Congress recently passed legislation that is supposed to result
in a more "sensitive" Internal Revenue Service. You know, not
such a lean, mean, tax-collecting machine. I DON'T THINK SO!
Here's why.
A few months ago, one of my clients (let's call him Mr. Jones)
got one of those IRS "love letters" requesting more information
about his return, and the IRS wanted to meet with Mr. Jones in
person to discuss the situation (not a good sign!) Mr. Jones (a
local small 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 -- and so the IRS was
doing what it is allowed by law to do -- demand that the
taxpayer prove that those deductions were valid.
[By the way, most IRS audits are done these days by mail. Humans
are rarely involved in these so-called "correspondence audits."
Those big IRS computers can check and cross-check all kinds of
information that should be reported on your tax return. And if
something doesn't show up on the return that is easily tracked
by the IRS computers, then the computer just spits out a
not-so-friendly "discrepancy notice", which you can respond to
via mail.]
Turns out that Mr. Jones 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.
Jones' lose the audit? Mr. Jones made two "classic" taxpayer
mistakes:
MISTAKE #1: "NO RECEIPT, NO DEDUCTION"
Mr. Jones lost several deductions simply because he didn't have
the proper documentation to prove the deductions.
What do I mean by "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, and
b) Proof of payment, which can be 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. Turns out that Mr. Jones was one of those "cash
guys". Do you know what I mean by a "cash guy"? Maybe you know
what kind of guy I'm 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 would just 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! 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 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!"
Think about that for a minute! At first, many clients 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!
And here's the second major mistake that Mr. Jones made:
MISTAKE #2: BOGUS DEDUCTIONS!
It turns out that Mr. Jones wasn't completely honest with me
about some of his deductions. He reported deductions that simply
were not real deductions. Here's one example: Mr. Jones owned
several rental houses. These rental houses, of course, required
maintenance and repair work. Many times Mr. Jones would do the
work himself rather than pay someone else to do the work.
Well, Mr. Jones 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. Jones deducted the value of his time -- a
big No-No!
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.
Well, that's what happened to Mr. Jones. He made a couple
classic mistakes and paid the consequences.
I hope you benefited by learning what can happen in a real
audit. If you ever get a letter from the IRS that demands
additional information, you'll have nothing to worry about 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!
About the author:
Wayne M. Davies is author of the new eBook, "The Tax Reduction
Toolkit: 29 Little-Known Legal Loopholes That Will Reduce Your
Taxes By Thousands (For Small Business Owners and Self-Employed
People Only!) Don't file another tax return until you visit:
http://www.YouSaveOnTaxes.com/toolkit.html
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