Small Business Taxes & ManagementTM--Copyright 2020, A/N Group, Inc.
We've often mentioned the importance of adequate documentation to substantiate a business deduction. Ideally you should have a canceled check and an invoice marked paid with the serial number of the item purchased or a description of the work performed. While that may be viable for certain big-ticket assets, realistically, that's not often the case for most expenses. And the IRS knows that. There are many other ways to document expenses that are acceptable. However, you should be able to show that payment was made (e.g., a canceled check, credit card receipt) and the nature of the item purchased (e.g., an invoice with a description of the item).
On more than one occasion we've heard taxpayers say "I'll remember the facts if I'm audited". Or "Fred will back me up." First, chances are you won't be audited until two years after the return is filed. And you may not be asked about the transaction until sometime later. Moreover, there's a good chance the return was filed a year after the transaction. Many people will not accurately remember the details three or more years later. Will Fred back you up? Probably, if he's still around and it doesn't cause him a problem. Don't take a chance.
Travel and entertainment, auto expenses and charitable contributions. There are separate rules for these items, and they're very strict. We won't deal with them here.
Canceled check. The check should have the payee and should show the cancellation on the back. Why the cancellation? In the case of large or unusual purchases, the IRS may check that the payee actually cashed the check.
Checks not returned. Many businesses (and individuals) no longer have their checks returned. The IRS will accept images of the check. In order to be accepted as proof of payment, the statement must exhibit a high degree of legibility and readability. If your bank doesn't send you hard copies of the images, you should be able to download PDF copies of the checks. Don't rely on the bank to save statements and check images. After a certain period of time you may not be able to retrieve them without cost. Download statements and images each month. (That's good advice for other statements where you may no longer receive hard copies such as telephone bills, etc.) You may also be able to show proof of payment by providing:
An account statement prepared by a financial institution showing check clearance will be accepted as proof of payment if the statement shows:
Credit/debit cards. If payment is made using a credit card, the IRS requires that you have an account statement that shows the amount of the charge, the date of the charge (i.e., transaction date), and the name of the payee. If payment is made using a credit card, the IRS requires that you have an account statement that shows the amount of the charge, the date of the charge (i.e., transaction date), and the name of the payee. Most likely your credit card company is already mailing you these statements monthly or providing them online. If online, download them each month. Cards specifically designed for business will also provide year-end summaries. Note, this will only provide proof of payment.
Electronic funds transfer. If you transfer funds electronically, the IRS will accept an account statement prepared by a financial institution showing an electronic funds transfer as proof of payment if the statement shows:
Invoice. You must have an invoice or other documentation showing what you purchased. A canceled check without an invoice or some other document showing the item purchase could be a problem. Statements from a supplier may be substituted, but only if they show the item. Fortunately, since most businesses are computerized, a supplier could generate a duplicate invoice if an agent insisted on seeing one. But it's best not to rely on that. When paying invoices, write the check number and amount paid on the invoice and the invoice number on the check so that you can cross reference them later if necessary.
Save all invoices. Don't assume the IRS will accept a check written to the telephone company without an invoice. The check could have been for payment of your personal line.
What about independent contractors? Even for small jobs, ask for an invoice. In addition, make sure you give the party a Form 1099, if applicable. No 1099? You could lose the deduction or be subject to penalties. What about those cash payments to some contractors? No invoice and no record of payment probably could mean no deduction.
Cash register tapes. You go to the local hardware store to purchase some fasteners for the business and get only a cash register tape with minimal or no details of the items purchased. Will it fly? If the total is relatively small and it's not a common occurrence, an agent probably won't question it. Write a description of the items on the slip--1 gallon paint for repainting wall; bolts for shelving. Fortunately, most stores now print the detail on the tape.
Caution on tapes. Many businesses, including major big box retailers, use heat sensitive tape to print receipts. The life can vary widely from less than 1 month under poor conditions (the glove box of your truck) to several years under good conditions. Don't take a chance. Make photocopies or electronic copies of the tapes. Store in a cool, dry place.
