of the framework for most IRS audits. The auditor proposes to increase income and decrease expenses, as in this case. The ensuing dispute usually involves trying to find an IRS employee or judge who will take a reasonable approach. This will invariably mean that the taxpayer is put in the position of having to ask the government to accept the use of estimates as records will always be inadequate for one reason or another. As this case shows, the burden falls heavily on taxpayers to advocate for expense estimates grounded in factual evidence like verifiable job cost ratios–expecting that even reasonable estimation methods often face resistance with the IRS.