Since I often help clients close out IRS audits when their records are lacking, I thought it was time to answer this question:
I recieved a letter to meet an auditor from the IRS to audit my 2005 – 2007 taxes. My house was broken into several times, and I don’t have any of my paperwork to show deductions. My computer was also taken the first time, and I did fill out a police report. What will happen if I don’t go to the audit, or if I go without anything?
There are many issues raised here, all important.
1. Poor records/lost records for the audit. Of course, the best case for an IRS audit is to have perfect records. Few people do. And that, believe it or not, is okay.
There is a well-recognized U.S. Tax Court case that permits recreating expenses when direct records do not exist. The case is Cohan v. Commissioner, 39 F. 2d 540 (2d Cir. 1930). Cohan established a rule that permits estimates to be made of paid expenses when direct proof does not exist. To make the estimate, a foundation has to be laid that the expenses were actually incurred. Here is a real life example:
Over-the-road truck driver hauls furniture for individuals moving cross country. He subcontracts in each city with laborers to load and unload the personal belongings of his clients. He cannot load and unload the furniture by himself. But he pays in cash, no receipts. Over $80,000 in expenses for this were being questioned by the IRS, a significant amount.
As a beginning premise, we knew he incurred the expense – couches and refrigerators do not move by themselves. So, we recreated from his travel log and calendar each job he did. He knew that if he moved 10,000 pounds of furniture, it would take two men a total of 8 hours to complete the job, and the going rate was $150/day. He recreated a spreadsheet for each day, listing the city he was in, his recollection of the weight of the load, how many men he used and the time it took to complete the job.
This took some work, but an $80,000 deduction was on the line.
The IRS allowed everything he recreated. We were able to establish that the amounts were actually paid, and a reliable method was used to prove it.
I have had similar cases, for example, for an owner of a landscaping company, who paid his subcontractors in cash and kept no receipts. Those lawns were not mowed by themselves. Jobs and customers were recreated, detailing how many workers were used per job. This Cohan method of recreating expenses has been applied to have the IRS allow other expenses like charitable contributions, or business miles driven by a real estate agent (recreating a mileage logbook). Cohan is an important rule that should be used to alleviate a harsh result in cases where perfect records do not exist to prove expenses that were clearly paid.
2. Understand who you are dealing with. IRS auditors sometimes take very narrow views of substantiation cases. But if you cannot reach an agreement in audit, you have the right to have an appeals hearing or to take your case to U.S. Tax Court. In appeals, there is a broader view of your case. The question appeals officers ask themselves is “If this case went to court, what would happen?” If you can testify to a reasonable basis to the expenses being incurred, appeals officers will likely allow a portion of the expenses. Appeals officers try to replicate what a Tax Court judge would do. Auditors are often too distant from that reality, and usually do not allow enough leeway. See my prior post “Tax Court – proving a level playing field in audits.”
3. Do not ignore the audit. If you do, the IRS will send you what is called a “Notice of Deficiency.” This is your notice that the IRS has found a “deficiency” in your taxes, and calculates the tax, interest and penalties they are charging. If you ignore this notice, the amount becomes final and the IRS will start collection activities. Participate in the audit to the extent that you can determine if the auditor is open to application of the Cohan rule (they should be). If the audit is not going your way, exercise your rights to have an appeals hearing, and if necessary to have your expenses reviewed by the Tax Court. If you are entitled to it, you will be allowed expenses equal to the level of your credibility.
If you incurred the expenses, do not walk away from the audit. There are methods to recreate the expenses and reach the correct result.