Administration: Audit - Incomplete Records
September 28, 2022
Re: § 58.1-1821 Application: Individual Income Tax
Dear *****:
This will respond to your letter in which you seek correction of the individual income tax assessments issued to ***** and ***** (the “Taxpayers”) for the taxable years ended December 31, 2018, and December 31, 2019. I apologize for the delay in responding to your letter.
FACTS
The Taxpayers filed Virginia resident income tax returns for the 2018 and 2019 taxable years claiming itemized deductions reportable on federal Schedule A and business expense deductions on federal Schedule C. Under audit, the Department requested documentation to support the deductions. When no response was received, the Department disallowed the deductions and issued assessments.
Subsequently, the Taxpayers submitted some documentation. The Department allowed the full deductions claimed in 2018 for home mortgage interest and real estate taxes, and in 2018 and 2019 for personal property taxes. The deductions for real estate taxes and home mortgage interest claimed in 2019 were adjusted based on the submitted receipts. The Department continued to disallow the deductions for charitable contributions and the business expense deductions, other than a deduction for annual business personal property tax paid. As a result, the Department adjusted the assessments and issued a new determination.
The Taxpayers appeal the assessments, contending they provided sufficient documentation and that certain business expenses are allowable deductions under the “Cohan rule” even without documentation. The Taxpayers also assert that the Department should allow depreciation that was begun in prior years or, in the alternative, remove a bonus depreciation fixed date conformity addition reported on their 2019 return.
DETERMINATION
Conformity
Virginia Code § 58.1-301 provides, with certain exceptions, that terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the Internal Revenue Code (IRC) unless a different meaning is clearly required. Conformity does not extend to terms, concepts, or principles not specifically provided in the Code of Virginia. For individual income tax purposes, Virginia “conforms” to federal law, in that it starts the computation of Virginia taxable income with federal adjusted gross income (FAGI). Income properly included in the FAGI of a Virginia resident is subject to taxation by Virginia, unless it is specifically exempt as a Virginia modification pursuant to Chapter 3 of Title 58.1 of the Code of Virginia.
As a general rule, the Department relies on the accuracy of information and computations reflected on the federal income tax return when reviewing Virginia individual income tax returns. If the information provided on the federal return looks reasonable, there is generally no reason to look behind those computations. The Department, however, retains the authority to adjust the FAGI and itemized deductions where there is clear evidence that the amounts reported on the federal or Virginia income tax return are not consistent with the IRC. See Virginia Code § 58.1-219.
Itemized Deductions
Virginia Code § 58.1-322.03 1 allows an individual to deduct from their Virginia adjusted gross income certain amounts allowed for itemized deductions for federal income tax purposes. These deductions include those for real estate taxes, home mortgage interest, personal property taxes, medical expenses, and charitable contributions, provided they are claimed in accordance with the IRC and its related regulations.
The auditor requested that the Taxpayers provide documentation supporting the itemized deductions claimed on their 2018 and 2019 returns. The requests clearly indicated the documentation required to substantiate each type of deduction. The Taxpayers sent the requested documentation for all of the deductions with the exception of certain charitable contributions and a portion of the real estate tax and mortgage interest reported paid in 2019. Deductions for property taxes, charitable contributions, and other expenses are allowable only when payment of the expenses can be substantiated through items such as receipts or cancelled checks. See Public Document (P.D.) 14-155 (8/28/2014) and P.D. 19-78 (7/29/2019). The Department adjusted the initial assessments based on the documentation provided, but that part of the deductions for which no substantiation was provided remained denied.
The Taxpayers provided no additional information regarding the itemized deductions with their appeal. The Taxpayers believe the itemized deductions should be allowed as filed since most of the deductions were substantiated. The Taxpayers, however, made no legal arguments regarding how the Department erred in disallowing the deductions.
Schedule C Expenses
Under IRC § 162, taxpayers are permitted to deduct all of the ordinary and necessary business expenses paid or incurred during the taxable year in carrying on any trade or business. Such expenses must be directly connected with or pertaining to the taxpayer’s trade or business. See Treas. Reg. § 1.162-1.
