Audit Proof your Records

Ten Forty + Quality Tax Preparation & Financial Services 281-397-7777 Fax 281-397-7443 Tips to Audit-Proof Your Records You may hate the keeping records part of the tax system, but it’s critical to your tax health. It’s also important to your business health. Good records help you monitor and improve your business. Do not depend on the IRS for mercy when it comes to your tax records. You will never find the word “mercy” in the same sentence with the IRS. It does not exist in the code or the regulations. Since there is no mercy, you have no choice but to get your records right. Getting your tax records right is not difficult when you know what to do. This article gives you the record-keeping basics you need and helps you spend less time keeping records. Checking Accounts The first rule to keeping good records: Do not commingle activities in your checking accounts. Most taxpayers should maintain separate checking accounts for · husband, · wife, · each separately reported Schedule C business, · each corporation, and · rental property (if there are substantially different types of rentals, then additional separate accounts may be necessary here). Example. You operate your business as a proprietor and cover your spouse with a Section 105 medical reimbursement plan. If you have only one checking account for the family and the proprietorship, writing the reimbursement check to yourself likely would destroy the Section 105 plan. That’s how Darwin Albers lost his Section 105 plan deductions. The Albers case is just one example of how using a joint account for both business and personal reasons causes a loss of deductions. Rule 1. Maintain a separate checking account for each business activity. Deposit Receipts in the Account for the Business That Earns the Money You may not earn income in your personal name and then assign that to your corporation. Income is taxed to the person or entity that earns it. You don’t want business receipts in your personal accounts or personal receipts in your business accounts. The separate checking gives you the ability to avoid commingling which is something to avoid always. When the IRS gets confused looking at your accounts, it simply taxes all the income. True, you might be able to undo that assertion and prove that all the deposits are not taxable, but that takes time and effort. By simply getting the deposits right to begin with, you save yourself from confusing the IRS—which saves the IRS, in turn, from frustrating you. Record Deductible Expenses Daily We heard you screaming when you saw the word “daily” above. Don’t worry, the daily requirement, which actually existed for auto expenses in 1984, was repealed and replaced with an adequate records requirement. So the IRS now gives you a week to meet the “timely” and “adequate” records requirements for vehicles, travel, entertainment, and listed property. We doubt that you will, but you probably should thank the IRS for the one-week rule. Why? Because recording your business expenses within one week makes good business sense. After all, if you wait too long, you won’t remember the nature or reason for the expenses. Keep Logs To deduct your vehicle expenses, you need proof of business use. This is true regardless of the form your business takes. Thus, if you operate as a corporation, you (the employee) must submit proof of your business use to the corporation. We recommend that you keep your vehicle mileage in your appointment book so it reflects your business activities for each day. Further, the appointment-book recordings facilitate use of a sampling method, such as the three-month log of business miles to prove business use for the year. If you own rental properties, you should track for at least three consecutive months the time spent on the rentals, to prove material participation and, if applicable, real estate professional status. If you claim a deduction for an office in the home, you should track time spent working in the home office. Your use of the home office must meet the “regular use” test. If you use your home office a little more than 10 hours a week on a consistent basis, you meet the requirements for regular use as set out in Green. Record Required Elements of Travel and Entertainment Regardless of business form, you need to prove, for each day of travel, where you were and why you were there. For entertainment, you need to record who, what, when, where, why, and how much. You can meet all these requirements by adding a short note to the receipt with the · name of the person you entertained, and · why you entertained this person. The “why” should relate to the immediate or future business benefit you hope to achieve with the entertainment. Try to keep the “why” explanation to seven words or less. We made up this seven-word guideline and have used it successfully for the past 30 years because it makes for a clear explanation of the entertainment activity. Further, you have additional corroborative evidence in your files and e-mails. The receipt contains the remaining documentation for · what (e.g., food, drinks, golf); · when (date); · where (name and address of the place); and · how much. If you operate as a corporation, you need to turn the documentation in to the corporation, and the corporation needs to either pay for the entertainment and travel expenses directly (say, with a corporate credit card) or reimburse you for the amounts spent. Make certain the corporation pays. You do not want to claim deductions for these expenses as employee business expenses. Best Advice For all expenses, from the purchase of your desk to pens for your office, keep these two points in mind: 1. You need to prove what you bought. 