For the first part of this article preparing for an office audit, click here.
Table of Contents
8. Previous Audits
IRS records of your audit history are spotty. Examination reports as recent as a year or two ago probably won’t be in the new auditor’s file. So don’t be surprised if you are asked if you’ve been audited before and how it came out.
RESOURCE:
Unless you came out clean, say that you don’t recall. If the auditor really wants the old report, he or she can hunt for it.
Unless no problems were found, you won’t be rewarded by showing a copy—which points to issues in the new audit. If the auditor does have the old report, however, and the prior auditor found problems, be prepared to address those same issues if they are on your newly selected tax return.
9. Other Years’ Tax Returns
During an audit, the auditor routinely asks to see your tax returns for the year before and after the audit year. The reason is obvious—to see whether adjustments should be made for those years.
But the IRS has those returns, so why ask you?
Even in this electronic age, the IRS doesn’t yet have computer-scanned copies of tax returns. Paper tax returns are piled high in warehouses for ten years and then destroyed. Your return filed two years ago may be in box 147963a-7 in the middle of Kansas. If the auditor internally requests your old tax return, it takes months to find it—if it ever surfaces.
Usually, the auditor just forgets it, but even if the IRS finds the return, the IRS audit clock may have run out. And if you didn’t file a return for those other years, don’t assume the IRS suspects you of not filing because you were asked for those returns.
What this means is that you can safely ignore the audit notice where it says to bring other tax returns.
10. Fraud
Tax fraud—big-time tax cheating, not just fudging a few deductions—is an issue in fewer than 5% of all audits.
CAUTION:
If you are concerned that it might arise in your audit, talk to a tax attorney before meeting the auditor. Tax fraud may be punished by a heavy fine—75% of the amount of tax found due—or by a long jail term.
If you’re contacted by someone identifying him- or herself as an IRS special agent, it means the person is from the IRS criminal investigation division. Start to worry.
Prove Your Deductions
Prove your tax return was prepared properly and substantiate everything on it, and you’ll win your audit. It is as simple as that—but most people lose their audits because something goes wrong.
Proving that your return was prepared properly isn’t generally the issue. But verifying everything on it, particularly your deductions, may be another story.
You must pass two tests to be entitled to claim a deduction: you must substantiate the expense and you must show that the expense was reasonable and necessary.
Substantiation
This is usually the crux of an audit. Ideally, your proof, verification, substantiation—it doesn’t matter what term you use—is in writing. But auditors have the discretion to accept oral explanations in place of documents.
Of course, this destroys the great IRS myth: That if you can’t prove a deduction in writing, it won’t be allowed by an auditor. The fact is otherwise.
Courts have told the IRS that taxpayers can’t be expected to keep flawless records.
Published Tax Regulations and court decisions allow taxpayers—within limits—to:
- Claim substantial compliance
- Offer oral explanations
- Claim certain business expenses under $75 without receipts
- Reconstruct records when the originals are missing
Reasonable and necessary
Deductions—expenses—of running your business or working your investments so they produce income must be reasonable and necessary. So even if you can substantiate an expense, the IRS may reject it if it’s unreasonable or unnecessary.
EXAMPLE:
Elmer owns a hot dog stand with gross receipts of $40,000 per year. Elmer claims a deduction of $20,000 in entertainment expenses. The auditor would likely call this unreasonable and unnecessary, even if Elmer could prove he spent this amount on his good customers. If Elmer owned a hot dog factory and made $500,000 a year, however, a $20,000 deduction in entertainment expenses would probably fly.
In reality, this is usually not a major audit issue, as long as your expenses aren’t laughable in size or nature.
Substantial Compliance
If you can’t find the paperwork to support a certain deduction, be ready to tell the auditor that you are nevertheless in substantial compliance with the tax laws and show what you do have.
“Substantial compliance” means you can show sufficient proof you obeyed the tax law, even if the evidence is incomplete.
EXAMPLE:
The auditor okays Rufus’s deducting a cleaning person’s charges of $125 per month for his real estate offices. The cleaner insisted on payments in cash because she didn’t have a bank account to cash checks. Rufus cannot find four months of handwritten receipts for cash payments, and so the auditor says “no deduction” for $500. Rufus counters that the cleaner dropped out of sight, so he can’t get the receipts now. But he contends he is in substantial compliance and the auditor should average the other eight months ($1,000) to approximate the missing four ($500).
This example shows the wisdom of preparing well ahead of the audit.
RESOURCE:
If you can’t find bills or canceled checks, order copies from suppliers and banks. Expect to wait a few weeks; few businesses keep old records handy. And few give priority to getting copies out unless you are an exceptional customer.
If getting the records in time for the audit looks like it will be a problem, call the IRS and reschedule.
