Records and Expenses

The government has a responsibility to collect taxes to maintain our highways and roads, provide schools and facilities for our children and elderly, and keep our communities safe from crime. We pay our fair share of taxes to protect our freedoms and maintain our way of life, but there's no reason to pay more taxes than you have to unless you want to.

Maintaining good books and records is a chore for many people. Without it, a taxpayer can undergo a costly and challenging examination by the IRS. By properly utilizing the provisions of the Code and Treasury Regulations, one can eliminate excess tax liability. The IRS can reasonably determine, through a model, a percentage corresponding to each expenditure relative to the gross income reported for any business or individual. This is called a DIF Score. The higher the particular expense item, the higher the DIF score. Since the IRS examines two to three percent of the returns filed, most of the ones examined will carry the highest DIF scores.

Keeping adequate records is one way to help prevent a costly audit. Without it, there is nothing to substantiate a taxpayer's deductions. At the beginning of an audit, the examiner normally does a test check for a few months of expenses against their gross income. The typical focus is travel and entertainment expenditures for the self-employed, corporations, partnerships, and joint ventures. The auditor will look at a general ledger or a spreadsheet of the monthly expenditures to see if it appears reasonable or out of line.

To get a sense of what is being audited, let's perform one on a window washer named Willy. Willy derives substantially all his income as a wage earner but works part-time washing windows. He reports $1000 of income on a Schedule C form. Willy has two vehicles and utilizes a pick-up truck for the business for which he claims a 56 percent business usage. On his Schedule C, he claims $13,000 of depreciation for his new vehicle, $3,000 of automobile expenses, and another $900 for other expenses. The usage of the vehicle breaks out to 2,431 business miles and 1,910 of commuting miles to come up with the 56 percent business usage. Unfortunately for Willy, there are no logs showing time and place, and miles driven for each trip that produced his $1000 income. It would have been more reasonable for the taxpayer to utilize the standard mileage rate to determine a vehicle expense of $1374. This equivalent to 2431 miles x .565 cents per mile. Depending on the type of industry, the expense for automobiles is expected to range from 5 to 20 percent of the income reported. In this example, Willy is at risk of having a possible IRS examination.

To better understand what is required for record keeping I recommend reading Chapter 5 from IRS Publication 463:

http://www.irs.gov/publications/p463/ch05.html#en_US_2013_publink100034066

Within this chapter, you will find out what records are needed to prove expenses and what qualifies as adequate records. In addition to logs, statements, and account books, you should also maintain and keep documentary evidence such as receipts to support expenses. A good tax preparer will review and help qualify to an extent what is an adequate record to protect the taxpayer. This type of judgment is not provided with tax preparation software and is well worth the extra fee of an experienced tax preparer. Accuracy-related penalties resulting from the use of tax preparation software is increasing due to usage. Cases involving accuracy-related penalties are now being pursued by the IRS. No matter what choice you make, please make sure that your preparer or software vendor can provide representation during an audit.

For the full IRS publication on Travel, Entertainment, Gift, and Car Expenses see

http://www.irs.gov/publications/p463/index.html

About the author

As a former Internal Revenue Agent (International), now retired, I have experience with audits, tax research, court cases, Internal Revenue Code and regulations, and tax treaties. I'm currently a consultant to NAP Tax Service Inc in Orlando, FL.  If you have questions and would like a consultation, please feel free to contact me at eataxexpert at gmail.com or call me at (863) 274-3829.

Disclaimer: Much effort has been made to provide current and accurate tax information in this blog. Please use careful judgment before acting on any tax decisions based on any provided information. This blog is not a replacement for seeking professional advice based on your unique individual needs.