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.
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:
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.
RELATED: Audit Survival Guide: How to Handle a Business Tax Audit in 2020
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:
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.
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.
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.
To talk with an experienced tax representative from our team, call (410) 872-8376“>(410) 872-8376 or use our online contact form.
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.
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