There are quite a few tax court cases involving taxpayers who did not have sufficient records to substantiate their tax positions. This is probably more than half of the cases that end up in the U.S. Tax Court. But what about the opposite situation where there are too many records?
How is one to contend with cases where there are too many records? The IRS auditors usually will not sift through all of the records and they do not help taxpayers organize the records. It takes time to organize voluminous records. By the time the IRS conducts the audit and has the appeals conference, taxpayers still may be in the process of organizing records. The tax matter will probably have moved on to the tax court process by the time the taxpayer has the records in a somewhat manageable form. So, by this point, the question often is how to present the voluminous records to the court. The recent Anderson v. Commissioner, T.C. Memo. 2024-95, provides an opportunity to consider this question.
Facts & Procedural History
The taxpayers in this case were a married couple. Their finances were structured with six companies that were owned by a partnership entity and trust. The amounts all flowed through to the taxpayers individual income tax returns.
The taxpayers did not file income tax returns for 2010-2015. In 2019, the IRS caught wind of the situation and filed “substitute for returns” or SFRs. The taxpayers ended up contesting the balances. The dispute ended up in the U.S. Tax Court. While this was pending, the taxpayers were involved in other litigation. This included a multi-year dispute in state court involving a promissory note.
The taxpayers eventually prepared income tax returns and accounting records for the entities and trusts. The court notes that the accounting records were divided into seven sections, one for each entity and trust, and each included the following:
- Summary Statement
- Income Statement
- Operating Expense Supporting Details
- Cash Receipts Journal
- Cash Disbursements Journal
- Account Register
- Analysis of Partners’ Capital Account
- Estimated Basis Calculation
The Cash Disbursements Journals list expenditures day by day, referencing a date, a check number or account number, payee (e.g., TelePacific Communications), a description (“phone and internet”), and an amount. The accounting records were over 200 pages long.
In court, the taxpayers explained that they did not produce other supporting records given that the records were voluminous and, for some of the records, they were tied up in the ongoing litigation outside of the tax court litigation.
The General Substantiation Rules
The court begins its opinion by outlining some of the fundamental substantiation rules for tax cases. We won’t get into these rules in depth as we have covered these rules in several other articles (such as substantiating gambling losses, substantiating charitable deductions, substantiating travel expenses, and others). Here are a few key points for substantiating tax positions:
- Burden of proof: The taxpayer bears the burden of proving their entitlement to claimed deductions.
- Record-keeping requirement: Taxpayers are obligated to maintain records that support their claimed tax deductions.
- Cohan rule: Courts have the discretion to estimate the amount of allowable deductions in the absence of perfect records. This principle derives from the landmark case Cohan v. Commissioner.
- Reasonable basis for estimation: The courts have generally held that they will only make such estimations if there are at least some records or credible evidence that provide a reasonable basis for doing so.
These rules strike a balance between the need for accurate reporting and the practical challenges taxpayers may face in maintaining flawless records. However, as we’ll see in this case, having too many disorganized records can be just as problematic as having too few.
When There Are Too Many Records
When you really have too many records, it may be tempting to just provide them all to the IRS and let the IRS sort it out.
The courts have generally said that taxpayers cannot “dump” a large amount of records on the IRS. There are numerous court cases that address this situation. We’ll use the United States v. Quebe, 321 F.R.D. 303 (S.D. Ohio 2017) case as an example.
In Quebe, the court addressed the issue of a “document dump” in the context of a tax dispute involving research tax credits. The defendants produced over 340,000 pages of documents in response to the IRS’s discovery requests, but, according to the court, they failed to provide sufficient, responsive information. The court criticized this tactic, describing it as an attempt to “camouflage behind their document dump a barren evidentiary landscape.” One has to take this statement for what it is, as the IRS often demands voluminous records for research tax credits. No matter what documents are provided for the research tax credit, they are often never found to be sufficient.
But for this case, the court noted that producing a vast number of mostly irrelevant documents without identifying specific, relevant portions obstructs the discovery process and prejudices the opposing party. This approach, often called a “document dump,” was deemed insufficient and noncompliant with the court’s discovery orders. The court in Quebe emphasized that such actions result in misdirection, delay, and unnecessary expenditure of resources by the opposing party, thereby justifying sanctions against the defendants.
Ultimately, the court sanctioned the defendants under Rule 37(b), requiring them to provide detailed responses to specific interrogatories, pay the plaintiff’s reasonable fees and expenses, and barred them from introducing any new evidence after the discovery deadline.
