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The Importance of Proper Record Keeping
Proper record-keeping is the foundation for a solid tax return with multiple advantages:
1. It minimizes your fraud exposure by properly reporting all of your income. Failure to understate your income by 25% or more may allows the IRS to audit you for up to 6 years, with a greater chance of implicating frauds: http://www.forbes.com/sites/robertwood/2011/02/10/irs-pushes-for-6-years-to-audit/
2. It reduces your tax liabilities by up to 50% or more by maximizing your tax deductions.
3. It minimizes your chances of being audited.
4. Even if you do get audited, you're prepared for it.
5. The best defense against charges of frauds is "I relied on my bookkeeper, accountant or attorney." However:
Ideally, your returns should be prepared in such a way that you'd be prepared for an audit. To that end, we will ask you for a long list of documents and receipts. We will also ask you how you run your business. In some cases, we may also come inspect your place of business and/or watch your operation to determine the legitimacy of your business and the deductibility of your expenses.
Most business owners (and many accountants) do not fully understand the IRS concept of proper records. As a minimum, some of those taxpayers were saddled with a large amount of assessment by the IRS auditors. As a maximum, some have lost their houses, businesses and/or freedom. Over the years, the most common tax returns that we've seen from other tax preparers are:
1. Fabricated Figures: The IRS auditors are most likely to refer these frivolous tax returns to Criminal Investigation Division, FBI and/or U.S. Department of Justice. Criminal penalties are usually charged. Unfortunately, even when the preparer fabricated the tax returns, the taxpayers are ultimately held liable, even if they know nothing about taxes.
2. Summary of Expenses: This is the most common method for small “mom and pop” businesses (such as nail salon, dry cleaner, restaurants, etc.). In this method, the business owners summarize activities for the day, week, month or year. This “Tally” of sales and expenses may be useful to the business owners to ensure profitability but it does nothing to defend an IRS audit. It is not uncommon for the IRS auditors to disallow most, if not all of the expenses. Civil Fraud Penalties are usually assessed.
3. Quick Books/Peach Tree, etc.: This is the most common method for more sophisticated or higher volume businesses (such as construction, retail, law office, medical clinic, etc.). Many business owners hire bookkeepers, accountants, former IRS agents or even CPA's to keep their records in one of these popular accounting software. In this case, the taxpayers fall into a false sense of security, thinking that they have a) Good software and b) Good professionals. First, the software is only as good as the information entered into it. Hence, the term GIGO (Garbage In, Garbage Out). Second, many of these bookkeepers/accountants come from large organizations and the accounting techniques that may be overlooked in the large organizations are not allowable to small businesses. Third, these accountants are used to having all of the necessary documentations automatically delivered to them -They do not have to hunt down the business owners to ask for the missing information. Consequently, it is not unusual for the IRS auditor to assess millions in additional taxes. Fourth, former IRS agents are used to sit on the other side of the table. Just because they switch their chairs to sit on your side of the table doesn't guarantee that they 'd know what to do. Think about it, a construction inspector is not necessarily a good builder. Furthermore, inter-company transactions and loans are considered as income if not properly documented. Negligence Penalties may be assessed but Civil Fraud Penalties and even Criminal Fraud Penalties may also be assessed, especially when the assessments are substantial (for example, over $100,000).
