For any taxpayer, maintaining proper records is vitally important. This is especially true if you have millions of dollars in business expenses riding on whether or not you meet the tax regulations’ standard for a “real estate professional.” A technology business owner discovered a hard lesson regarding this matter when the U.S. Tax Court rejected his appeal and upheld the Internal Revenue Service’s imposition of a tax deficiency well in excess of a half-million dollars. The ruling reminds all taxpayers that there is simply no substitute for records created and updated contemporaneously, as opposed to creating a document months or years after the fact.
Douglas Schumann was the president of an electric controls manufacturing business. During 2008 and 2009, Schumann had commercial rental properties in Connecticut and Maine, along with 12 residential rental properties in Florida. On his federal income tax returns for those years, the taxpayer listed more than $2.8 million in expenses. The IRS disallowed almost $1.9 million in deductions, deeming the activities to be passive, not active. A passive activity loss under Section 469 is generally disallowed for the taxable year and becomes a deduction or credit for the next taxable year.
Even though the tax code says that rental businesses typically are deemed per se passive activities, regardless of the taxpayer’s level of material participation, the law exempts those individuals who qualify as real estate professionals. Part of the regulatory process for qualifying as a real estate professional involves establishing that you materially participated in your real estate business for at least the minimum number of hours mandated by the tax regulations. A taxpayer may show that he or she satisfied this time requirement by a variety of means. One of the keys to achieving success in having the IRS (or the Tax Court) accept your documentation involves when you created and updated your documentation. Information placed in writing at the time the work occurred will generally carry much more weight, and give you a greater chance of success, than documents created after the fact. As the court stated in Schumann’s case, “we are not required to accept a postevent ‘ballpark guesstimate.'”
Schumann’s documentation proved to be his undoing. Although he testified that he worked on his rental real estate business, primarily in the capacity of sending and receiving emails, for 5-6 hours per day, six days per week, his witness testified that the number was only 3-4 hours per day, four days per week. Regardless, the taxpayer brought forward none of the emails as evidence, leaving the court to reject both men’s testimony. The taxpayer’s documentation consisted of a narrative summary of the actions he undertook related to the business. The narrative summary, however, was general, did not indicate hours, and was not created at the time the work was performed, making exactly the sort of “ballpark guesstimate” that the court was free to reject. Schumann also offered bank records, checks, and receipts, but these also did nothing to establish how many hours the taxpayer put in.
The court also ruled that the taxpayer lacked sufficient evidence to show that he participated in the business on a “regular, continuous, and substantial” basis. Again, the lack of documents created at the time of the work doomed Schumann. The court reiterated that it could not “overemphasize the importance of keeping thorough, contemporaneous time records rather than making estimates after the fact.”
For all businesses, large and small, the tax code contains many opportunities for deductions to defray one’s tax liability, but these deductions also require completing certain tasks to establish one’s eligibility. For knowledgeable and diligent advice and representation regarding your business’s income tax deduction issues, consult the experienced tax attorneys at Samuel C. Berger, P.C. and CPAs at S.C. Berger, P.C. Their skill and experience can help you ensure that your return won’t create problems for you down the road. To consult our attorneys and CPAs, contact us online or call (201) 587-1500 or (212) 380-8117.
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