It’s the type of nightmare that could make a person wake up in a cold sweat: you get a letter that says the IRS is going to audit your business, and you haven’t kept any kind of organized records. You’re missing all sorts of documentation and receipts for business expenses.
If you’re facing this worst-case scenario, you’re probably a little stressed. We’re here to help, and to tell you that you can get through this — you don’t need to flee to Mexico or buy a fake mustache and glasses. In this article, we’ll talk through your situation and explain how to put yourself in the best possible position to survive your audit.
Don’t Try to Hide From an Audit!
What you don’t want to do after receiving notice of an audit is ignore the problem. If the Internal Revenue Service has selected you for an audit, there’s no getting out of it, so you need to start taking proactive steps to get ready. (You’ll receive a letter from the IRS notifying you of an audit. Letters are the only way that the IRS notifies taxpayers that they’re being audited — IRS agents will never call you or show up at your home.)
During an audit, the IRS can examine income tax returns you’ve filed in the last three years. However, if the agency identifies a significant error, they can go back even further and look at additional tax returns — up to six years.
Although you can’t get out of an audit, you may be able to buy yourself more time to get organized. The IRS agent should accept a postponement request for certain valid reasons, such as:
- You need more time to gather your records
- You need more time to secure legal representation
- Your accountant or tax professional can’t make the date of the current audit
- You have a significant commitment at the time of the audit, and you can’t reschedule
- You have a medical issue that makes it impractical for you to participate in the audit
Incomplete Financial Records for an IRS Audit? You’re Not Alone
First, know that you’re far from the first person who’s walked into an audit with financial records that are less than flawless. In a perfect world, all of us would keep impeccably organized records that are ready at a moment’s notice. In the real world, many small business owners get behind on recordkeeping or never get organized in the first place.
In fact, missing or incomplete records are such a common issue during audits that the United States Tax Court established a tax law rule that allows taxpayers to recreate expenses when direct records don’t exist. This rule is called the Cohan rule because it originated in a 1930s tax court case, Cohan v. Commissioner.
The Cohan rule says that in the absence of receipts or other concrete proof of business expenses, a taxpayer can create an estimate for those expenses and then use those estimates to claim tax deductions and credits. However, the estimates for the expenses need to be reasonable.
So, if you’re trying to estimate the value of a power drill you purchased for your solo contracting business, you might use the market value of that model of drill to establish the value of the expense.
The Cohan rule can provide an “out” if you truly have no other way to prove a business expense, but it’s more of a last-ditch option. Some taxpayers who have gone to court with the IRS and tried to rely on the Cohan rule have lost. Also, the rule does not apply to travel expenses, entertainment expenses, gifts, and certain other types of property that are listed in section 274(d) of the U.S. tax code.
Gather as Much Evidence as You Can
Even if you don’t have receipts on hand, a little legwork may turn up a lot of useful documentation for your business expenses. Here are a few possible methods you can use to reconstruct your records:
- Reach out to vendors and suppliers for copies of receipts or invoices. Thanks to digital, cloud-connected point-of-sale and invoicing systems, it’s easy for many companies to store detailed records of purchases for many years. You may be surprised at how many receipts you can gather by getting in touch with businesses where you made purchases. The same goes for charitable contributions as well.
- Review your bank account statements and credit card statements. A line item on a bank statement may not be as good as a detailed receipt or invoice, but it’s much better than nothing when you want to prove that an expense was real and legitimate. Canceled checks can also substitute for receipts in many cases.
- Check your calendar or appointment book. If you can at least pinpoint when and where you made a purchase for your business, that’s a start.
- For mileage and travel expenses, check your social media history or cell phone records. If you’re a frequent social media user, you may be able to reconstruct your travel history use the location tags on your social media posts. Otherwise, cell phone records may require a bit more work to obtain, but they can help you figure out where you traveled and when. Once you’ve reconstructed your travel history, you can use a map program like Google Maps to figure out the exact mileage you traveled.
If there’s absolutely no way to get a receipt or other reliable record for an item you purchased for your business, then take a picture of the item. Write down everything you can remember about where and when you bought the item as well as approximately how much you paid. If you purchased the item new, look it up in the store’s print or online catalog and take a picture or screenshot to show the price. If you bought the item used, look up similar items on Craigslist or eBay to try and establish the item’s value on the secondhand market.
How a Tax Professional Can Help
Hiring a tax professional is usually a wise move in all but the most straightforward audit situations. (And if you’re missing receipts and other documentation, then your audit process probably won’t be a simple one.) An experienced tax representative can protect your rights and help you get organized. If your tax pro has handled audits before, they should know exactly what you need and how to gather it, and they’ve most likely represented people in similar situations to yours.
Not only can an experienced professional look out for you during an audit, but they can also take a lot off your plate and make the whole process much simpler and less stressful. Once you hire a tax attorney, enrolled agent, or another qualified representative, you may not even need to speak with the auditor anymore. You can focus on other things that demand your time while your tax representative manages the audit and keeps you in the loop.
After your tax audit wraps up, your tax professional should be able to give you advice that will help you avoid similar tax problems in the future. They should also be able to assist you with any tax preparation needs or refer you to a qualified tax preparer who will.
S.H. Block Tax Services Is Here to Help With Your Business Audit
If you or someone you know is facing a business audit, S.H. Block Tax Services is here to help. In fact, for existing clients, our software can alert taxpayers before an audit actually happens. This allows you to amend your income prior to the IRS getting involved. With this service, you can potentially avoid the time, money, and aggravation involved in a business tax audit.
The content provided here is for informational purposes only and should not be construed as legal advice on any subject. Please read our full disclaimer here.