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Meals, entertainment, travel expenses, and expenses relating to listed property under IRC Sec 280F, fall within a special provision of the law that requires additional documentation to deduct the expenses on your tax return. Audits conducted by the IRS routinely result in large tax assessments relating to the deduction of these expenses on tax returns by self employed individuals and small business owners. Additionally, these assessments often involve substantial penalties relating to negligence and substantial understatements of income. Consequently, the business owner may end up owing twice as much as the regular tax liability, primarily due to ignorance or disregard of these substantiation requirements. Due to this hazard, it is imperative that all small business owners educate themselves as to what is expected of them, relating to the record retention requirements.
IRC Section 162 states that there shall be allowed as a deduction against income, all the ordinary and necessary expenses paid or incurred during the taxable year in carrying out a trade or business.
IRC Section 6001 States that every person liable for tax under the regulations shall keep such records, render such statements, make such returns, and comply with such rules and regulations as the secretary may prescribe. and the Secretary may require any such person ...to keep such records as the Secretary deems sufficient to show whether or not such person is liable for tax under title 26
IRC Sec 274(d) Substantiation required. No deduction or credit shall be allowed--
(1) under section 162 or 212 [IRC Sec. 162 or 212] for any traveling expense (including meals and lodging while away from home),
(2) for any item with respect to an activity which is of a type generally considered to constitute entertainment, amusement, or recreation, or with respect to a facility used in connection with such an activity,
(3) for any expense for gifts, or
(4) with respect to any listed property (as defined in section 280F(d)(4) [IRC Sec. 280(d)(4)]),
unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating the taxpayer's own statement
(A) the amount of such expense or other item,
(B) the time and place of the travel, entertainment, amusement, recreation, or use of the facility or property, or the date and description of the gift, (C) the business purpose of the expense or other item, and
(D) the business relationship to the taxpayer of persons entertained, using the facility or property, or receiving the gift. The Secretary may by regulations provide that some or all of the requirements of the preceding sentence shall not apply in the case of an expense which does not exceed an amount prescribed pursuant to such regulations. This subsection shall not apply to any qualified non personal use vehicle (as defined in subsection (i)).
IRC Reg 1.274-5T Substantiation requirements (temporary).
(a) In general. For taxable years beginning on or after January 1, 1986, no deduction or credit shall be allowed with respect to --
(1) Traveling away from home (including meals and lodging),
(2) Any activity which is of a type generally considered to constitute entertainment, amusement, or recreation, or with respect to a facility used in connection with such an activity, including the items specified in section 274(e) [26 USCS § 274(e)],
(3) Gifts defined in section 274(b) [26 USCS § 274(b)], or
(4) Any listed property (as defined in section 280F(d)(4) [26 USCS § 280F(d)(4)] and § 1.280F-6T(b)),
unless the taxpayer substantiates each element of the expenditure or use (as described in paragraph (b) of this section) in the manner provided in paragraph (c) of this section. This limitation supersedes the doctrine found in Cohan v. Commissioner, 39 F. 2d 540 (2d Cir. 1930). The decision held that, where the evidence indicated a taxpayer incurred deductible travel or entertainment expenses but the exact amount could not be determined, the court should make a close approximation and not disallow the deduction entirely. Section 274(d) [26 USCS § 274(d)] contemplates that no deduction or credit shall be allowed a taxpayer on the basis of such approximations or unsupported testimony of the taxpayer. For purposes of this section, the term "entertainment" means entertainment, amusement, or recreation, and use of a facility therefore; and the term "expenditure" includes expenses and items (including items such as losses and depreciation).
(b) Elements of an expenditure or use --
(1) In general. Section 274(d) [26 USCS § 274(d)] and this section contemplate that no deduction or credit shall be allowed for travel, entertainment, a gift, or with respect to listed property unless the taxpayer substantiates the requisite elements of each expenditure or use as set forth in this paragraph (b).
(2) Travel away from home. The elements to be provided with respect to an expenditure for travel away from home are --
(i) Amount. Amount of each separate expenditure for traveling away from home, such as cost of transportation or lodging, except that the daily cost of the traveler's own breakfast, lunch, and dinner and of expenditures incidental to such travel may be aggregated, if set forth in reasonable categories, such as for meals, for gasoline and oil, and for taxi fares;
(ii) Time. Dates of departure and return for each trip away from home, and number of days away from home spent on business;
(iii) Place. Destinations or locality of travel, described by name of city or town or other similar designation; and
(iv) Business purpose. Business reason for travel or nature of the business benefit derived or expected to be derived as a result of travel.
(3) Entertainment in general. The elements to be proved with respect to an expenditure for entertainment are --
(i) Amount. Amount of each separate expenditure for entertainment, except that such incidental items as taxi fares or telephone calls may be aggregated on a daily basis;
(ii) Time. Date of entertainment;
(iii) Place. Name, if any, address or location, and destination of type of entertainment, such as dinner or theater, if such information is not apparent from the designation of the place;
(iv) Business purpose. Business reason for the entertainment or nature of business benefit derived or expected to be derived as a result of the entertainment and, except in the case of business meals described in section 274(e)(1) [26 USCS § 274(e)(1)], the nature of any business discussion or activity;
(v) Business relationship. Occupation or other information relating to the person or persons entertained, including name, title, or other designation, sufficient to establish business relationship to the taxpayer.
