The IRS and Income Reconstruction
Believe it or not, if you do not keep good records to support what's on your tax return, the IRS can reconstruct your income using any method it can convince the court is reasonable.
In a case involving Michael F. and Jody D. Lambaiso (T.C.Memo. 1999-343), the IRS used the percentage markup method to reconstruct the taxpayer's gross sales of liquor (the taxpayer ran a bar) because the taxpayer couldn't back up the information on his tax return with acceptable business records.
The IRS calculated the taxpayer's income by marking up the bar's liquor purchases. The taxpayer did not introduce any evidence to try to prove the IRS numbers were inaccurate and lacked records to substantiate what was claimed on the taxpayer's tax return.
Anybody got a bit of money?What the IRS did applies across the board. If you can't substantiate a deduction taken on your personal return, the IRS can-and will-deny it. In Rockwell Banker (T.C. Memo. 1999-351), the tax court sided with the IRS in disallowing miscellaneous itemized deductions. The taxpayer argued that he relied on his ex-spouse in taking deductions. The court found that, since he signed the return, he was responsible for checking the accuracy of the information contained on the return.
While a formal study hasn't been done, tax professionals agree that more taxpayers lose deductions because of poor record keeping than because the item isn't deductible under the tax law. In Mary K. Moylan (T.C. Memo. 1999-338), the court found the taxpayer's records were insufficient to support her deductions. The court tried to give the taxpayer the benefit of the doubt, but found her testimony far from convincing. Moreover, she couldn't explain at least two of the expense items.
When one is in business, there are many reasons to keep records in addition to tax purposes. One should keep records for insurance purposes, for getting a loan and to keep track of how business is doing.
Good records will help with the following:
o Identify sources of income
Gross receipts are the income you receive from your business. Keep supporting documents that show the amounts and sources of gross income. Examples include bank deposit slips, receipt books, cash register tapes and invoices, purchase price, credit card charge slips, cost of any improvements, Forms 1099-MISC., Section 179 deductions taken, etc. You may receive money or property from a variety of sources. Records can identify the sources of the income. This information separates business from non-business income and taxable from nontaxable income, and distinguishes profitable from non-profitable activities.
o Keep track of expenses
You may forget an expense unless you record it when it occurs. Use records to identify expenses for which you can claim a tax deduction. This will help determine if you can itemize deductions on your tax return.
o Keep track of the basis of property
Keep records that show the "basis" or cost of your property. This includes the original cost of the property and any improvements made. When selling the property, records enable you to determine if you incurred a loss or realized a gain.
o Support items reported on tax returns
Keep records in case the IRS has a question about an item on your return. If the IRS examines your tax return, you may be asked to explain the items reported. Good records will help explain any item and arrive at the correct tax with a minimum of effort. Without records, you may have to spend time getting statements and receipts from various sources. Without the correct documents, you may have to pay additional tax and be subject to penalties.
o Supporting documents
Purchases, sales, payroll, and other transactions in your business will generate supporting documents such as invoices and receipts. These documents contain the information you need to record in "balance sheets" and "income statements." These statements can also help you in dealing with your bank or creditors. It is important to keep these documents because they support the entries in your books and on your tax return. You should keep them in an orderly fashion and in a safe place. Supporting documents includes sales slips, paid bills, invoices, receipts, deposit slips, and canceled checks.
Other recordkeeping benefits
A well-organized system for your records will make it easier to prepare a tax return and will also help answer questions if the return is selected for examination or if you are billed for additional tax.
How long should one keep records? Records such as receipts, canceled checks and other documents that support an item of income or a deduction appearing on the tax return should be kept until the statute of limitations expires for that return. Usually, this is three years from the date the return was due or filed, or two years from the date the tax was paid, whichever is later.
Keep some records indefinitely, such as property records, since you may need them to prove the amount of gain or loss if the property is sold. Generally, income tax returns should be kept for a three-year period. They will help you prepare future tax returns and amended returns. Keep all employment tax records for at least four years after the tax is due or paid, whichever is later.
There is no particular method of bookkeeping one must use for a business. However, use a method of bookkeeping that clearly reflects income and expenses.
For more information on the specific documentation for travel, entertainment, gifts, car and other business expenses, consult IRS Publication 583, Starting a Business and keeping Records; and IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses. You can obtain these publications at your local IRS office or by calling 1-800-tax-form.