Maintenance
Part of Tax Records and Audits: Does a Stack Prove a Deduction?
What tax audits require of your records: three questions
An examiner starts with the return and works backwards. What a records request names, the three questions each figure must answer, and who carries the burden.
What to take away
- An examiner starts with the return and works backwards, asking for the records behind certain lines.
- Every requested figure has to answer three questionsdid it occur, was it for business, and how was it calculated.
- Section 6001 requires records sufficient to establish income, deductions and credits, and the burden of proof sits with the taxpayer.
- A record you rebuilt after the fact should be marked as rebuilt.
- You can retain representation, and you can appeal an IRS decision.
How an examination starts
An examiner starts with the return and works backwards. The request is usually the records behind certain lines, not every document you own. The IRS will tell you which records you will need, and the examination can proceed more easily if you gather them before any interview.
Read the request line by line before you pull anything. Each line it names is a figure on your return, and each figure has to be backed by a record you can produce. Gather what the request names first, and treat everything else as a second step.
The three questions behind every figure
Any number on a return has to answer three questions. Did the transaction occur? Was it for business? How was the figure calculated? The first is usually easy, and the other two are where examinations land, so prepare each requested figure with all three in mind.
Three things to support
- That it happenedstatement, invoice, contract
- What it was forbusiness purpose, recorded fresh
- How you arrived at the figureworkings kept
- Purpose and workingswhere disputes happen
- Occurrence evidenceusually the easy part
Occurrence is shown by the receipt, invoice or statement line. Business purpose is shown by what the item was and why the business needed it, which is the test in business deductions. Calculation is shown by the workings: the log, the schedule or the allocation behind the total.
Bank and card statements show that money moved. They do not show what it bought or why. A statement answers the first question only, and the tax records and audits article covers what a stack of statements can and cannot prove.
What the law puts on you
The authority is Internal Revenue Code section 6001 and the regulations under it. It requires records sufficient to establish income, deductions and credits. The burden of proof sits with the taxpayer, not the examiner, so an unsupported line is yours to solve.
Publication 583 is the readable version for small businesses. It splits the paperwork into gross receipts, purchases, expenses, assets and employment taxes. The table shows what a request can name in each category and which question that record answers.
| Category | Records a request can name | The question it answers |
|---|---|---|
| Gross receipts | Sales slips, invoices, receipt books, register tapes, deposit slips | Did it occur? |
| Purchases | Invoices, cancelled checks, card and bank statements | Did it occur, and what was bought? |
| Expenses | Receipts, petty cash slips, invoices, statements | Was it for business? |
| Assets | Cost, improvements, depreciation, disposal | How was the figure calculated? |
| Employment taxes | Wage and tip totals, deposits, Forms W-2 and W-4 | How was the figure calculated? |
Records that cannot be made afterwards
A few records lose force when they are assembled afterwards. Mileage logs and tip records are the clear cases. The IRS expects a car log written at or near the time of the trip, and Publication 463 sets out what a car record must show under both methods.
The mileage rates comparison covers why the format matters as much as the totals, and how the standard mileage rate and the actual expense method diverge. An examiner who asks for the log is asking for the workings behind a mileage figure.
How states and open matters stretch the file
Each state sets the period for the taxes it administers, so a state examination follows the state's own clock. Sales tax is the one that catches businesses out, because the state controls that file, not the IRS.
As a working range, most states ask for between three and five years. California asks for four years, Washington five, and New York three. Read the state's own page, because the period changes.
The clock can restart. An unfiled return extends the period. So does an open assessment or a live audit, so the file stays until the matter closes. The state business tax points cover the registration and filing side of the same duty.
When the request letter arrives
Answer the request as a list rather than a charge. Take each named line in order, pull the records behind it, and keep a copy of everything you hand over with the date it went out. The aim is a file another person can check.
- Read the request and write down each line or item it names.
- Pull the records behind those lines only.
- Test each figure against the three questionsoccurred, business, calculated.
- Mark any record you rebuilt as rebuilt, and say from what evidence.
- Tell your preparer, and decide whether to retain representation.
- Keep the whole file until the matter closes.
Know your published rights before the letter arrives. The IRS Taxpayer Bill of Rights lists the right to retain representation and the right to appeal an IRS decision in an independent forum. The tax recordkeeping checks cover how to capture records so the file is ready before any letter.
Common questions
What if a required record was never made?
Rebuild it from other evidence, mark what is reconstructed, and tell your preparer. Then fix the step that failed so the next year's file does not have the same gap.
Does an examiner ask for every document I own?
The request is usually the records behind certain lines, not every document you own. Answer what is named, and ask your preparer before you volunteer more than the request asks for.
Who has to prove a deduction?
The burden of proof sits with the taxpayer, not the examiner. That is why each figure needs a record showing that it occurred, that it served the business, and how it was calculated.
Can someone speak for me?
The Taxpayer Bill of Rights lists the right to retain representation. Ask your preparer or another professional you trust whether to use it before you answer the request.