2. You need to prove that you paid for what you bought. Step 1: What you bought. Generally, the receipt or invoice will prove both the description of what you bought and how this purchase relates to your business. With entertainment at a restaurant, the receipt that proves what you bought is the receipt that shows the details of what you had to eat and drink. Step 2: What you paid. Tax law considers the charge to a credit card as payment, regardless of when the card gets paid.6 Thus, you can prove payment by credit card with either the credit card receipt that shows the total charge or the credit card statement. The canceled check proves payment by check. The bank statement proves payment by electronic transfer. As a general rule, don’t pay in cash. These are the first questions an auditor will ask about a cash payment: · Where did the cash come from? · How good is the trail of cash to the payment? · Was an ATM withdrawal evident before the cash payment? · Did the taxpayer really spend the cash or just make up this deduction? You face no such questions for payments by check or credit card. Petty Cash For most small businesses, a petty cash system is a disaster. If you have such as system and it works well for you, fine. If not, use the reimbursement method. Under the reimbursement method, if you or an employee spends money on behalf of the firm, you simply have the firm write a check to reimburse the expense based on documentary evidence such as · a receipt for the expenditure, and · an expense report for the auto mileage, if applicable. The reimbursement method is direct, clear, and less subject to mistakes than the petty cash system. Statute of Limitations The “statute of limitations” refers to the period of time when you and the IRS can make changes to your tax returns. Most taxpayers think of the limitation periods as the time frames during which the IRS can audit returns. The periods laid out in IRS publications are listed below:7 · Three years, if you filed on time or with extensions and did not understate your income by 25 percent or more, and did not file a fraudulent return Six years, if you filed on time or with extensions but understated your income by more than 25 percent · Forever, no limit, if you filed a fraudulent return · Forever, no limit, if you did not file a return Three years after filing or two years after the tax was paid, if you filed an amended return or other change to your original return, such as a quick claim for refund · Seven years, if you filed a claim for a loss from worthless securities or a bad-debt deduction If you have employees, you must keep your employment tax records for four years after the date the tax was paid or due, whichever is later. How Long to Keep Records The statutes of limitations tell you the time period during which the IRS can audit your returns. If your returns are examined, you need tax records that prove your deductions. This means you need to keep your records for longer than you might think. Assets. Assets such as your car, desk, computer, and office building are relevant to your tax return during their depreciable class lives. · If you are depreciating the assets, the depreciation shows up in those returns. If you used Section 179 to expense the assets, then you have potential recapture during the depreciable class life. Example. You buy a $1,500 desk and depreciate it over the seven-year MACRS life (this takes eight years). In year eight, you still have to prove the depreciation. That means you need the original purchase record in year eight. You also need the purchase record in year eleven to meet the three-year statute of limitations on this year eight deduction. If you used Section 179 expensing on this desk, your records requirement is identical to the example. You have recapture exposure during the eight years, and you need to hold onto your proof of purchase for three years beyond that, or 11 years in total. Make this easy. For any asset that has a life of more than one year, keep the purchase records in a permanent file. With a separate permanent file of asset purchases, you don’t have to think or worry about class lives or limitation periods. The five-drawer method. To use the five-drawer method, you need to keep your permanent files in another place (such as a different set of file drawers). Next, you must report your income and file and pay your taxes on time or with extensions, to limit your audit exposure to three years from the date you filed your return. If you fit this profile, the five-drawer system can simplify your records retention. It works like this: · Drawer 1: Accumulation of current year tax return information · Drawer 2: Last year (tax return filed this year, say on April 15) · Drawer 3: Two years ago · Drawer 4: Three years ago · Drawer 5: Four years ago At the beginning of each year, the contents of drawer 5 go to the dump and all drawers move down one notch. Employment taxes. If you have employees, you must keep all employment tax records for at least four years after the date the tax becomes due or is paid, whichever is later. Again, simplify. If you have employees, use a six-drawer method. Toss the sixth drawer when your four-year statute expires. Thoughts That Make Keeping Records More Pleasant Think of your business records in the way you think of golf handicaps and batting averages. The records tell you what you need to do to continue improving. The fact that the tax law requires the records is another incentive to keep them. But really, if no tax law existed, as a businessperson you would want records that show you where you have been and where you might go. Please call us if you have any questions. 2016 Tax Extension Deadlines are approaching. Go to www.tenfortyplus.com and complete your online organizer (under forms and documents). Make your appointment using our online appointment system. Call 281-397-7777 and get a user id with password set up so you can send us all your information through our online secure portal and do your taxes from the comfort of your home or office or come see us at our office. 1040 + Quality Tax Preparation & Financial Services Joseph C Becker EA www.tenfortyplus.com 281-397-7777, Fax 281-397-7443 joeb@tenfortyplus.com Contact Us There are many events that occur during the year that can affect your tax situation. Preparation of your tax return involves summarizing transactions and events that occurred during the prior year. In most situations, treatment is firmly established at the time the transaction occurs. However, negative tax effects can be avoided by proper planning. Please contact us in advance if you have questions about the tax effects of a transaction or event, including the following: • Pension or IRA distributions. • Retirement. • Significant change in income or • Notice from IRS or other deductions. Revenue department. • Job change. • Divorce or separation. • Marriage. • Self-employment. • Attainment of age 59½ or 70½. • Charitable contributions • Sale or purchase of a business property in excess of $5,000. • Sale or purchase of a residence or other real estate.