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Burst Water Pipe Helps Taxpayers Avoid Accuracy-Related Penalty.

(Parker Tax Publishing February 22, 2015)

A taxpayer was unable to take a large portion of claimed deductions as records substantiating expenses were destroyed due to a burst water pipe. But because the situation was beyond his control, the Tax Court declined to assess an accuracy-related penalty. Lain v. Comm'r, T.C. Summary 2015-5.

Background

S. Scott Lain worked in Florida as a stockbroker for Chase Investment Bank during the first half of 2010, and as an insurance salesman for MetLife during the latter half. Lain's work at both Chase and MetLife required him to drive his vehicle from his offices to the offices and homes of prospective and current clients to discuss investments, retirement income plans, and other services Chase and MetLife offered.

Lain and his wife have one child, JL, who was diagnosed with autism spectrum disorder when he was three years old, necessitating numerous medical and educational expenses.

On his joint 2010 tax return, Lain reported various deductions related to medical and education expenses for JL, charitable contributions, and unreimbursed employee expenses. Lain took medical and education expense deductions of $46,596, charitable contribution deductions of $8,880, and miscellaneous itemized deductions of $17,091.

The IRS disallowed all of Lain's claimed deductions and assessed an accuracy-related penalty. Lain then petitioned the Tax Court for redetermination, arguing that he was unable to substantiate many of the expenses underlying the claimed deductions because his tax records were destroyed by water from a pipe that had burst. Lain believed that because the destruction of his records were beyond his control, the IRS incorrectly disallowed his deductions.

Analysis

Taxpayers are required to maintain records that are sufficient to enable the IRS to determine their correct tax liability (Code Sec. 6001). When a taxpayer's records have been destroyed or lost due to circumstances beyond the taxpayer's control, the taxpayer may substantiate his or her claimed expenses, including Code Sec. 274(d) expenses, through reasonable reconstruction (Malinowski v. Commissioner, 71 T.C. 1120 (1979)).

On the basis of Lain's testimony, the Tax Court was satisfied that his 2010 tax records were destroyed because of circumstances beyond his control, as it was impossible for Lain to have anticipated a burst pipe would destroy the records substantiating his expenses. Nonetheless, the court noted that even if a taxpayer establishes that his records were lost or destroyed because of circumstances beyond his control, he must still substantiate the claimed expenditures through secondary evidence (Boyd v. Comm'r, 122 T.C. 305 (2004)). Based on Lain's testimony and secondary records, the court only allowed, $22,499 of the $72,567 total claimed deductions.

Although Lain's burst pipe did not relieve him of his duty to substantiate claimed expenses, it did enable him to avoid the accuracy related penalty imposed by the IRS. Code Sec. 6664(c)(1) provides an exception to the accuracy related penalty if the taxpayer establishes that there was reasonable cause for, and the taxpayer acted in good faith with respect to, the underpayment.

Relying in part on Higbee v. Comm'r, 116 T.C. 438 (2001) the court found that the destruction of tax records resulting from the burst pipe constituted a reasonable cause for the underpayments. Because the water incident prevented Lain from accurately substantiating his deductions, despite his best efforts to do so, and because he prevailed with respect to some of the claimed deductions, the court believed that he might have been able to substantiate many of his claimed deductions had his records stayed intact, and declined to impose an accuracy-related penalty.

For a discussion of accuracy related penalties, see Parker Tax ¶ 262,120. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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