In the past few years, Congress has passed legislation that is supposed to result in a more “sensitive” Internal Revenue Service. You know, one that is not such a lean, mean, tax-collecting machine. While we can say that this is somewhat true (hey the IRS really isn’t seizing houses any more), having been in this business for some time we do know there are some things the IRS doesn’t move on. And if you are in one of these high risk categories, then your return stands a greater chance of being selected for review or audit:
- High Wages
- Large Amounts of Itemized Tax Deductions
- Unreported Taxable Income
- Home Office Tax Deductions
- Unreported alimony
- Automobile Logs for people who use their car in business
A few months back, one of our clients (let’s call him Mr. Beegus) got one of those IRS “love letters” requesting some information about his return. To make matters worse, the IRS actually wanted to meet with Mr. Beegus in person to discuss the situation.
Mr. Beegus (a local business owner) was required to show up at the local IRS office with all his records. The IRS was questioning the legitimacy of several business deductions. With that said, the IRS was doing what it is allowed by law to do; demand that the taxpayer prove that those deductions were valid.
Turns out that Mr. Beegus lost the audit and ended up owing the IRS a significant amount of money – the additional tax, plus penalty and interest for late payment of that tax. Why did Mr. Beegus lose the audit? Well, he made two “classic” taxpayer mistakes:
First Mistake – “No Receipt, no deduction”
Mr. Beegus lost several deductions simply because he didn’t have the proper documentation to prove the deductions. What do we mean by “proper” documentation?
Well, if the IRS requires you to substantiate a deduction on your tax return, you must be able to provide written proof that the deduction really happened. The easiest way to prove a deduction is to hang on to:
a) The receipt or invoice
b) Proof of payment, which can be a canceled check, cash receipt, or credit card statement.
Mr. Beegus reported numerous deductions for which he simply didn’t have the documentation. No receipts, no canceled checks, no nothing. Turns out that Mr. Beegus was one of those “cash guys.” Maybe you know what kind of guy we’re talking about – he never wrote a check in his life, just carried a wad of cash around in his pocket. He paid for everything with cash, and never kept any of his receipts.
Every year he’d sit down with his wife and “remember” how much he spent on different things. No way to prove any of this, of course. He just had a “feel” for how much cash he had spent, and he had run his business for so many years that he just “knew” how much it cost to purchase certain things. Well, this is the kind of taxpayer that the IRS loves!
Despite the IRS being more sensitive, it really is true; if you can’t prove that you paid for something (with receipts, invoices, canceled checks, etc.), then you run the risk of them removing/disallowing the deduction in an audit.
One of the most common questions we’re asked by clients is this: “I know I paid for something, but I don’t have a receipt. Can I still report the deduction?”
Our response is usually this: “You only need a receipt if you get audited.”
At first, people don’t know if we’re joking or not. But the statement really does have some truth to it. If you don’t have the documentation to prove a deduction, you can still report the deduction (although ill-advised), because you only have to prove the deduction if you get audited. But if you do get audited, knowing that there are undocumented deductions on the return, be prepared to lose the deduction. Fair enough?
And here’s the other major mistake that Mr. Beegus made:
Second Mistake – Bogus/Fabricated Deductions
It turns out that Mr. Beegus wasn’t completely honest with us about some of his deductions. He reported deductions that simply were not real deductions. Here’s one example: Mr. Beegus owned several rental houses. These rental houses, of course, required maintenance and repair work. Many times Mr. Beegus would do the work himself rather than pay someone else to do the work.
Well, Mr. Beegus would estimate what he would have had to pay someone else to do the work that he did himself, and then he would report that amount as a deduction, even though he didn’t actually pay anybody to do the work.
In other words, Mr. Beegus deducted the value of his time – which is non-deductible.
This is an important point; you can never legitimately deduct the value of your time for work you did. You have to actually pay someone else to do the labor.
When it comes to preparing a tax return, sometimes people are tempted to push the envelope. They either report things they don’t have documentation for, embellish the numbers or completely put false information on the return. Like our president Jared says, it doesn’t matter who prepares your return. He’s not the one who will get the letter from the IRS, you the taxpayer will. At that point, it’s up to you to defend yourself as you were the one who signed the bottom of the return…
“Under penalties of perjury, I declare that I have examined this return and accompanying schedules and statements, and to the best of my knowledge and belief, they are true, correct, and complete.”
But, if you ever get a letter from the IRS demanding additional information, you’ll have nothing to worry about if you do exactly the opposite of what Mr. Beegus did. If you can properly document your deductions and assuming you have no bogus information, you’ll pass the audit with flying colors.