If you are self-employed, you should know that you are more likely to have your individual tax returns audited by the Internal Revenue Service than your friends and family members who earn traditional Form W-2 income as employees. This is primarily the result of the IRS’s claims that most tax cheats are self-employed individuals who have either not claimed all their income or claimed tax deductions they were not eligible to take.
Most tax professionals stress that the best defense against the IRS in an audit is clear and accurate business record keeping, including retaining all necessary receipts. But it is not uncommon for busy individuals running a small business to forget to save their receipts, misplace them, or simply lose them. That is why we recommend you use a tax receipt organizer to properly track your records. So if you have received notice from the IRS that you are the subject of a tax audit and cannot find all relevant receipts, you are not alone. The IRS regularly deals with missing receipts and will often allow you to prove those business expenses using other means.
What to do if you don't have receipts
Facing an IRS tax audit with missing receipts? The IRS often allows self-employed taxpayers to substantiate expenses throgh other means
The IRS will only require that you provide evidence that you claimed valid business expense deductions during the audit process. Therefore, if you have lost your receipts, you only be required to recreate a history of your business expenses at that time.
However, if you cannot access your receipts when you are preparing your income tax returns, it is generally a good idea to substantiate your business’s expenses at that time and not claim your expense deductions based on a “best guess” or “estimate.” This will help ensure that the expenses you claim on your return correspond with what you can prove and save you a lot of time and effort if your return is selected for auditing.
How does the IRS choose who to audit?
According to the IRS, most tax returns selected for an income tax audit are chosen using two different methods:
- Random selection and computer screening. The IRS will sometimes select returns for audit based on a statistical model that compares the returns against the “norms” for similar returns. These norms are developed from IRS audits of a random sample of returns.
- Related examination. This is where the IRS selects returns for audit based on issues it has found with the tax returns or financial accounts of related taxpayers, such as business partners, whose returns have been selected for audit.
While the IRS will not specify exactly which factors it uses to determine which self-employed returns will be audited, most experts believe these items will raise red flags:
- Failure to report income to the IRS that is included on Form 1099s filed by businesses that have made payments to you.
- Deductions that seem suspiciously high, like claiming all of the costs related to your home are deductible, a deduction for the entire cost of your personal vehicle, or deductions for overly generous charitable contributions.
- Misclassifying employees or failing to issue information returns like Forms W-2 and 1099.
- Earning a high income. In recent years the IRS has been more likely to audit taxpayers with a taxable income of more than $1 million annually.
Remember, the IRS has three years from when an income tax return was due or filed to impose additional taxes, whichever date is later. So a few years may go by between the time you filed a return and when you will need to show your receipts for the tax year in question.
What happens during an audit?
Movies and TV shows often depict IRS audit notices as dramatic showdowns between the taxpayer and IRS agents. However, unless the IRS is alleging tax fraud or criminal activities, most are rather low-key affairs where agents ask the taxpayer for additional information and make adjustments to your tax bill or tax refund. The IRS will notify you of your audit by mailing you an audit letter by certified mail.
The majority of IRS audits fall into three categories:
- Correspondence Audits. During a correspondence audit, the IRS will send a letter to the taxpayer seeking additional information. This is usually the result of the taxpayer omitting income from his or her return or making a serious error. You will have the option of providing the necessary documents and receipts, paying the amount the IRS says is due, or disputing the IRS’s findings using an enrolled agent who is federally authorized to represent taxpayers.
- Office Audits. These are in-person interviews in the IRS office. You should have a CPA, enrolled agent, or tax attorney to accompany you for the interview with these types of audits.
- Field Audits. Field audits are rare for small businesses but can be very invasive and involve a review of a business’s processes, accounting procedures, and internal controls.
- Line-by-Line Audits. If your return is chosen at random, the IRS will review each line to establish the norms that will be used to trigger future audits.
It is during the tax audit that the IRS will expect you to provide receipts that documents all of your claimed expenses and related deductions.
If you are heading into an audit and know that you have not reported significant business income to the IRS, it is generally a good idea to hire a tax pro to represent you during the audit. Don't be too worried about jail time for the audit but you will need the assistance of a professional with a good understanding of tax law to guide you.
The Cohan Rule for missing or incomplete records
The issue of missing or lost receipts is so common that in 1930 the United States Court of Appeals For the Second Circuit outlined a rule on how the IRS should proceed in those situations. The rule was outlined in the court’s decision in Cohan v. Commissioner, which involved undocumented business deductions claimed by the famous Broadway showman George M. Cohan.
In his court case, Cohan claimed he was too busy to keep organized records to document the business travel and entertainment expenses he claimed on his federal tax return. The IRS sought to disallow all of the claimed deductions. The Second Circuit found that it was clear that Cohan had incurred some expenses, even if he could not substantiate the exact amounts. The court then laid out the Cohen rule, which states that a taxpayer who has no receipts documenting business expenses can still claim the expenses if they are reasonable and credible.
However, if you have no receipts, the IRS will not allow you to deduct the full amount of your expenses. The IRS will calculate the minimum standard amount for the service or item purchased by a taxpayer and will only allow a deduction for that amount.
It is often a lifesaver for business owners who cannot locate their receipts, but several recent rulings by the United States Tax Court have enforced limits on the use of the Cohan rule. In doing so, the Tax Court has said that the taxpayer needs to supply information to substantiate their claimed expenses. For example, the court refused expense deductions for claimed business travel when the taxpayer could not document every element of his trips, including the number of trips, when they were taken, and their business purpose.
Documenting your business expenses without receipts
The Cohan rule gives taxpayers a number of options beyond providing receipts for demonstrating that money was spent on business operations, but it will require a bit of effort on your part. It is a great audit defense tool. Doing the following will often allow you to reconstruct your business expenses in a manner that will satisfy IRS auditors:
- Contacting suppliers and service providers for invoices and receipts. Many businesses use automated billing and invoicing systems and can print up a copy on request. Even if the supplier still uses handwritten invoices, they may still be able to supply you with a carbon copy of the invoice that they keep for their records. Some businesses will charge a fee for the time their staff spends retrieving these records.
- Reviewing bank account statements, canceled checks, and credit card statements. These documents can be used to show the date payment was made and who received the payment. While this documentation will show that the expense was legitimate, it rarely shows why the payment was made.
- Reviewing your calendar. If you keep a business calendar, you may use that information to determine when and where you traveled for a job or business meeting. It can also be used to determine when you may have had an appointment with a service provider or meeting with a vendor.
- Searching old emails. If you can remember the approximate date or name of the other business, you may locate an email copy of the receipt you are looking for or some sort of confirmation email that shows you incurred an expense. These emails can also show that you made travel arrangements.
- Checking your smart phone’s location data. Your smart phone collects a startling amount of data about you and where you have been. Whether it be through your social media accounts or apps like Google, you may be able to track where your phone has been to show where you have traveled on business.
What happens after the audit
After the IRS has completed its audit it will notify you of the results within 30 days. You can then either accept the IRS’s findings or file an appeal. If you believe that the findings were not in keeping with the evidence or the U.S. Tax Code, you can file an appeal that will be heard by an IRS appeals agent who will make a determination based on the facts of your case.
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At Keeper, we’re on a mission to help people overcome the complexity of taxes. We’ve provided this information for educational purposes, and it does not constitute tax, legal, or accounting advice. If you would like a tax expert to clarify it for you, feel free to sign up for Keeper. You may also email firstname.lastname@example.org with your questions.