Who's afraid of the IRS? Almost everyone. The key to surviving a
tax audit -- and even coming out on top -- is not to panic, but to prepare.
If you go it alone, before meeting the auditor, you should
thoroughly review the tax returns being audited. Be
ready to explain how you, or your tax return preparer, came up with the
figures. If you can't, then contact your tax preparer
or another tax pro.
Find all records that substantiate your tax return. As discussed, the IRS
has a right to look at any records used to prepare your tax return. Organize
your records for the auditor in a logical fashion. Your pre-audit organization
of receipts, checks and other items will refresh your recollection for the audit
meeting.
Neatness counts. Forget about dumping a pile of receipts
before an auditor and telling him or her to go at it. Messy records mean more
digging, and more digging, to the IRS, means more gold for them. Conversely,
auditors frequently reward good recordkeepers by
giving these folks the benefit of the doubt if any problems arise. Neatness
builds your credibility with the auditor. Tidiness and order appeal to an
accountant's mentality, and most auditors are accountants.
Pinpoint problems backing up income sources or expense deductions . You'll
need to legally show your right to take tax deductions or other tax benefits
claimed on your return. Research tax law, if necessary.
Audit success means documenting your expenses. Proof should be
in writing, though auditors are allowed to accept oral
explanations. A list of items the auditor wants to see usually accompanies your
audit notice.
At a minimum, the IRS will expect you to produce the following
documents:
·
Bank Statements, canceled checks, and
receipts. The auditor will want to see bank records from all of your
accounts, both personal and business. As a rule, don't
discard any business-related canceled checks, invoices, or sales slips. If you
paid some expenses with cash, keep the paperwork
(handwritten notes, notebooks, receipts, or petty cash vouchers) showing the
payments.
·
Electronic records. Most banks don't return canceled checks anymore, and many business
expenses are charged on credit or debit cards. Bank and charge card (Visa,
MasterCard, American Express) statements are now
accepted by the IRS as proof of payment. They must show the name, the date, the
amount, and the address of the payee.
Since charges and statements don't
always show the business nature of the expense, you can't rely on them as your
only records.
·
Books and records. The auditor will ask
to see your "books." The tax code doesn't
require small businesses to keep a formal set of books; don't let an auditor
tell you otherwise. If you keep records with only a checkbook and cash register
tapes, so be it. If you maintain more formal records such as
ledgers and journals, the auditor is entitled to see them. If your data
is on a computer, the auditor will want to see a printout.
If you don't produce
adequate records, the auditor is legally permitted to estimate your income
and/or expenses and to impose a separate penalty for your failure to keep
records.
·
Appointment books, logs, and diaries. Businesses that
offer services typically track activities and expenses using calendars,
business diaries, appointment books and logs. An entry in a business diary
helps justify an expense to an auditor as long as it appears to be reasonable.
Additionally, you must keep special records
for certain equipment, called "listed property," that is often
used for both business and personal purposes. (IRC § 280F.)
Cell phones, computers kept at home but used for business, and vehicles used
for both business and pleasure are designated as
listed property.
Purely business equipment is not in this category. For example,
mechanic's tools, a lathe, or a carpet loom are purely
business tools, and no records of usage are required. But
when assets are put to both business and personal use, the auditor can demand
records of usage. For example, if you use a computer for
business email and to play solitaire, keep track of the business
portion. One way is to make notes in a note pad next to the computer.
If you haven't kept usage records of
listed property, reconstruct them by memory or reference to projects that you
worked on during the year.
·
Auto records. As mentioned, a
vehicle can be "listed property" if it's
used for personal purposes as well as business. So
business use of your personal auto requires detailed records showing the work
portion. A log is the best way to keep track (and it's
easy to keep a little notebook in the glove compartment), although it's not
required by the tax code. Alternatively, you can keep all gas and repair
receipts in an orderly fashion, with notations of trips showing how the car was used for business. A less accurate way to keep records
is to add up the gas bills and divide by the number of miles per gallon that
your car averages. Show the auditor your auto trip receipts and explain how
they link up to sales trips by your business diary or calendar notations.
·
Travel and entertainment records. By law, out-of-town
business travel and entertainment expenses (T & E, in auditor lingo)
require greater recordkeeping than most other expenses. You must have a written record of the
specific business purpose of the travel or entertainment expense, as well as a
receipt for it. (IRC § 267.)
A good way to document T & E expenses is with an appointment
book or log, noting each time you incur a business expense, and the reason.
Most folks aren't disciplined enough to write down
every expense as it is incurred. It is okay to put together a log or diary
after you have received an audit notice. But be
up-front about it -- don't insult the auditor's intelligence by trying to pass
off wet-inked paper as an old record. Remember, it's key to develop and
maintain credibility with the auditor.
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Expenses for renting or buying property. To prove business
rental expenses, bring in a copy of your lease. If you purchased the property
or equipment, have the purchase contract. This establishes grounds for claiming
these expenses as well as a beginning tax basis of the property, if you claim
depreciation expenses.