Reasons for purchase. The business purpose of most of your purchases may be obvious. An agent is unlikely to question a laser printer cartridge, a computer, a book on how to use a computer program, etc. But be prepared for questions if the invoice or tape shows the purchase of items that normally wouldn't be business related or could be personal as well as business. For example, the purchase of a book with no clear business relationship, power tools by a computer consulting business, etc. Don't take a chance on remembering the reason several years later when you're audited. Write the business reason on the receipt or attach a description to the receipt.
Avoid personal purchases through the business. It's convenient to use a company check or credit card to purchase personal items. Resist the urge. Your accountant may spend time making entries to adjust your expenses. If he doesn't or misses some that an agent catches, the agent might increase his scrutiny of all your expenses. You could be liable not only for additional taxes and interest but also an accuracy-related penalty.
Caution. In flagrant cases the IRS may claim fraud, particularly if other indications are present. While unusual, it can happen. For example, the general contractor who deducts materials ostensibly for client jobs and uses them to build or repair his vacation home.
Checks made to cash. While you should try to avoid them at all cost, that's nearly impossible. The larger the amount, the more careful you should be. Be sure to indicate on the check what the purchase was for. This is one time when an invoice can be critical. An invoice marked paid in full would certainly help your position. But be aware, if the vendor is asking for cash or a check made to cash, he's probably not going to report the income.
Cash expenses. Some expenses will be so small that an invoice or even a cash register tape is impractical. You may also be paying in cash rather than by using a check or credit card. Keep a diary showing the date, place, amount, and description of the item purchased or service obtained. For example, "11/20/12, Madison Hardware, $2.25, nuts and bolts for shelving".
Business standards for documentation. Any invoice, contract, etc. should be up to industry standards. For example, a receipt from a local deli for sandwich platters for the office party may be scribbled on an invoice without a number (it should, of course, be dated). But an invoice for a collision repair on the company truck should contain detailed parts and labor, since the shop normally does that for insurance purposes.
Other documentation. You should also retain other documentation that might be used in addition to or in place of an invoice. For example, a contract for services, lease on equipment or office space, warranties on equipment, service contracts, etc.
Petty cash. If you keep a petty cash fund, slips showing expense reimbursements should be sufficient to document the expenses. That's assuming the expenses are small, as one would expect. Make sure that the nature of the expense is clear from the slip. Employees should check that and, if not, write on the slip the type of expenses and the vendor.
Expense reports. We're not talking travel and entertainment here. It's not unusual for an employee to purchase office supplies, small equipment, shop supplies, maybe even items to be used on the manufacturing floor that may be critical. Officers and especially officer/shareholders often pay company expenses out of their own pocket. While it's best to avoid such situations, that's not always possible. The correct procedure is to have the employee file an expense report and attach the documentation. The company should then cut the employee a check for the amount documented. For example, you need a color printer for a rush job. An employee buys an inkjet printer with his own credit card. He should file an expense report and attach the credit card slip and any other documentation from the store.
This can be especially critical when it comes to an employee/owner/shareholder. Without the expense report the company can't take the deduction because the business didn't pay for the item; the employee/owner can't take the deduction because it's not a valid deduction for him or her. Special rules apply to partnerships and there's an exception if the business has a policy of not reimbursing. Talk to your tax advisor.
There's another approach for an employee/owner/shareholder. Pay for the item out of your own pocket and make it a capital contribution to the business. That can make sense on larger purchases. For example, a big box store is having a sale on computers. You purchase six laptops for the office for a total of $7,500. It's recorded on the books as a capital contribution and an asset purchase. The problem is often in the accounting. Since it's not going through a business account, a bookkeeper is going to have to post the entry. It also means you're not going to get reimbursed. Finally, if you have partners or other shareholders, things can get messy. One time it makes sense? When starting the business.