CAUTION:
Businesses don’t usually charge for copies of invoices or receipts, but banks gouge around $3 per canceled check copy. You may want to order copies of major expense checks only.
Oral Explanations
Be ready with an oral explanation of why you can’t produce a record or why you’re entitled to the deduction. An auditor must give some weight to an oral excuse, as long as it’s reasonable.
Perhaps your records were lost along with all the rest of your worldly goods moving from Iowa to New Mexico when the moving van was totaled and exploded into flames.
Credibility is the key
“Aliens with ray guns hijacked it near Area 51” won’t fly, even if the auditor is addicted to X-Files reruns.
More than anything, once the audit begins you want to establish and maintain credibility with the auditor. If you lie to the auditor once, he or she may not believe anything else you say. You won’t get the benefit of the doubt down the road. If you must, be ready to say something like,
“I’m not sure” or “I’ll check on that.”
Business Expenses
You are entitled to claim most business deductions of up to $75 each without a receipt.
CAUTION:
This rule doesn’t apply to the purchase of goods for resale or travel, lodging, and entertainment expenses. These expenses require receipts, no matter the amount. The receipt may be a cash register tape, credit card slip, or invoice marked paid.
As long as the receipt looks legitimate, you should be okay.
Not needing a receipt doesn’t mean that you can throw away all traces of these expenses. Keep a record of some kind. For instance, your business calendar notation, log, or diary should indicate the amount of the expense, to whom it was paid, the time and place, the business purpose, and the relationship you have with the person on whom you spent the money.
Reconstruction of Records
Generating records from scratch is not fun, but is sometimes necessary for audit success. In addition, you may have gaps from missing documents that you need to fill in by recreating lost or destroyed records.
As long as the newly minted records appear to be reasonable, the auditor can’t entirely disregard them. It’s a judgment call on the part of the auditor, however, and different auditors apply different standards.
Courts provide some guidance on what it takes to successfully reconstruct records. The first rule is that if you once possessed records but no longer have them—due to no fault of your own—you are entitled to reconstruct them.
RESOURCE:
IRS Regulation 1.274-5(c)(5); Gizzi v. Commissioner of Internal Revenue,65 T.C. 342 (1975).
You must provide the IRS with a reasonable explanation of why the records are missing.
EXAMPLE:
Ted’s tax records were destroyed when the Mississippi River flooded into his basement. Ted can use photos of the flooded basement, an insurance claim form, or even newspaper clippings reporting the flood to provide an explanation of why he doesn’t have the records.
Documenting the expenses recorded by the lost documents is the next step. Let’s say you spent $1,200 for materials in fixing up your office but lost all the paperwork. You could reconstruct the expenses with a letter from your landlord attesting to the improvements or a statement from a friend who saw you doing the work.
Before-and-after photos are very persuasive. If you think hard enough about reconstructing paperwork for an expense, you can do it. Be creative.
You can even write up your own receipts. You can make up duplicate paid receipts from the hardware store with the name of the store, amount, and date of purchase.
Most important is to be up front with the auditor; tell him or her the receipt is a reconstruction. Together with your landlord and friends’ letters and photos, this might carry the day.
Cohan Rule
An early court ruling has saved many audit victims with missing records. George M. “I’m a Yankee Doodle Dandy” Cohan was nailed for not producing expense receipts in a roaring ‘20s IRS audit.
Cohan fought the IRS, and a U.S. Court of Appeals held that Cohan could “approximate” reasonable business expense deductions, as he had shown that some amounts must have been spent through his testimony and that of other witnesses.
RESOURCE:
Cohan v. Commissioner of the Internal Revenue,349 F.2d 540 (2nd Cir. 1930).
The Cohan Rule is still the law, but has two principal legal limitations:
- As with any reconstruction of records case, you must show why the records are not available. They may have been lost or destroyed, for very small amounts, or from transactions for which receipts are not normally given.
- The Cohan Rule can’t be used to approximate travel and entertainment expenses. You must verify those actual expenses.
Be ready to use the Cohan Rule as a bargaining chip with the auditor. If the auditor says “no deduction without documentation,” cry “Cohan.”
The auditor’s eyebrows will likely raise in surprise, and he or she may become more reasonable. If the auditor balks, ask why it doesn’t apply to your situation.
Don’t Over-Cooperate
Reread the audit notice one last time. Look at the list the auditor plans to examine. As you are putting together the documents that relate to the items on that list, don’t include anything else. An auditor can’t force you to produce anything unrelated to what is in an IRS office audit notice.
And remember my earlier advice—if you’re asked to bring other years’ returns, don’t, with a few exceptions.
EXAMPLE:
Another year’s tax return may relate to the one under audit—for instance, loss carryovers or depreciation of assets reported in other years. In this case, bring to the audit only the relevant part of the other year’s tax return—such as a schedule of depreciation—and not the whole return.