Preparing Summaries of Records
Given these types of “document dump” cases, taxpayers may think that the answer is to simply provide summaries, such as accounting records that the taxpayers offered in this case. As you may have guessed, there are also rules and court cases involving summaries of records.
The tax court generally applies the Federal Rules of Evidence, as modified by the court’s own rules. Federal Rule of Evidence (“FRE”) 1006 allows a party to use a summary, chart, or calculation to prove the content of voluminous writings, recordings, or photographs that cannot be conveniently examined in court. The courts have said that this rule does not apply if the evidence is not voluminous as a summary is not needed.
The summary also has to be admitted into evidence in the court proceeding. This is usually handled via stiplations. The tax court rules require the parties to stipulate or agree that documents are admissible. This forced stipulation process is unique to the tax court. Other courts use a motion in liminie process whereby the parties file a pre-trial motion to ask the court to decide whether documents are admissible. This deviation from standard court processes is one of several ways that the tax court differs from most other courts.
Absent stipulations, summaries can be admitted into evidence by presenting the underlying data and testimony from the party that compiled the summary to verify that it is true and complete. The court can then decide to admit or not admit the evidence.
Going Forward With Summaries
With these two positions, the taxpayers in this case opted to press forward by just providing Summaries.
The court described it this way:
To substantiate their reported Schedule C and E expenses, petitioners primarily rely on the Cash Disbursements Journals and the Account Registers found in Exhibit 18-J for each entity. Those documents detail outlays by date, check number, account number, payee, and the like, but, except with respect to the Table Expenses, petitioners have not directed us to anything in the record evidencing actual payment.
The court then made this statement:
In other cases where a taxpayer has presented us with accounting documents merely containing lists of categories and amounts of expenses without the introduction of any source documents underlying the figures, we have treated the documents “as argument — not evidence.”
The court went on to explain that it opted not to use its discretion to make estimates using these records as the taxpayers maintained the underlying records, but simply chose not to provide them.
Had the taxpayers simply provided their bank statements and credit cards, the court may have reached a different conclusion. But to avoid this situation entirely, the common practice is not only to provide the bank and and credit card statements, but to also note on the summary the pages of the bank and credit card statement where the expenses can be found. For example, the summary might list “travel expenses” and note that these expenses are found on pages 1, 2, 3, etc. of the bank statement.
The Cash Disbursements Journals that the taxpayer prepared in this case may have provided a very good starting point for this record system. They apparently listed the expenditures day by day, referencing a date, a check number or account number, payee (e.g., TelePacific Communications), a description (“phone and internet”), and an amount. Just adding the cross reference to the bank and credit card statements may have been all that was needed.
With that said, it can be tedious to present records in this format. And there are instances where even this is not possible given the voluminous nature of the records or the disparate types and formatting of the records.
Asking the Court for Help
Assuming the records are still too voluminous or in a format that cannot be presented as described above, there are still other options that one may consider.
For example, taxpayers can ask the court to limit the scope of the trial to a representative sample of records. This approach, often called a “test case” or “sample case” method, allows the court to examine a smaller, manageable subset of records that are representative of the larger set. The court’s findings on this sample can then be extrapolated to the entire set of records.
Taxpayers can file a motion requesting a pretrial order from the court regarding the admissibility of their summaries and underlying documents. This proactive approach can help resolve evidentiary issues before the trial, potentially streamlining the presentation of evidence.
In some cases, taxpayers might ask the court to take judicial notice of certain facts or documents that are not reasonably in dispute. This is usually for records that are in the public domain, such as published IRS regulations, official government reports, publicly filed SEC documents, or widely recognized economic indicators like interest rates or inflation figures.
While the Tax Court already has a process for stipulations, in cases with particularly voluminous or complex records, taxpayers might request that the court issue a specific order directing the parties to stipulate to the admissibility of certain summaries or categories of documents. This can help ensure that key evidence is admitted without prolonged disputes over admissibility.
Taxpayers can also ask the court to schedule a pretrial conference specifically to address issues related to the presentation of voluminous records. During this conference, the parties and the judge can discuss strategies for efficiently presenting the evidence, potentially leading to court-approved methods for managing the volume of records.
These options may allow taxpayers to avoid the pitfalls of both “document dumps” and overly simplified summaries.
The Takeaway
This case helps explain how to handle the situation where you have to present voluminous financial records in tax court. Taxpayers should prepare comprehensive summaries of their records, ideally linked to underlying source documents like bank statements and invoices. When records are too numerous, consider asking the court for assistance, such as limiting the trial scope to a representative sample or seeking pretrial orders on admissibility. The key is to avoid both overwhelming “document dumps” and overly simplified summaries not supported by underlying source documents.
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