Loan documentation. Getting a loan from your local bank or other commercial lender? Documentation (as long as you have it in your files) is rarely a problem. But small business owners often borrow from stockholders or owners, friends, associates, or relatives. That's just when good documentation is more important, but it's usually deficient or nonexistent. (Same rules apply when the business loans money to a shareholder, partner, etc. If the business pays interest be sure to issue a 1099-INT for amounts over $10.
A full discussion is beyond the scope of this article, but you should have a written promissory note stating the term of the loan (don't make it a demand note or open-ended), the interest rate, and the parties. The business should carry it on the books as a loan. The loan should be commercially feasible. There are other requirements. Talk to your tax advisor, accountant, or attorney. If you're audited the IRS is certain to request documentation. Can't make the payments on time? Talk to a tax professional as soon as possible. Since the numbers are often significant, you don't want to have the IRS reclassify a loan as equity capital, or worse.
Loans between related parties such as two related businesses, loans between relatives, or even between friends should be documented. Without the documentation deposits into a bank account could be characterized as unreported income by the IRS. The loan may be recharacterized as a gift, etc. (Avoid cash. Advance the principal and repay the loan with checks so that you have additional documentation.)
Related party transactions. Another IRS audit point. Loans between related parties (shareholders and corporation, relatives, etc.) can be recharacterized by the IRS. But so can other transactions. The sale of a vehicle or other property at other than the fair market value can be a dividend or capital contribution to a business. If there's no published price for the property (e.g., a blue book on a car) consider an appraisal. Make sure you have at least the same documentation you would for a transaction with an unrelated party.
Purchase products or services from relatives? Make sure the terms are similar to what they'd charge other businesses. (And vice versa if you perform services or sell to them.) Get an invoice detailing the work performed.
Employing your relatives in the business? You should be able to justify why you're paying them. You should pay them the same as you would an outsider doing the same work. If there are no comparable in house positions, you should be able to substantiate the amount. If you don't have a time clock you should document their work by maintaining a time sheet including hours and work done.
Carrying through. You went to your accountant and he and your attorney drafted a purchase and sale agreement so that your S corporation could purchase a small business your brother owned. Now make sure you carry out the letter of the agreement. The only thing worse than not documenting the transaction is documenting it and not following through.
1099s Be sure to issue 1099s to independent contractors if required. It's a critical part of the required documentation.
Unusual transactions. Not infrequently small business owners engage in transactions that would be viewed out of the ordinary if compared to mid- to large-sized businesses. It could be as simple as a barter transaction between an electrician and an excavator or a transaction involving several farmers trading services, produce, or property. The more out of the ordinary the transaction, the more you want to be sure to document it.
Spouse or relatives on a business trip. The general rule is that you can't deduct the expenses of the other party unless he or she is an employee and there's a bona fide business reason. Two points here. First, if you want it to be deductible and you meet these requirements, be sure to document the reason for the travel. Keep a diary or log if there's any question. Second, if it's not deductible, be sure to reimburse the business for the airfare, hotel room (the spouse's portion), etc.
Business and pleasure. You can combine them, but you've got to be careful. We won't go into details, but only the business portion is deductible. Friday and Monday meetings out of town, but you stay over the weekend. You can deduct the whole stay. Friday only but you leave Monday afternoon--only Friday hotel and meals are deductible. Going to that convention and taking your spouse on his birthday? Be especially careful about documenting the reason for the trip. Same for trips around holidays. One such trip may not be noticed, but multiple trips with your spouse or other relatives may raise questions.
Cost of goods sold. While technically not a deduction (it's an adjustment to income), the IRS can challenge the amount. If you maintain an inventory, you should do a physical count at yearend.
Cohan rule. The last resort. It's called the Cohan rule because it evolved from a court case where the taxpayer was George M. Cohan. Cohan claimed travel and entertainment expenses for which he had no receipts. The court allowed him a deduction based upon the fact he was able to convince the court he incurred expenses but did not have proof of payment or the actual amount. Ironically, this rule cannot be applied to travel and entertainment expenses any longer. Now if required, no receipt, no deduction, no exception for those expenses.
