Imagine that you travel to a neighboring state and look at some construction equipment you’re considering buying for three days. Within the next month, you will attend several daily workshops covering industry best practices at a construction industry convention. All the expenses you incurred on both trips can be deducted as business expenses at tax time. Is this correct?
If your deductions are substantiated with receipts, yes. In the absence of receipts, your deductions may be rejected by the IRS. The unwary can easily get into trouble if they fail to document business-related expenses properly. Suppose the IRS rejects one of your business expense deductions. In that case, you will not only be liable for taxes on income resulting from the disallowed expense, but you may also have to pay penalties and interest.
Tax law requires taxpayers to be able to provide proper records or sufficient evidence to prove certain business expenses. Otherwise, they cannot be taken as deductions.
Substantiation: What Is It?
The federal tax law requires that a trade or business expense be substantiated before it can be deducted. To substantiate a business deduction, you must be able to demonstrate the nature of the expense and prove the amount paid.
Within a reasonable period of time after the expense has been paid or incurred, employees must provide evidence of the expense’s amount, time, place, and business purpose.
What Is “a Reasonable Period of Time”?
Two methods are available to determine if substantiation and excess amounts have been returned within a reasonable period of time:
- Fixed-date method: The employee must substantiate the expense within 60 days from the date it was paid or incurred, and the employer must be reimbursed for any excess advance within 120 days after the expense was incurred or paid.
- Periodic statement method: An employer can send the employee a periodic statement listing amounts paid that have not been substantiated, requiring the employee to either substantiate or return the excess amount within 120 days of receiving the statement. Statements must be sent no less than once a quarter.
Employers may offer hybrid plans that combine both methods. The fixed-date method may require substantiation of out-of-pocket expenses and mileage reimbursements. The employer may use the periodic statement method to substantiate company credit card charges.
Employers may also provide an employee with a statement for business expenses that have been submitted for reimbursement, but the employee will not be reimbursed unless proper substantiation is provided.
What Are the Kinds of Business Expenses Covered by the Substantiation Rule?
The substantiation rule covers the following types of expenses:
- Expenses associated with travel and lodging;
- The cost of entertainment;
- Gifts to business associates; and
- Automobile, computer, and cell phone expenses.
Since these types of expenses are susceptible to abuse, they are required to be substantiated.
What Do I Need to Substantiate?
Taxpayers must provide evidence of four things:
- How much the expense was;
- When and where the expense occurred;
- What the expense is for; and
- You and the person who received your gift have a business relationship.
Is There Any Evidence I Need to Keep?
An employee should keep a written expense record before submitting it for reimbursement.
Records of expenses don’t need to be in a particular format, but they should be kept in a way that allows the employee to keep a detailed record of the amount, date, place, and purpose of the expense. Employees must also be able to document business meals taken at their tax home and meals provided for others when they are away from their tax home via the format used.
Employees must record the following information in their records to substantiate these expenses:
- Attendees’ names
- The meeting’s business purpose
- Date and location of the business meeting
Documentary evidence is the best acceptable evidence of an employee’s expenses. Examples include receipts, canceled checks, and bills. The document must, however, provide the amount, date, place, and essential character of the expense to be deemed acceptable.
The IRS typically requires documentary evidence for travel expenses only if the expense exceeds $75. Lodging expenses, however, are an exception. Because lodging bills may include other fees in addition to room charges (such as meals, telephone calls, laundry, Internet access, and video rentals), the hotel or motel must provide an itemized bill. Rentals of videotapes or other personal expenses should not be reimbursed.
An employee should keep a written record of all expenses before submitting them for reimbursement. Expense records provide detailed proof of an employee’s expenses.
Account books and expense diaries are generally acceptable types of records. For expenses over $75, receipts and paid bills are usually required as proof.
A written document is preferable to an oral confirmation, and contemporaneous records are better than those not prepared at or near the time of the expense.
What Are Per Diem Rates?
If you use per diem rates to determine reimbursement amounts, you can simplify your bookkeeping and have more control over expenses. Travel expenses include lodging, meals, and incidentals. Travel expenses are paid to employees as per diem. Instead of paying their actual travel expenses, they receive this allowance.
The federal per diem rate covers the cost of lodging and meals together, as well as the cost of meals alone. The per diem rates also differ for different parts of the country due to the varying cost of living between states and cities. When your business uses per diem rates that are less than or equal to the federal rates, the IRS won’t require you to substantiate your expenses. The time, location, and business purpose of employees’ trips will still need to be substantiated.
Imagine you travel to a neighboring state and look at some office equipment you’re considering buying. The following month, you attend an industry convention where you attend daily workshops on industry best practices.
Both trips can be deducted as business expenses at tax-time if you have receipts that substantiate your deductions. If not, the IRS may reject your deductions.
Is There An Exception to the Substantiation Rule?
Yes. A taxpayer may use other reasonable means to substantiate expenses if they can show they were lost due to circumstances beyond their control (e.g., fire, earthquake, or flood). Otherwise, the substantiation rule is usually strictly applied.
Do All of My Expenses Have to Be Business Expenses?
The taxpayer must make a reasonable allocation only to deduct the expenses related to business and not to personal purposes when expenses (e.g., entertainment expenses) are incurred for both business and personal purposes at the same time.
The Importance of Business Expense Substantiation
Employees are often required to incur expenses that their employers will later reimburse. Without proper substantiation, expense reimbursements may be treated as taxable income, resulting in the employee paying taxes on the income.
Can an Attorney Help Me With My Tax Problems?
Tax laws are complex and constantly changing. The various tax preparation software available on the market can help you prepare your tax returns. Still, they cannot provide the same level of service as an experienced and knowledgeable tax attorney.
If you are unsure about the characterization of your expenses or need someone to represent you before the IRS, a tax attorney can help.
