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.
Mr. Jones (a 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. The IRS was doing what it is allowed by law to do -- demand that the taxpayer prove that those deductions were valid.
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". 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'd 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."
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 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 -- which is non-deductible. 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.
If you ever get a letter from the IRS demanding 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.