The IRS knows very well that you can claim anything in your books and on your tax returns, because you create or complete them yourself. For this reason, the IRS requires that you have documents to support the deductions you list in your books and claim on your tax return. In the absence of a supporting document, an IRS auditor may conclude that an item you claim as a business expense is really a personal expense, or that you never bought the item at all. Either way, your deduction will be disallowed. You can hire an accountant or bookkeeper to record your deductions in your books, but you must document your deductions yourself. You need to learn the IRS’s documentation rules and live by them each day. This post provides guidelines on: how to document, what document to keep and how long you should keep the record, and what if you don’t have proper tax records for your tax deductions.
What Supporting Documents Do You Need?
The supporting documents you need to prove that a business deduction is legitimate depend on the type of deduction involved. However, at a minimum, every deduction should be supported by documentation showing: what, how much, and who. That is, your supporting documents should show:
- what you purchased for your business
- how much you paid for it, and
- who (or what company) you bought it from.
Additional record-keeping requirements must be met for deductions for local transportation, travel, entertainment, meal, and gift deductions, as well as for certain long-term assets that you buy for your business.
You can meet the what, how much, and who requirements by keeping the following types of documentation:
- Canceled checks
- Sales receipts
- Bank statements
- Credit card sales slips
- Petty cash slips for small cash payments
Let’s discuss about those in a bit more details. Read on…
Canceled Check + Receipt = Proof of Deduction
Morgan, a sole proprietor photographer buys a $500 digital camera for his Business from the local electronics store. He writes a check for the amount and is given a receipt. How does he prove to the IRS that he has a $500 business expense? Could Manny simply save his canceled check when it’s returned from his bank?
Many people carefully save all their canceled checks [some keep them for decades], apparently believing that a canceled checks is all the proof they need to show that a purchase was a legitimate business expense.
This is not the case!. All a canceled check proves is that you spent money for something. It doesn’t show what you bought. Of course, you can write a note on your check stating what you purchased, but why should the IRS believe what you write on your checks yourself? Does Morgan’s sales receipt prove he bought his camera for his business? Again, no! A sales receipt only proves that somebody purchased the item listed in the receipt. It does not show who purchased it. Again, you could write a note on the receipt stating that you bought the item. But you could easily lie. Indeed, for all the IRS knows, you could hang around stores and pick up receipts people throw away to give yourself tax deductions.
However, when you put a canceled check together with a sales receipt (or an invoice, a cash register tape, or a similar document), you have concrete proof that you purchased the item listed in the receipt.The check proves that you bought something, and the receipt proves what that something is.
This doesn’t necessarily prove that you bought the item for your Business, but it’s a good start. Often, the face of a receipt, the sales slip, or the payee’s name on your canceled check, will strongly indicate that the item you purchased was for your business. But if it’s not clear, note what the purchase was for on the document. Such a note is not proof of how you used the item, but it will be helpful. For some types of items that you use for both business and personal purposes—cameras are one example—you might be required to keep careful records of your use.
Account [Bank] Statements
Sometimes, you’ll need to use an account statement to prove an expense. Some banks no longer return canceled checks, or you may pay for something with an ATM card or another electronic funds transfer method. Moreover, you may not always have a credit card slip when you pay by credit card—for example, when you buy an item over the Internet. In these events, the IRS will accept an account statement as proof that you purchased the item. The chart below shows what type of information you need on an account statement. Here is how to prove payments with bank statements:
If payment is by: The statement must show:
Check – Checks number
– Payee’s name
– Date the check amount was posted
to the account by the bank.
Electronic funds transfer – Amount transferred
– Payee’s name
– Date the amount transferred was posted
to the account by the bank
Credit card – Amount charged
– Payee’s name
– Transaction date
Using a credit card is a great way to pay business expenses. The credit card slip will prove that you bought the item listed on the slip. You’ll also have a monthly statement to back up your credit card slips. If you’re a sole proprietor, you should use a separate credit card for your business.
If your business is organized as a corporation, LLC , LLP , or partnership, it’s best that the card be in the Business’s name. That way, you avoid paying for business expenses with your personal funds and then having to go to the trouble of being reimbursed by your business.
Automobile Mileage and Its Expense Records
If you use a car or other vehicle for business purposes other than just commuting to and from work, you’re entitled to take a deduction for gas and other auto expenses. You can either deduct the actual cost of your gas and other expenses or take the standard rate deduction based on the number of business miles you drive. Either way, you must keep a record of:
- your mileage
- the dates of your business trips
- the places you drove for business, and
- the business purpose for your trips.
The last three items are relatively easy to keep track of. You can record the information in your appointment book, calendar, or day planner. Or, you can record it in a mileage logbook—you can get one for a few dollars from any stationery store and stash it in your car glove compartment.
Calculating your mileage takes more work. The IRS wants to know the total number of miles you drove during the year for business, commuting, and personal driving other than commuting. Commuting is travel from home to your office or other principal place of business. If you work from a home office, you’ll have no commuting mileage. Personal miles other than commuting include all the driving you do other than from home to your office—for example, to the grocery store, on a personal vacation, or to visit friends or relatives. There are several ways to keep track of your mileage; some are easy, and some are a bit more complicated.
52-Week Mileage Book
The hardest way to track your mileage—and the way the IRS would like you to do it—is to keep track of every mile you drive every day, 52 weeks a year, using a mileage logbook or business diary. This means you’ll list every trip you take, whether for business, commuting, or personal reasons. If you enjoy record keeping, go ahead and use this method. But there are easier ways. For more details discussion read another post of mine: Basic Tax Rule For Vehicle Expense.
