Ready for a scary tax story? A few years ago, one of my clients (let’s call him Mr. Jones) got one of those IRS “love letters” requesting more information. The IRS wanted to meet with Mr. Jones, a small business owner, in person to discuss the situation.

So Mr. Jones was required to appear at the local IRS office with his tax records. The IRS was questioning the validity of several business deductions. The IRS was doing what it is allowed by law to do — demand that the taxpayer prove that those deductions were genuine.

Well, unfortunately Mr. Jones lost the audit and ended up owing the IRS a chunk of change — the additional tax, plus penalty and interest for late payment. Why did Mr. Jones’ lose the audit? He made two “classic” taxpayer mistakes:

MISTAKE #1: “NO RECEIPT, NO DEDUCTION”

Mr. Jones lost some deductions simply because he didn’t have the proper documentation to prove them. What do I mean by “documentation”? Well, if the IRS requires you to prove a deduction on your tax return, you must be able to produce written proof that the deduction really occurred. The easiest way to prove a deduction is to keep:
a) The receipt or invoice, and
b) Proof of payment, such as a canceled check, cash receipt, or credit card statement.

Mr. Jones reported numerous deductions for which he simply didn’t have the documentation. No receipts, no canceled checks, no nothing. It turns out that Mr. Jones was one of those “cash guys”. Maybe you know what I mean — he never wrote a check or used a credit card. He just kept a wad of cash in his pocket and that’s how he paid for everything. And never never kept any receipts.

Every year he’d sit down with his wife and “remember” how much he spent. There was really no way to prove this. He just had a “feel” for how much cash he had spen. He ran 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! It really is true – generally speaking, except for a few rare exceptions, if you can’t prove that you paid for something (with receipts, invoices, canceled checks, etc.), then you run the risk of losing that deduction in the event of an audit.

One of the most common questions I am asked by clients is this: “I know I paid for something, but I don’t have a receipt. Should I still report the deduction?” My response is usually this: “You only need a receipt if you get audited.”

At first, people don’t know if I am joking or not. Well, I do make that comment with my tongue planted firmly in cheek, but there really is a lot of truth to it. If you don’t have the documentation to prove a deduction, you can still report the deduction (if you want), 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. Jones made:

MISTAKE #2: BOGUS DEDUCTIONS

It turns out that Mr. Jones wasn’t completely honest with me. He reported expenses that were not valid. For example: Mr. Jones owned several rental properties. These rental houses required maintenance and repair work. Many times Mr. Jones would do the work himself rather than pay someone else to do it.

So Mr. Jones would estimate what he would have paid someone else to do this work, and then he would report that amount as a deduction, even though he didn’t actually pay anyone.

In other words, Mr. Jones deducted the value of his time — which is big no-no. Take note — you can never deduct the value of your time for work you did. You must actually pay someone.

If you ever get a letter from the IRS demanding more information, you’ll have nothing to fear if you do exactly the opposite of what Mr. Jones did. If you can properly document your deductions and assuming you have no bogus information, you’ll pass the audit with flying colors.

Author Bio: Wayne Davies is the Internet’s Top Tax Preparer and the author of 3 tax-slashing ebooks on tax deduction strategies for small business owners and the self-employed. For a free copy of his Special Report, “How To Instantly Double Your Deductions” visit YouSaveOnTaxes.

Category: Business
Keywords: small business tax deductions, IRS audit