There is no such thing as a ‘perfect’ tax return. This is due to differing interpretations of the tax laws, human error and/or computer error. Further, tax returns may be chosen for examination on a random basis without any apparent errors. So, the question is not if you will be subjected to a tax audit but when. When that happens, the issues become which taxing authority is examining you, how good are your records, how much is it going to cost you in additional taxes, and who can help you keep that number as low as possible?
The following discussion will help you answer the most personally-manageable of those which is “How good are my records?” because supporting your numbers is more than half the battle.
Rule #1: Your tax return data is YOUR responsibility
- Your Preparer is NOT responsible for your tax return. However, many preparers will defend their work.
- Your Preparer MUST depend upon you for numbers and support. Your preparer’s responsibility is limited to helping you determine what expenses are legitimate deductions, guiding you in proper tracking procedures, and making sure your taxes are prepared properly based on the information you have provided.
- When you sign your tax return, you attest to its accuracy. You cannot avoid tax penalties and interest by claiming that you relied solely on a professional.
Rule #2: Documentation is the single most important part of surviving an audit.
- It is the key to supporting your tax position. You have the burden of proof as far as the IRS is concerned.
- It is required by law. If you don’t have good records, you can be held liable for fraud.
- Without it, your deductions may be disallowed. If your deductions are disallowed, you may end up with a huge tax debt plus penalties and interest on the tax.
Rule #3: The cost is high if your deductions are disallowed
Business owners are taxed on the profits of their business. Deduction disallowance increases taxable income and the resulting tax debt.
- Businesses are taxed at 15.3% of profit for Social Security (Self-Employment)
- PLUS the regular income tax on the profit of 10% or more
- PLUS a standard 10% penalty for late payment past the due date of the return
- PLUS .5% per month penalty during the period you fail to pay the tax
- PLUS an increase to 1% per month if the tax isn’t paid within 10 days of notice from the IRS that there is tax due
- PLUS 20% of any underpayment due to negligence or lack of reasonable basis
- PLUS 75% of any underpayment attributable to fraud
Rule #4: Avoid Penalties by Meeting Record Requirements
You can avoid most of the problems by maintaining accurate, reliable records of all activities.
- Become a Pack Rat – save each and every receipt. There is no such thing as too much information when it come to protecting yourself in a audit.
- Build a filing system separated into business and personal information by month and type of information.
- Permanent Records should include your home and auto purchases plus the records of any other assets you will keep for more than 1 year.
- Temporary or Regular Records should include any records that pertain to only one year such as checks, invoices and receipts and forms 1099 or other official tax paperwork.
- Daily Diary should keep track of mileage, appointments, etc.
- Use 3-part checks. Keep one copy in a numerical file and the other with the receipt.
- Use a business credit card to reduce your need for record keeping. The credit card invoice details purchases and create a paper trail for you. Some even provide annual summaries by type of expense.
Rule #5: Retaining your Records
You must keep your records in sufficient detail to establish your income and deductions. Such records must be available for inspection for as long as the contents are material in the administration of any tax law. What that means in English is:
- Three Year Rule – All taxes must be assessed by IRS within three years from the date the return is filed or due, whichever is later. The longer you wait to file, the longer they have to come after you and the longer you have to keep the records.
- Six Year Rule – If you omit an amount in excess of 25% of gross income, the 3-year limitation is automatically extended back another 3 years to 6 full years.
- No Limitation – If you fail to file or file a fraudulent return, there is no statute of limitations.
- Extension by Agreement – The statute of limitations may be extended by a written agreement between you and the IRS. We recommend this be avoided if at all possible.
We recommend keeping records for 7 to 10 years AFTER the date the activity occurred and/or the asset was sold or disposed of. Make certain you make copies of heat-sensitive receipts as they will fade very quickly and become useless. Lastly, electronic copies of bank and credit card statements and reports can be very helpful in any audit.