Schedule C is used to report income or loss from a business, including a sole proprietorship. Income from the business is offset by expenses. This income or loss is reported on a taxpayer’s federal income tax return and thus is reflected in FAGI reported on the Virginia return.
The auditor requested that the Taxpayers provide documentation supporting the expenses claimed on Schedule C for the 2018 and 2019 taxable years. The requests clearly indicated the documentation required to substantiate each type of expense.
The Taxpayers did not submit any documentation to substantiate the business expenses with the exception of receipts for business personal property tax. The auditor, accordingly, disallowed the expenses other than the business personal property tax. As discussed above, substantiating payment of expenses through items such as receipts or cancelled checks is required to claim the deductions.
The Taxpayers assert that, at a minimum, the expenses claimed for supplies should be allowed under the “Cohan rule.” In Cohan v. Comm’r, 39 F.2d 540 (2d Cir. 1930), the court established a judicial doctrine in which courts may allow estimates of certain business expenses when the taxpayer proves the existence of the expense but lacks documentation proving the amount of the expense. The Taxpayers, however, did not provide any evidence to establish the existence of the claimed expenses. In any event, the “Cohan rule” is a discretionary judicial doctrine and it does not mandate that the Department estimate expenses in the absence of sufficient substantiation.
The Taxpayers also believe that they should be allowed to take depreciation expenses based on depreciation that was begun in prior years. The auditor requested that the Taxpayers provide their federal Form 4562, Depreciation and Amortization, for the property being depreciated along with documentation such as dated paid invoices, evidence of payment, and information on business use. The Taxpayers have made no attempt to provide the requested evidence to support the claimed deductions. Alternatively, the Taxpayers suggest that if the depreciation deduction is not allowed, then the corresponding fixed date conformity addition for bonus depreciation that the Taxpayers reported on their 2019 return should be removed.
CONCLUSION
Taxpayers must maintain records sufficient to allow the IRS to determine their correct tax liability. See Treas. Reg. § 1.6001-1(a). Similarly, Virginia Code § 58.1-310 provides:
Whenever in the opinion of the Department it is necessary to examine the federal income returns or any copy thereof of any individual, estate, trust, partnership or corporation in order properly to audit such returns, the Department or the commissioner of the revenue shall have the right to require such taxpayer to provide such return or a copy thereof and all statements, inventories, and schedules in support thereof.
Under the provisions of Virginia Code § 58.1-205, in any proceeding relating to the interpretation of the tax laws of Virginia, an “assessment of a tax by the Department shall be deemed prima facie correct.” As such, the burden of proof is on the Taxpayers to show that the assessment was erroneous.
Sufficient documentation has not been provided by the Taxpayers to support the charitable contributions that the auditor removed from the Taxpayers’ Schedules A for the 2018 and 2019 taxable years, or to refute the auditor’s adjustments to the real estate taxes and mortgage interest reported on their 2019 return. In addition, the Taxpayers have not submitted any documentation to support the business expense deductions claimed on the Taxpayers’ Schedules C submitted with their 2018 and 2019 federal income tax returns. I agree with the Taxpayers, however, that the addition for bonus depreciation reported on the 2019 Virginia return should be removed because the corresponding depreciation deduction has been disallowed.
Accordingly, there is no basis to abate the Department’s assessment for the 2018 taxable year. The assessment for the 2019 taxable year, however, will be adjusted by the auditor to remove the bonus depreciation addition. The Department’s records indicate that the Taxpayers have paid the assessments in full. After adjusting the 2019 return, a refund will be issued as warranted.
The Code of Virginia sections and public documents cited are available online at www.tax.virginia.gov in the Laws, Rules, & Decisions section of the Department’s website. If you have any questions regarding this determination, you may contact ***** in the Office of Tax Policy, Appeals and Rulings, at *****.
Sincerely,
Craig M. Burns
Tax Commissioner
AR/4059.X