If you are a sole proprietor writing off your business expenses on a schedule C you should be aware that certain expenses claimed by sole props are especially vulnerable to IRS audits.
Because the IRS has limited resources to audit (or verify) that taxpayers are putting correct information on their returns, and thus, paying the correct amount of tax (and not cheating) the government targets certain types of filers more than others.
Specifically, the schedule C (and schedule E) filers are a favorite target. There are many reasons for this but the IRS can rely on two.
First, people running small businesses may not have the time or expertise to gather or create adequate substantiation of their business expenses. Many truckers, plumbers, landscapers, and so forth are busy driving, building, installing, or just simply working long hours, to keep up with daily or weekly bookkeeping entries. They simply do not have time to balance their check books, complete year-end balance sheets or do annual bank statement reconciliations. Bookkeeping can be, after all, a full time job in itself.
Therefore, even if the small business owner did incur a deductible business expense, being able to prove that to the IRS during an audit might be difficult to do and the IRS is fully aware of this.
Second, unfortunately, many small business owners wrongly pad their expenses, and the IRS is fully aware of this as well. Generally, most wage earners get a paycheck every two weeks and a Form W-2 every year. The IRS gets a copy of that W-2 from the employer (by way of the Social Security Administration) independently. So, the wage earner’s income is already known to the IRS. And items that a wage earner can usually deduct, like mortgage interest paid, state and local taxes paid and even charitable contributions are usually easy to verify. Thus, the wage earner can’t cheat (or can’t cheat much).
The sole prop however, self-reports almost everything. Gross receipts and deductible business expenses are reported on a return under an “on your honor” system. There is some independent reporting via Forms 1099, but certainly not in all cases. Thus, the sole prop can really put anything on a return and the chances are high that it will never be questioned. Please don’t do this.
As I said at the beginning, certain expenses are more vulnerable to the audit process than others. These extra dangerous expenses are auto expenses (mileage), travel, and meals and entertainment.
The reason these get hit first in most schedule C audits is that the substantiation requirements are generally higher than other expenses, and they are usually the most difficult to reconstruct.
There is a very famous tax case called Cohan v. Commissioner of Internal Revenue where the Tax Court generally stated that where the taxpayer is unable to substantiate the exact amount of an expense and evidence indicates that an expense was incurred, the proper amount may be estimated by the court.
Congress, not caring for this outcome, overruled this finding (by making a new law) when it comes to auto, travel, meals, and entertainment expenses.
Many tax pros will refer to these as § 274(d) expenses (that means section 274(d) of the Tax Code known as the Internal Revenue Code). This section provides that no deduction will be allowed (by the IRS or the Tax Court) due to approximations or unsupported testimony of the taxpayer for those certain expenses.
The IRS wants, and the tax regulations generally require, that a taxpayer substantiate mileage deductions by adequate records or by sufficient evidence, which will corroborate his or her own testimony. This really means that a taxpayer tells the IRS I drove 100 miles for business reasons, and the IRS says, that’s great, where’s the proof? The taxpayer’s word alone is not good enough.
For travel away from home, the taxpayer must have adequate records to prove the amount, the time, the place, and the business purpose.
For entertainment expenses, the taxpayer must have adequate records to prove the amount, the time, the place, the business purpose, and the business relationship.
For business mileage (travel not away from home), the taxpayer must have adequate records to prove the amount, time, and business purpose.
So as I said, the busy business man/woman, besides installing, building, servicing, or delivering, needs to find the time to create and keep adequate records of business expenses paid.
A brief note: With mileage, the taxpayer can deduct total business miles driven or actual auto expenses like fuel and maintenance. In my opinion, using the mileage rate is the better alternative in most cases, at least for the one person business because it is much easier to do. All you need to know is the number of business miles driven and the IRS mileage rate for that year. Under the actual expense option, substantiation like gas, repairs and maintenance receipts are needed. Also, the mileage rate is usually high enough to cover fuel costs plus upkeep (fuel efficient vehicles can help you here too).
Here are some small tips that I use to help me keep those records. If you have mobile email (a smart phone) Google map, Map Quest or whatever you use, total the miles and send yourself an email when you reach you destination (you also can find apps that will help you with this).
In the body of the email list the number of miles traveled, why you went there and who you met with (for example, 22 miles, met with Bob Smith, delivered widget). The email will automatically contain the date. Save your email to a folder for business miles. Later if you’re unlucky enough to get audited – print out the emails – now you have written records, that were made at the time the expense was incurred that include the number of miles driven (the amount), the date (time) and the business purpose (delivery of widget to Bob Smith).
Having dinner with clients? Use credit/debit cards if possible, the statements are good backup proof. On the back of the check or receipt, write who you had dinner with and what business was discussed. The receipt should be dated by the restaurant. This type of expense is a little different than the mileage example. The IRS will want to see that an expense was paid (which is why you need a receipt).
Thus, when audit time comes, you can prove with an adequate record (the receipt) that on a particular day (time) and expense was incurred (the dinner) and that you had a business discussion with a client or potential client (business purpose).
Another useful method is scanning receipts. I’ve done this myself. However, it too can become a chore. But if it works for you use it. Make flash drive back ups, per year (maybe two backups) and keep the flash drives with your tax return – someplace safe, cool, and dry – not a basement. For some unknown reason, the IRS seems to be able to sniff out a taxpayer that has been struck by a flooded basement, within a year or two right before an audit.
Remember, if you don’t have the substantiation to support your business deductions, the IRS will disallow them. It might be a burden to create adequate records, but getting hammered at an audit will make you wish you had.