Getting ready for your IRS audit: Organizing your records
Most IRS audits start because the IRS believes there is something wrong with your tax return.
I mean, let’s face it, the IRS is not spending time auditing tax returns that they think are clean.
In other words, an audit starts with you behind the eight ball, presumed to have filed a return that has mistakes on it.
How do you fight that negative presumption of guilt before you even get started? One word: credibility.
Credibility in IRS audits does not come from words, but from organization.
But how do you organize you records for the auditor to gain credibility? And what if your records are incomplete?
Here are some tip to solve frequently encountered problems in preparing for your records for an IRS audit:
1. Make the auditor’s job easier. That means understanding what the auditor wants ahead of time, and giving it to him. You do not want to go through and organize that box of receipts, and neither does the IRS auditor. But somebody has to. And it is better you then the auditor. Remember, the auditor is coming in expecting the worst; try to gain credibility by slowly adjusting his preconceived expectations of you. So, put the time in so the IRS auditor does not have to. Ultimately, your preparation can give you the benefit of the doubt on judgment calls – you want those calls to go your way.
If possible, put your receipts in their own file folders. Each expense should have its own file folder – i.e., one for subcontractor labor, one for your charitable contributions, one for your home office expenses. Name each file folder for the expense it holds.
If necessary, receipts should be marked to further explain the expense it verifies. For example, if you entertained for business, mark on the receipt who you entertained, and why.
If you have a bill for services and a check showing the bill was paid, staple the check to the bill.
Add the totals of the receipts up for each expense category and provide your tabulation to the auditor.
Do away with plastic grocery bags with receipts in them. This makes for a poor presentation and takes away credibility.
Prepare this way: How would you like the records to look if you were the auditor? What would impress you?
2. A receipt alone may not be enough. IRS auditors are infamous for rejecting a receipt for an expense that is not marked paid or otherwise does not show payment. The auditor’s question will be “How do I know this was paid? It just shows a purchase, but not payment.” This would require you to get a statement from the vendor that it was paid, or a cancelled check, or a credit card receipt. But don’t be upset if you cannot get any of those – there are solutions for when your records are not enough.
The IRS follows the Tax Court case of Cohan v. Commissioner, 39 F.2nd 540 (2nd Cir. 1930). Cohan stands for the legal proposition that it is permissible to estimate your expenses if you do not have direct evidence of what you spent, or if your evidence is not complete. In other words, your verbal statements can support an expense, and that it was paid.
Let’s take those receipts that are not marked paid. Your testimony that you paid the bill can support the expense. Maybe your testimony would be supported by your statement that the expense was ongoing – like labor, and your subcontractors would not have stayed on the job if they were not paid. In other words, make it so its obvious the expense was incurred and paid.
The IRS wants the direct evidence – a check, statement or receipt verifying the expense. But indirect evidence – your supporting testimony- is permissible under the law.
That being said, know in advance that many IRS auditors are very uncomfortable with indirect evidence and your testimony, and will not accept it, regardless of the law. If that’s the case, you have rights to review of the auditor’s decision to reject your testimony by filing an appeal with the IRS and, ultimately, to a hearing before a judge in U.S. Tax Court.
3. Mileage logs for business use of car. Tax laws put heavy burdens on you to maintain records when you use your personal auto for business. This is because the use of the car is commingled between what is deductible (business use) and nondeductible (personal use).
You are required to keep a log that shows, for each business trip, your start point, each business destination, the miles driven from each point, and your business purpose in making each drive. As if that’s not enough, you have to make record of these items when you make the drive, not a week later, or at the end of the year. High standards of proof, and the IRS knows it.
Most people do not understand the legal record keeping requirements and do not have the records they are required to maintain. Unfortunately, the Cohan rule, allowing you to testify to establish your tax expenses, does not apply to your business use of your car. You need that log book.
What if you don’t have the log book? You could recreate it, but that takes time, and technically, the law requires you to maintain it contemporaneously.
In these situations, you will not have the records to satisfy your auditor. But, again, you have the right to appeal.
Most IRS appeals officer will accept some recreation of your mileage. This is usually in the form of car maintenance receipts (oil changes or repairs) that have your mileage noted. Find an auto repair receipt from the beginning of a year, middle of the year, and end of the year. With that, you have established some basis for how often you used the car. Let’s say its 20,000 miles – and you did not drive 20,000 miles in a year to the grocery store and the movie theater. Some of that is for business. If it’s obvious, a fair appeals officer will give you some of your miles.
The goal headed into your audit is to be prepared to the point that the auditor finds he does not need to do much. Your credibility in your preparation may lead the auditor to only skim your records rather than go through each item with a fine tooth comb. That’s to your advantage.
That being said, some auditors may not be accommodating, regardless of your efforts. For those situations, it is important to remember that the auditor is the beginning of a process only. If you don’t think that the auditor is playing fair, always know that your auditor does not represent the end of the line in your audit. You have rights past the auditor – to meet with an IRS appeals officer to review his findings, and to a Tax Court trial. Take your records and organization to appeals or to Tax Court, where they can be reviewed by a fresh set of eyes.