(4) Entertainment directly preceding or following a substantial and bona fide business discussion. If a taxpayer claims a deduction for entertainment directly preceding or following a substantial and bona fide business discussion on the ground that such entertainment was associated with the active conduct of the taxpayer's trade or business, the elements to be proved with respect to such expenditure, in addition to those enumerated in paragraph (b)(3) (i), (ii), (iii), and (v) of this section are --
(i) Time. Date and duration of business discussion;
(ii) Place. Place of business discussion;
(iii) Business purpose. Nature of business discussion, and business reason for the entertainment or nature of business benefit derived or expected to be derived as the result of the entertainment.
(iv) Business relationship. Identification of those persons entertained who participated in the business discussion.
(5) Gifts. The elements to be proved with respect to an expenditure for a gift are --
(i) Amount. Cost of the gift to the taxpayer;
(ii) Time. Date of the gift;
(iii) Description. Description of the gift;
(iv) Business purpose. Business reason for the gift or nature of business benefit derived or expected to be derived as a result of the gift; and
(v) Business relationship. Occupation or other information relating to the recipient of the gift, including name, title, or other designation, sufficient to establish business relationship to the taxpayer.
(6) Listed property. The elements to be proved with respect to any listed property are --
(i) Amount -- (A) Expenditures. The amount of each separate expenditure with respect to an item of listed property, such as the cost of acquisition, the cost of capital improvements, lease payments, the cost of maintenance and repairs, or other expenditures, and
(B) Uses. The amount of each business/investment use (as defined in § 1.280F-6T (d)(3) and (e)), based on the appropriate measure (i.e., mileage for automobiles and other means of transportation and time for other listed property, unless the Commissioner approves an alternative method), and the total use of the listed property for the taxable period.
(ii) Time. Date of the expenditure or use with respect to listed property, and
(iii) Business or investment purpose. The business purpose for an expenditure or use with respect to any listed property (see § 1.274-5T(c)(6)(i) (B) and (C) for special rules for the aggregation of expenditures and business use and § 1.280F-6T(d)(2) for the distinction between qualified business use and business/investment use).
See also § 1.274-5T(e) relating to the substantiation of business use of employer-provided listed property and § 1.274-6T for special rules for substantiating the business/investment use of certain types of listed property.
(c) Rules of substantiation --
(1) In general. Except as otherwise provided in this section and § 1.274-6T, a taxpayer must substantiate each element of an expenditure or use (described in paragraph (b) of this section) by adequate records or by sufficient evidence corroborating his own statement. Section 274(d) [26 USCS § 274(d)] contemplates that a taxpayer will maintain and produce such substantiation as will constitute proof of each expenditure or use referred to in section 274 [26 USCS § 274]. Written evidence has considerably more probative value than oral evidence alone. In addition, the probative value of written evidence is greater the closer in time it relates to the expenditure or use. A contemporaneous log is not required, but a record of the elements of an expenditure or of a business use of listed property made at or near the time of the expenditure or use, supported by sufficient documentary evidence, has a high degree of credibility not present with respect to a statement prepared subsequent thereto when generally there is a lack of accurate recall. Thus, the corroborative evidence required to support a statement not make at or near the time of the expenditure or use must have a high degree of probative value to elevate such statement and evidence to the level of credibility reflected by a record made at or near the time of the expenditure or use supported by sufficient documentary evidence. The substantiation requirements of section 274(d) [26 USCS § 274(d)] are designed to encourage taxpayers to maintain the records, together with documentary evidence, as provided in paragraph (c)(2) of this section.
(2) Substantiation by adequate records --
(i) In general. To meet the "adequate records" requirements of section 274(d) [26 USCS § 274(d)], a taxpayer shall maintain an account book, diary, log, statement of expense, trip sheets, or similar record (as provided in paragraph (c)(2)(ii) of this section), and documentary evidence (as provided in paragraph (c)(2)(iii) of this section) which, in combination, are sufficient to establish each element of an expenditure or use specified in paragraph (b) of this section. It is not necessary to record information in an account book, diary, log, statement of expense, trip sheet, or similar record which duplicates information reflected on a receipt so long as the account book, etc. and receipt complement each other in an orderly manner.
(ii) Account book, diary, etc. An account book, diary, log, statement of expense, trip sheet, or similar record must be prepared or maintained in such manner that each recording of an element of an expenditure or use is made at or near the time of the expenditure or use.
