How to Audit Proof Your Tax Return-An Example of What NOT to Do
You DO NOT want to get audited by the IRS. Spending extended time substantiating every minuscule deduction that you took is not my idea of fun.
A few months ago, one of my clients (let's call him Mr. Johnson) received an exciting letter from our dear friends at the IRS requesting more information about his return. Mr. Johnson, a local small business owner, was required to meet with the IRS and provide answers to certain concerns they had about his tax return business deductions. An in person interview was required and necessary according to the IRS representative...obviously
This was not a good day for Mr. Johnson. He lost the audit and ultimately owed the IRS a significant some of money which included the additional tax owed for deductions that the IRS would not accept, in addition to the penalty and interest for paying the tax late. Mr. Johnson learned a valuable lesson from this ordeal which I will share with you so you don't have to learn the hard way - he made two common but easily correctible mistakes.
MISTAKE #1: YOU'RE GOING TO HAVE A PROBLEM IF YOU DON'T HAVE A RECEIPT
Mr. Johnson lost several deductions because he couldn't properly prove the deductions. Pretty simple concept. If the IRS requires you to substantiate a deduction, you'll need to provide written proof that the deduction occurred. The easiest way to prove a deduction is to show the following:
a) The invoice for payment, and
b) Proof of payment, which can be a canceled check, cash receipt, or credit card statement.
Mr. Johnson didn't have this documentation for many of his deductions - no invoices and no receipts...basically nothing to prove that he actually paid these expenses. He liked to use cash and documented very little of his purchases. Instead of documenting the deductions the right way, Mr. Johnson would sit down around tax time and try to "remember" how much he spent on certain business expenses. He had run his business for so long that he just"knew" how much he spent on certain items for the business throughout the year. As far as I know, Mr. Johnson wasn't trying to trick anybody, but that reasoning is not going to fly with the IRS.
The million dollar question is then, if you know you paid for something, but you don't have the receipt, should you still report the deduction? For all practical purposes, the answer is you only need the receipt if you get audited. It's one of those, "I'm joking, but I'm not joking" type deals. If you don't have the documentation to prove a deduction, you can still report it if you want to because you only have to prove it if you get audited. But keep in mind, if you do get audited and you know you don't have proper documentation for certain deductions on the return, you should be prepared to lose those deductions.
Mr. Johnson wasn't done through. The second mistake made by Mr. Johnson was a bit more egregious.
MISTAKE #2: CLAIMING DEDUCTIONS FOR THE VALUE OF YOUR TIME IS NOT APPROPRIATE
It turns out that Mr. Johnson reported deductions that were, you know, like, not real. For example, Mr. Jones owned several rental houses which required maintenance and repair. At times, Mr. Johnson would do the work himself instead of paying someone else to do it.
The value of Mr. Johnson's time is not deductible, so Mr. Johnson just estimated what he would have had to pay someone else to do the work which he did himself and then he reported that estimate as a deduction. Doesn't work that way. You cannot deduct the value of your time for work you did. You have to actually pay someone to do the labor.
Bottom Line: Remember the mistakes made by Mr. Johnson when you itemize your deductions. If you keep proper documentation for your deduction expenses and don't make stuff up, and audit letter from the IRS shouldn't be as scary. But of course, an audit is always scary and it can be extensive. The Tax Experts at Wolf Tax are available to provide the professional representation that you'll need to fight any audit.