Recent Decision Highlights the Importance of Record Keeping for the Self-Employed

written on behalf of Feigenbaum Law

When going into business for oneself, it makes good business sense to do whatever you can to reduce your tax liabilities. After all, the less money that goes into paying taxes, the more money is available to stay within a business or be distributed to shareholders. A recent decision from the United States Tax Court, Aaron J. Sonntag et al. v. Commissioner, shows just how important it is for business owners to work with tax professionals to ensure they are in compliance with tax laws while also taking advantage of all legal ways to minimize tax. The decision we discuss today deals with a married couple who worked as producers and musicians. They included a long list of business expenses in their 2017 tax return. These expenses totalled $47,385 and led to a business loss of $28,835. The case serves as a great example of what types of expenses might go unrecognized by the IRS while also highlighting the importance of proper record keeping.

Self-employed couple submits a large volume of expenses

The parties submitted their taxes jointly, and both parties were self-employed. The husband was a musician, while the wife operated a recording studio out of their home. Some of the expenses were in relation to the husband’s travel, while some were tied to the home business. The court grouped their expenses into three categories. The first was travel, the second was meals and entertainment, while the third was “other expenses.”

Travel expenses

The husband travelled often throughout 2017. The parties’ tax return included $11,713 in travel-related expenses. Most of the expenses in this group were for the cost of five flights. The parties did not submit actual receipts for any of the flights, though they did include credit card statements containing information on two of the flights.

The court pointed out that there are stringent substantiation requirements that must be met for a taxpayer to deduct travel expenses. The Tax Code states that in addition to receipts or “sufficient evidence” to show the cost of travel, the taxpayer must also provide “adequate records” that would generally include an account book, a diary or log, a statement of expenses, and other evidence to show that travel expenses are tracked in detail. While a taxpayer may be able to provide evidence after the fact if they didn’t maintain proper records in the first place, the taxpayers in this case failed to do so. Instead, they provided spreadsheet information that could not be verified by the court. The IRS conceded some of the travel expenses, those that were not conceded were denied by the court.

The meals and entertainment expenses were for the most part allowed by the IRS, with the exception of a trip to a nail salon, which the husband said he had visited along with business partners as a “thank you” outing. The court disallowed this expense since he could not demonstrate he had visited the spa with anyone. An itemized receipt would have helped here.

Personal expenses

There were several expenses submitted that were later considered to be personal in nature. In some cases, the taxpayers had receipts for these, but in other cases, they did not. We’ll take a moment to review some of the more notable expenses in this category.

The parties submitted $849 in expenses related to credit card interest and annual fees. The husband testified that the accounts associated with the fees and interest were used solely for business, but under cross-examination admitted that there were multiple personal transactions. With no evidence presented by the taxpayers to show these were business-related expenses, the entire amount was disallowed.

There was a total of $1,821 which the taxpayers submitted in relation to stage costumes worn by the husband when performing. The court pointed out that generally speaking, wardrobe expenses are considered non-deductible since business clothing is usually suitable for general wear. Exceptions may be made when clothing is used only in the business environment in which the taxpayer worked. In this case, the husband conceded that the wardrobes he wears on stage are similar to everyday clothing that someone might wear. These expenses were disallowed.

Another group of expenses most people incur was classified as “research” expenses by the taxpayers. These included the costs of concert admission fees, and a portion of their cable tv bill, Apple Music and Spotify subscriptions, and a Netflix subscription. The law doesn’t address internet subscriptions specifically, but case law has held that newspaper subscriptions must be considered personal, and these expenses are similar enough in nature to warrant the same finding. This stands in opposition to something like a trade magazine, which could be deducted.

There were $1,293 in “studio supplies” claimed by the taxpayers, who said that it was important for them to keep entertainment items in the studio for visiting musicians to use, such as a dartboard. However, in keeping in line with the pattern that has emerged, the taxpayers failed to produce itemized receipts for these studio expenses, leading the court to disallow them.

Work with the experienced professionals at Feigenbaum Law to ensure compliance with tax legislation

The taxpayers at the center of the case discussed in today’s blog are not unlike many other people who run afoul of tax authorities who try to be honest in their tax returns but might not have the day-to-day organizational practices to ensure they meet their legal obligations. That’s why it is extremely important to work with an experienced tax professional to proactively set a business up for strategic tax planning and compliance. The tax law team at Feigenbaum Law, led by Mark Feigenbaum, has extensive experience working with businesses to reduce their tax burden while shielding clients from liabilities and tax pitfalls. We are uniquely positioned to help clients in both the United States and Canada, particularly those who do business on both sides of the border. Please reach us online or call us at 1-877-275-4792 to see how we can help you today.