Entertainment, Meal, Travel, and Gift Expenses
Deductions for business-related entertainment, meals, and travel are a hot button item for the IRS because they have been greatly abused by many taxpayers. You need to have more records for these expenses than for almost any others, and they will be closely scrutinized if you’re audited. For more detail explanation about this you may want to read another post of mine: Tax Deductions On Meal and Entertainment Expenses.
Receipt or Credit Card Slip Alone
An easy way to document an entertainment, gift, travel, or meal expense is to use your receipt, credit card slip, invoice, or bill. A receipt or credit card slip will ordinarily contain the name and location of the place where the expense was incurred, the date, and the amount charged. Thus, three of the five facts you must document are taken care of. You just need to describe the business purpose and business relationship if entertainment or meals are involved. You can write this directly on your receipt or credit card slip.
Receipt Plus Appointment Book
You can also document the five facts you need to record for an expense by combining the information on a receipt with entries in an appointment book, day planner, calendar, diary, or similar record.
Appointment Book Alone
If your expense is for less than $75, you don’t need to keep a receipt [unless the expense is for lodging]. You may record the five facts in your appointment book, dayplanner, daily diary, or calendar or on any other sheet of paper.
Listed property refers to certain types of long-term business assets that can easily be used for personal as well as business purposes. Listed property includes:
- cars, boats, airplanes, motorcycles, and other vehicles
- cellular phones, and
- any other property generally used for entertainment, recreation, or amusement—for example, VCR s, cameras, and camcorders.
Because all listed property is long-term business property, it CANNOT be deducted like a business expense. Instead, you must depreciate it over several years or deduct it in one year under Section 179. With listed property, the IRS fears that taxpayers might claim business deductions but really use the property for personal reasons instead. For this reason, you’re required to document how you use listed property. Keep an appointment book, logbook, business diary, or calendar showing the dates, times, and reasons for which the property is used—both business and personal. You also can purchase logbooks for this purpose at stationery or office supply stores.
Exception to Record-Keeping Rule for Computers
You usually have to document your use of listed property even if you use it 100% for business. However, there is an exception to this rule for computers: If you use a computer or computer peripheral (such as a printer) only for business and keep it at your business location, you need not comply with the record-keeping requirement. This includes computers that you keep at your home office if the office qualifies for the home office deduction. This exception applies only to computers and computer peripheral equipment. It doesn’t apply to other items such as calculators, copiers, fax machines, or typewriters.
How Should You Keep The Records?
You need to have copies of your tax returns and supporting documents available in case you are audited by the IRS or another taxing agency. You might also need them for other purposes—for example, to get a loan, mortgage, or insurance.
You should keep your records for as long as the IRS has to audit you after you file your returns for the year. These statutes of limitation range from three years to forever—they are listed in the table below. To be on the safe side, you should keep your tax returns indefinitely. They usually don’t take up much space, so this is not a big hardship. Your supporting documents probably take up more space. You should keep these for at least six years after you file your return. Keeping your records this long ensures that you’ll have them available if the IRS decides to audit you.
Keep your long-term asset records for three years after the depreciable life of the asset ends. For example, keep records for five-year property (such as computers) for eight years. Here is IRS statute of limitations:
If: The limitations period is:
You failed to pay all the tax due 3 years
You underreported your gross income 6 years
for the year by more than 25%
You filed a fraudulent return No limit
You did not file a return No limit
What If You Don’t Have Proper Tax Records?
Because you’re human, you may not have kept all the records required to back up your tax deductions. Don’t despair, all is not lost—you may be able to fall back on the “Cohan rule“. This rule [named after the Broadway entertainer George M. Cohan, involved in a tax case in the 1930s] is the taxpayer’s best friend. The Cohan rule recognizes that all businesspeople must spend at least some money to stay in business and so must have had at least some deductible expenses, even if they don’t have adequate records to back them up.
If you’re audited and lack adequate records for a claimed deduction, the IRS can use the Cohan rule to make an estimate of how much you must have spent and allow you to deduct that amount. However, you must provide at least some credible evidence on which to base this estimate, such as receipts, canceled checks, notes in your appointment book, or other records. Moreover, the IRS will only allow you to deduct the least amount you must have spent, based on the records you provide. In addition, the Cohan rule cannot be used for travel, meal, entertainment, or gift expenses, or for listed property.
If an auditor claims you lack sufficient records to back up a deduction, you should always bring up the Cohan rule and argue that you should still get the deduction based on the records you do have.
At best, you’ll probably get only part of your claimed deductions. If the IRS auditor disallows your deductions entirely or doesn’t give you as much as you think you deserve, you can appeal in court and bring up the Cohan rule again there. You might have more success with a judge. However, you can’t compel an IRS auditor or a court to apply the Cohan rule in your favor. Whether to apply the rule and how large a deduction to give you is within their discretion.
Reconstructing Tax Records
If you can show that you possessed adequate records at one time, but now lack them due to circumstances beyond your control, you may reconstruct your records for an IRS audit. Circumstances beyond your control would include acts of nature such as floods, fires, earthquakes, or theft. Loss of tax records while moving does not constitute circumstances beyond your control. Reconstructing records means you create brand-new records just for your audit or obtain other evidence to corroborate your deductions—for example, statements from people or companies from whom you purchased items for your business.