(A) Made at or near the time of the expenditure or use. For purposes of this section, the phrase "made at or near the time of the expenditure or use" means the element of an expenditure or use are recorded at a time when, in relation to the use or making of an expenditure, the taxpayer has full present knowledge of each element of the expenditure or use, such as the amount, time, place, and business purpose of the expenditure and business relationship. An expense account statement which is a transcription of an account book, diary, log, or similar record prepared or maintained in accordance with the provisions of this paragraph (c)(2)(ii) shall be considered a record prepared or maintained in the manner prescribed in the preceding sentence if such expense account statement is submitted by an employee to his employer or by an independent contractor to his client or customer in the regular course of good business practice. For example, a log maintained on a weekly basis, which accounts for use during the week, shall be considered a record made at or near the time of such use.
(B) Substantiation of business purpose. In order to constitute an adequate record of business purpose within the meaning of section 274(d) [26 USCS § 274(d)] and this paragraph (c)(2), a written statement of business purpose generally is required. However, the degree of substantiation necessary to establish business purpose will vary depending upon the facts and circumstances of each case. Where the business purpose is evident from the surrounding facts and circumstances, a written explanation of such business purpose will not be required. For example, in the case of a salesman calling on customers on an established sales route, a written explanation of the business purpose of such travel ordinarily will not be required. Similarly, in the case of a business meal described in section 274(e)(1) [26 USCS § 274(e)(1)], if the business purpose of such meal is evident from the business relationship to the taxpayer of the persons entertained and other surrounding circumstances, a written explanation of such business purpose will not be required.
(C) Substantiation of business use of listed property --
(1) Degree of substantiation. In order to constitute an adequate record (within the meaning of section 274(d) [26 USCS § 274(d)] and this paragraph (c)(2)(ii)), which substantiates business/investment use of listed property (as defined in § 1.280F-6T(d)(3)), the record must contain sufficient information as to each element of every business/investment use. However, the level of detail required in an adequate record to substantiate business/investment use may vary depending upon the facts and circumstances. For example, a taxpayer who uses a truck for both business and personal purposes and whose only business use of a truck is to make deliveries to customers on an established route may satisfy the adequate record requirement by recording the total number miles driven during the taxable year, the length of the delivery route once, and the date of each trip at or near the time of the trips. Alternatively, the taxpayer may establish the date of each trip with a receipt, record of delivery, or other documentary evidence.
(2) Written record. Generally, an adequate record must be written. However, a record of the business use of listed property, such as a computer or automobile, prepared in a computer memory device with the aid of a logging program will constitute an adequate record.
(D) Confidential information. If any information relating to the elements of an expenditure or use, such as place, business purpose, or business relationship, is of a confidential nature, such information need not be set forth in the account book, diary, log, statement of expense, trip sheet, or similar record, provided such information is recorded at or near the time of the expenditure or use and is elsewhere available to the district director to substantiate such element of the expenditure or use.
(iii) [Reserved]. For further guidance, see § 1.274-5(c)(2)(iii).
(iv) Retention of written evidence. The Commissioner may, in his discretion, prescribe rules under which an employer may dispose of the adequate records and documentary evidence submitted to him by employees who are required to, and do, make an adequate accounting to the employer (within the meaning of paragraph (f)(4) of this section) if the employer maintains adequate accounting procedures with respect to such employees (within the meaning of paragraph (f)(5) of this section.
(v) Substantial compliance. If a taxpayer has not fully substantiated a particular element of an expenditure or use, but the taxpayer establishes to the satisfaction of the district director that he has substantially complied with the "adequate records" requirements of this paragraph (c)(2) with respect to the expenditure or use, the taxpayer may be permitted to establish such element by evidence which the district director shall deem adequate.
(3) Substantiation by other sufficient evidence --
(i) In general. If a taxpayer fails to establish to the satisfaction of the district director that he has substantially complied with the "adequate records" requirements of paragraph (c)(2) of this section with respect to an element of an expenditure or use, then, except as otherwise provided in this paragraph, the taxpayer must establish such element --
(A) By his own statement, whether written or oral, containing specific information in detail as to such element; and
(B) By other corrobative evidence sufficient to establish such element.
If such element is the description of a gift, or the cost or amount, time, place, or date of an expenditure or use, the corrobative evidence shall be direct evidence, such as a statement in writing or the oral testimony of persons entertained or other witnesses setting forth detailed information about such element, or the documentary evidence described in paragraph (c)(2) of this section. If such element is either the business relationship to the taxpayer of persons entertained, or the business purpose of an expenditure, the corrobative evidence may be circumstantial evidence.
(ii) Sampling --
(A) In general. Except as provided in paragraph (c)(3)(ii)(B) of this section, a taxpayer may maintain an adequate record for portions of a taxable year and use that record to substantiate the business/investment use of listed property for all or a portion of the taxable year if the taxpayer can demonstrate by other evidence that the periods for which an adequate record is maintained are representative of the use for the taxable year or a portion thereof.
(B) Exception for pooled vehicles. The sampling method of paragraph (c)(3)(ii)(A) of this section may not be used to substantiate the business/investment use of an automobile or other vehicle of an employer that is made available for use by more than one employee for all or a portion of a taxable year.