The accounting method that is commonly employed by the small business owners – The IRS calls it “Summary of Expenses.” Below are some sample tax court cases to settle disputes between the IRS auditors (Respondent) and the taxpayers (Petitioner):
1.IRS AUDITOR AUTOMATICALLY DISALLOWS MOST, IF NOT ALL DEDUCTION CLAIMED BY SUMMARY OF EXPENSES: “Petitioner asked the RA (Revenue Agent/IRS Auditor) why she did not allow the postage and shipping amounts that petitioner listed on summary of expenses she presented to RA and respondent’s counsel (IRS attorney).” http://www.ustaxcourt.gov/InOpHistoric/ORELLANA.SUM.WPD.pdf
2.SUMMARY OF EXPENSES IS NOT ACCEPTABLE BECAUSE IT FAILS TO SUBSTANTIATE BUSINESS PURPOSES: “Petitioner failed to substantiate the business expenses and startup expenditures disallowed by respondent. At trial, petitioner introduced only a brief summary of expenses and two promissory notes purportedly issued as payment for professional services. None of those documents established the dates, description, or business purpose of the expenses. The evidence offered was completely inadequate to substantiate petitioner’s claimed expenses as required by section 6001 and related regulations.” http://www.ustaxcourt.gov/InOpHistoric/IntouchProperties.wpd.TCM.WPD.pdf
3. SUMMARY OF EXPENSES IS NOT ACCEPTABLE BECAUSE THE EXPENSES ARE NOT DEDUCTIBLE JUST BECAUSE YOU SAY SO: “We cannot conclude that the amounts paid for various services were reasonable if neither we, nor Mr. Van Wickler, know the amounts of those expenses. A deduction cannot stand on so flimsy a foundation. Luman v. Commissioner, 79 T.C. 846, 859 (1982). Even if we concluded that a portion of Mr. Van Wickler’s payments was made, pursuant to section 212, for allowable ordinary and necessary expenses, the record fails to provide a rational basis by which we could allocate deductible and nondeductible expenses. See Epp v. Commissioner, 78 T.C. 801, 806 (1982). An allocation of a portion of the payment would be “speculative, amounting to ‘unguided largesse.’” Luman v. Commissioner, supra at 859 (quoting Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957)). Accordingly, Mr. Van Wickler is not entitled to deduct expenses.” http://www.ustaxcourt.gov/InOpHistoric/vanwickler.TCM.WPD.pdf
4. SUMMARY OF EXPENSES + CANCELED CHECKS + CREDIT CARD STATEMENTS ARE NOT SUFFICIENT: We turn initially to the disallowed 2007 Schedule C expenses of $338,047.76. It is petitioner’s position that he is entitled to deduct those expenses under section 162(a). In support of that position, petitioner relies primarily on (1) certain schedules showing by month and type of expense the total amount that he claims he paid for each type of expense during each month in 2007 in carrying on his law practice (petitioner’s summary claimed expense schedules) and (2) a document titled “Profit & Loss Detail” showing by month and type of expense the petitioner’s 2007 Schedule C gross receipts that respondent determined in the notice. Respondent disagrees.
1. SUMMARY OF EXPENSES CONSTITUTES NEGLIGENCE AND FAILURE TO KEEP PROPER RECORDS: The term “negligence” also includes any failure by the taxpayer to keep adequate books and records or to substantiate items properly. Sec. 1.6662-3(b)(1), Income Tax Regs. The term disregard” includes any careless, reckless, or intentional disregard. Sec. 6662(c)....An understatement is substantial in the case of an individual if the amount of the understatement for the taxable year exceeds the greater of 10 percent of the tax required to be shown in the tax return for that year or $5,000. Sec. 6662(d)(1)(A). http://www.ustaxcourt.gov/InOpHistoric/CanatellaMemo.Chiechi.TCM.WPD.pdf
2. SUMMARY OF EXPENSES MEANS THAT TAXPAYER FAILS TO FOLLOW PROFESSIONAL ADVICES: A taxpayer’s reliance on the advice of a professional will be objectively reasonable only if the taxpayer has provided necessary and accurate information to the professional. Respondent argues that petitioner is liable for the accuracy-related penalty under section 6662(a) because of a substantial understatement of tax under section 6662(b)(2) and petitioner’s negligence or disregard of rules or regulations under section 6662(b)(1). http://www.ustaxcourt.gov/InOpHistoric/CanatellaMemo.Chiechi.TCM.WPD.pdf
3. SUBSTANTIAL UNDERSTATEMENT OF TAXES = FRAUD: We find that the understatements for the years at issue were substantial and are evidence of fraud. (Note: This is applicable, whether your bookkeeping were Summary of Expenses or Quick Books). http://www.ustaxcourt.gov/InOpHistoric/Medlin.TCM.WPD.pdf
4. LIST OF FRAUDULENT ACTIVITIES: Courts have developed a nonexclusive list of factors that demonstrate fraudulent intent. Those badges of fraud include: (1) understating income; (2) maintaining inadequate records; (3) implausible or inconsistent explanations of behavior; (4) concealment of income or assets; (5) failing to cooperate with tax authorities; (6) engaging in illegal activities; (7) an intent to mislead; (8) lack of credibility of the taxpayer's testimony; (9) filing false documents; (10) failing to file tax returns; and (11) dealing in cash http://www.ustaxcourt.gov/InOpHistoric/MohamedMemo.Halpern.TCM.WPD.pdf
In summary, If an IRS auditor will have to sit there and watch you sift through several boxes of documents to prove each and every daily deduction, then he/she will most likely disallow ALL deductions due to “failure to keep proper records.” Title 26 USC § 7203 - Willful failure to file return, supply information, or pay tax: Penalties of up to $100,000 plus 5 years imprisonment (for each year). http://www.irs.gov/uac/Related-Statutes-and-Penalties---General-Fraud
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