How does the Cohan rule work today? If you can show you definitely incurred the expenses and are entitled to a deduction but don't have the receipts or proof of payment, the court may allow a deduction based on an estimate. But there has to be some basis on which the court can make the estimate. For example, you have no receipts to prove your fuel oil expense for 2019 because you inadvertently destroyed the bills. In addition, the company went out of business. Clearly you incurred some charges to heat your building. The court may estimate the expense based on an average of fuel bills for several years.
This is a last resort for a number of reasons. First, you may have to go to court to get the deduction. Second, the court is almost assuredly going to try and underestimate the amount of your deduction. Third, the rule will probably not be applied if you have access to the documentation but don't produce it (e.g., you could ask a vendor to produce the necessary statements, even if it cost you). Fourth, you'll still have to convince the court you incurred the expenses. It may believe your testimony; it may not. You'll be on safer ground if you have some corroborating evidence.
Finally, the court is under no obligation to assist you. Even if your records are destroyed through no fault of your own (e.g., a fire), the court can require you to reconstruct. You'll fare better if you can show the lack of records either isn't your fault or, if it is, there are extenuating circumstances. For example, you gave the folders for two service providers to your accountant who lost them. If you simply have lousy recordkeeping and most of your documentation is missing, don't expect much sympathy.
Corroborating witnesses. Sometimes you can convince the IRS or the court you incurred the expenses by producing witnesses. That may work, but if the witnesses aren't convincing or the court believes the testimony may be biased (they're employees or relatives), it doesn't have to accept their testimony. And that happens in a high percentage of cases. Again, not an approach to rely on.
Business Purpose. It appears from court cases the IRS is questioning the business purpose more than 10 or 15 years ago. A power planer for woodworking may be questioned if you're not a contractor. Furnishings for your office, etc. If there's any possibility of personal use, write the business purpose on the receipt.
Rental properties. If you own rental properties as an individual, the same rules apply discussed below. But you should be even more careful when it comes to repairs and maintenance. Make sure it's clear the work was done on a rental property, and not your own residence or vacation home. Make sure any invoice for work includes the address of the property.
After-the-Fact. More than once taxpayers have said "if I'm audited I'll get the documentation". Sounds good but it rarely works out. By the time you're audited you won't remember the details and getting documentation from the vendor is sometimes difficult. It's always time consuming and expensive. It's a lot cheaper to get it up front and keep it.
Fraud. Making up documentation is called fraud. The IRS and the courts are very good at sniffing that out. There are many tell-tale signs. If you're found out you'll lose any credibility you had and be lucky if the government doesn't pursue a case of fraud.
Too much paper? In many cases you don't have to save paper copies. Electronic versions of statements received from vendors or others will normally suffice, but they must be readable. You can also scan documents and save them as electronic copies. If the documents are signed (e.g. a lease), you might want to retain an original copy. And consider retaining hard copies of important asset purchases. Talk to your tax advisor.
Retention time. You may have heard hold canceled checks and other documents for 3 years, but it's more complicated than that. Technically it's three years from the date you filed the return. But if the IRS suspects you underreported your income, it can go back 6 years. If it believes fraud is present, there is no limit. For assets such as autos, equipment, etc. you should retain all documentation for at least 3 years after the asset is disposed of. And longer retention periods can apply to employment records. If you need a single rule of thumb, use a 7-year holding period for most records. But the best approach is to check with your tax advisor.
Documentation vital. Based on an informal analysis, it appears that more taxpayers lose in Tax Court because they can't substantiate their expenditures than for any other reason. While the IRS sometimes does show some flexibility, it's generally a stickler for records and can disallow the smallest expenditure for lack of them.
Copyright 2020 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 07/24/20