No Tax Credit Without Substantiation
June 08, 2007
Imagine this phone call. You call the federal or state government tax department at the end of 2007 to tell them that your firm wasn't quite sure of all its expenses for the year, but you'd like credit for "oooohh, 2 million's worth." What's the first thing that happens?
First they would put you on hold for about 47 hours.
Then they would say, "You can't do that. You can't just throw numbers out and expect us to credit you money on your taxes. You need proof."
"Substantiation" is the $5 IRS word. And without it, no deduction.
For example, in Reynolds v. C.I.R., 296 F.3d 607 (2002), the court did not permit an attorney to deduct certain automobile and travel expenses associated with his law practice because Reynolds had failed to satisfy the substantia-tion requirements of 26 U.S.C. Sec.274 (d). (Reynolds did not maintain logs for each vehicle in their household to re-flect their use in the law practice.)
That section states that deductions will not be allowed for certain expenses unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating the taxpayer's own statement (a) theamount of such expense, (b) the time and place of the expense, (c) the business purpose of the expense or other item, and (d) the businessrelation-ship to the taxpayer of persons entertained, using the facility or property, or receiving the gift. 26 U.S.C 274 (d).
Now, let's move to the world of health-care deductions. It works the same way if you want money back.
For example, in 2003, the IRS ruled that expenses for over-the-counter medications can be reimbursed tax-free un-der health flexible spending accounts. But the reimbursement only comes if you provide a written statement from an independent third party stating that the medical expense has been incurred and the amount of the expense, coupled with a statement that the medical expense is not reimbursable under any other health plan coverage. Revenue Ruling 2003-43.
So, when you want money from the government, it requires proof.
But, alas, what happens when it's the other way around -- when government wants more money from you? Does it have to provide any evidence for the amount of money it seeks?
The governor didn't when he presented the ill-fated Gross Receipts Tax (GRT) proposal. Even though it failed, it should put us on guard for any new tax proposal affecting law firms.
One of the most alarming aspects of that GRT proposal was how it went from 1 percent to 1.95 percent without any "substantiation."
That quick percentage jump would have added millions to the cost of practicing law in Illinois, and no back-up evi-dence was provided. Maybe the substantiation wasn't provided because it wouldn't support the tax request. Unless there was a siting of running lepers loose, how could the government, in a 60-day period, discover that it suddenly needs twice as much money?
If your law firm expenses doubled that fast, think you could get away without documenting it?
Whether it is for expense deductions or state sales taxes, we have to document expenses. Lawyers have even a higher standard because we can lose our license if we don't properly document expenses to clients.
Failure to do so can subject an attorney to violations of Professional Conduct Rule 1.5 (a) obtaining unreasonable fees, Rule 8.4 for conduct involving dishonesty and breach of fiduciary duty, and Supreme Court Rule 771 for bringing the legal profession into disrepute. (See In Re Anthony Johnson, No 01 SH 53 -- ARDC Review Board (2002).)
So, while the government didn't document the anticipated expenses in the same manner as that demanded of us, that doesn't mean that we didn't see some measure of fairness with that GRT proposal.
The governor came calling for $7.6 billion.
