Taxpayer's Burden of Proof by Carolyn Flaherty

Most US citizens understand the concept of criminal law that provides a person is innocent until proven guilty. However, many fail to grasp that the same is not true in tax court. To the contrary, in general, the IRS commissioner’s determinations are presumed to be correct and the taxpayer bears the burden of proving that the positions are erroneous.

The IRS is allowed to reconstruct income using various manners including the commonly used method of bank account analysis. The IRS reconstruction of income is simply required to be reasonable in light of the surrounding facts and circumstances. As established by case law, all bank deposits constitute evidence of income and as such the IRS can simply assert that all deposits made to bank accounts are taxable income. If deposits represent loans, contributions from the owner of a business or transfers between accounts; it is the responsibility of the taxpayer to prove this fact. The Tax Court will not reconcile accounts to match transfers nor attempt to gather evidence to support the source of funds to an account. The substantiation must be efficiently and concisely supported by documentation provided by the taxpayer.

Furthermore, Tax Court Rule 142(a) states that deductions are a matter of “legislative grace” and the taxpayer therefore must prove that they are eligible for the deduction and also substantiate the deduction claimed with appropriate receipts and documentation. If the taxpayer is unable or unwilling to prove eligibility or substantiate the deduction, it will be denied.

Business income and expenses reported on Schedule C are increasingly scrutinized by the IRS. Ordinary and necessary expenses incurred in a trade or business are normally deductible. However, taxpayers should note that banks statements or tables of expenses generated from bank statements are not considered sufficient evidence of eligibility for deduction. The court asserts that the tables do nothing more than summarize purchases and therefore do not prove that they were ordinary and necessary business costs as opposed to personal or other non-deductible business expenditures.  In addition, a memo notation in a check is not necessarily enough to substantiate a payment as a legitimate business expense if it could also be presumed a personal expense.

The IRS may impose a 20% accuracy-related penalty when there is a substantial understatement of tax. Substantial understatement is considered to exist when it exceeds 10% of the tax required to be shown on the return (unless the understatement is less than $5,000). The penalty will not be imposed on any portion of the understatement which resulted due to reasonable cause and in good faith. To establish reasonable cause and good faith, the most important factor is the extent of effort the taxpayer has taken to arrive at the correct tax liability.

Therefore, careful record keeping and documentation are imperative. Moreover, business and personal expenditures should be maintained independently through separate bank accounts and credit cards. For more information on how to document and defend your tax position, contact a tax advisor.