There is a new tax court case that shows the importance of retaining records for closed tax years. Even if the statute of limitations had expired for those years, the records are important.
Why Is It Important To Keep Records For Closed Tax Years?
Let’s see why. There is a new tax court ruling, TC Memo 2024-86. According to this, a tax return itself does not establish the basis of items that are carried forward. Instead, you have to have the actual past records to substantiate carry forward items to future tax years. As an example:
- depreciation,
- capital loss carry forwards,
- business credit carry forwards,
- the nondeductible basis in an IRA, or
- NOL carryforward deductions.
For example, you buy this year a piece of equipment for your business costing $5,000. You will need to keep the payment receipt and any other documentation for this piece of equipment for at least 9 years, if you depreciate this equipment using a 5-year asset life.
Why? Well, because the depreciation expense generated by this 5-year life equipment can span over six years of tax returns. This depends on the depreciation method you are using. Plus, three years statute of limitations for year 6 tax return. We get to approximately 9 years that the records must be kept. Of course, there can be situations that extend the statute of limitations beyond the three years and records must be kept even longer.
Court Case
In this new court case, the taxpayer owned a high-end Japanese steakhouse and claimed in 2008 depreciation on significant expenses for build-out improvements and equipment. However, he lacked records, like receipts or invoices to substantiate these capitalized expenses. The IRS accepted the business owner’s 2008 return as filed and it did not audit this return.
However, later returns were inconsistent having no depreciation claimed or very little depreciation for these 2008 capitalized expenses. And some returns were not filed at all for which the IRS prepared substitute returns in which it did not claim any depreciation. The IRS issued a Notice of Deficiency for several years. The business owner hired a CPA to prepare and submit amended returns. The CPA claimed additional depreciation deductions calculated using the basis for the capitalized expenses shown on the 2008 return. The IRS did not accept these amended returns.
What Happened In Court?
In court, the business owner argued that the IRS accepted his 2008 return, which should allow for depreciation deductions in later years under the Cohan rule. That’s because under the Cohan rule, if a taxpayer can show that they incurred a business expense, but cannot substantiate the exact amount, the court can estimate the amount and allow a deduction. The court must have a reasonable basis for the estimate and should approximate as closely as possible, bearing heavily on the taxpayer whose lack of records caused the inexactitude.
The court agreed that our business owner incurred expenses in 2008. But, noted that the figures on the 2008 return were unsubstantiated estimates. In addition, the court ruled that the taxpayer was entitled to depreciation deductions for the years at issue based on only one-half and not on 100% of the basis amounts reported on the 2008 return. If he had the receipts and the documentation for the 2008 restaurant build out improvements and equipment, he would have been allowed the entire amount of depreciation. The amount would have been claimed on the amended returns filed by his CPA for tax years between 2010 and 2012 and 2014 and 2016. Thus, our business owner lost hundreds of thousands of dollars in deductions.
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Please note that this blog post is for informational purposes only and does not constitute tax, legal or accounting advice.