The IRS has received nearly $80 billion in new funding and is using that money to go on a hiring spree. That’s good news for job-hunting auditors…but bad news for millions of taxpayers—more IRS agents inevitably mean more IRS audits. Result: It is even more important for taxpayers to save the evidence they’ll need to defend their deductions and other tax return details in case they receive a dreaded audit letter from the IRS. Here’s what to save and what to do if such a letter does arrive—from tax expert Abby Eisenkraft…
Taxpayers have a right to claim reasonable deductions, but the IRS has the right to question those deductions—and when it does, taxpayers must provide proof. Hang onto any document that supports numbers entered into your returns for at least the past six years. The IRS typically can audit returns filed only in the past three years, but that stretches to six years if the IRS suspects the taxpayer has underreported his/her income by more than 25%.
Most of the documentation worth saving is obvious—if a piece of paper cites the amount paid for something you claimed as a deduction…an amount of income you received…or investment-related costs or proceeds, keep it. But there are a few details worth noting…
Save proof of payments in multiple forms. Previously proof of payment typically meant hard copies of receipts, canceled checks and printed invoices. But these days, receipts and invoices often are digital, and few banks return canceled checks although you may be able to get PDFs on the banks’ websites.
Digital versions of receipts, invoices and canceled checks are acceptable substitutes—but don’t rely exclusively on digital documents stored in your computer, e-mail accounts and/or your bank’s computers. Potential problems: The hard drives those records are stored on might crash…the account might be hijacked…or the company might not save digital customer records for long.
Smart strategy: Keep your own backups—save digital receipts on your computer and a separate storage device or in the cloud…or print them out and save hard copies. Reminder: Old-fashioned “thermal” cash-register receipts can quickly fade into illegibility.
Save bank and credit card statements that list deductible expenses in printed or digital form, but don’t expect these to be sufficient proof on their own. IRS regulations state that taxpayers can use these as proof, but auditors rarely put much stock in them—the statements show to whom a payment was made but not what was purchased. Instead, scanned receipts show the level of detail needed.
Prepare to explain the “why” of a deduction. Deductions must be reasonable, ordinary and necessary.
Smart strategy: If you claim a deduction that is not obviously reasonable, ordinary and necessary, save notes explaining why you believe it is reasonable in this case. That way, you won’t have to try to figure this out if the IRS raises the matter years later. Or better yet, don’t take potentially eyebrow-raising deductions in the first place.
Take care to obtain and retain documents related to topics of elevated IRS interest. When the IRS audits a return, it usually focuses on just one or two components of it. Four areas especially likely to attract auditor attention…
Charitable donations. If you make a donation of $250 or more, obtain and save an acknowledgement letter and a receipt from the nonprofit. The letter should state that the recipient is a
501(c)(3) tax-exempt organization…note the date and size of the donation…and say that no goods or services were provided in exchange for the donation. If a thank-you gift was provided—even a small gift—its cash value should be cited.
Medical expenses. If you deduct medical expenses, save the invoices/receipts showing the amounts you paid and correspondence from your health insurer/Medicare showing that this cost truly came out of your own pocket and was not later paid by your coverage provider. The IRS knows that people often deduct medical expenses that they initially paid out of pocket but that eventually were covered.
Rental property. Rental-property owners often can deduct from their rental income the cost of maintaining, repairing and furnishing their rental property—but saving receipts and invoices related to these expenses might not be enough to convince an IRS agent. The IRS knows that rental-property owners sometimes try to slip expenses from their own homes in with their rental-property expenses. To overcome these suspicions: Collect and save evidence that the cost truly was for the rental property. You could ask the repairperson to specify on the invoices the address and unit number where work was performed…and/or take and save your own photos of the work being done.
Small-business expenses. Business expenses often attract IRS scrutiny—the IRS knows that some business owners consider virtually every dollar they spend a business expense. Warning: IRS attention is especially likely when a small-business owner claims the Earned Income Tax Credit—fraud is common with this credit.
Here’s what to do if you receive a letter from the IRS informing you that your return is being audited…
Do not call the IRS—at least not immediately. The IRS letter will provide a phone number and instruct you to call, but don’t do so until you’ve calmed down from the initial shock…read the letter to see what, specifically, is being audited…carefully reviewed your relevant return to try to determine why it is on the IRS’s radar…and decided if you’re hiring a tax pro to assist you (more on this below). There’s no downside to taking this time as long as you respond by the deadline cited in the letter. People who dial the IRS before calming down often blurt things out that could work against them. Example: A taxpayer says, “I do my taxes the same way every year, and I’ve never had a problem before!” While he is hoping this will convince the auditor that the return is above reproach, it actually inspires the auditor to expand the audit to include returns from additional years.
Decide if you’re hiring help. If you’re being asked to submit only a document or two, you might opt to handle that on your own. But: If you are being asked to meet with an IRS agent, it’s usually wise to hire an enrolled agent or CPA who has significant audit experience to represent you throughout the audit. This could cost anywhere from a few thousand dollars to $10,000 or more, depending on the complexity of the audit and other factors. If that’s more than you’re willing to spend, consider paying a tax pro to review the audit letter and the relevant part of your return and then offer you guidance, which might take only a few hours of his/her time.
Separate the relevant documents from the rest of your tax paperwork. If you show up to the audit with a box full of unorganized receipts, the IRS agent will wonder how you were able to get to your numbers in the first place…or assume that some or all of the expenses were a guess or made up. Result: The audit might be expanded.
Smart strategy: Bring only the paperwork relevant to the specific topics cited in the audit letter and/or requested by the IRS on an “Information Document Request” (IDR). If the auditor asks to see anything else, say you didn’t bring it because it wasn’t mentioned on the IDR. Organize the documents you do bring to the audit by topic, not chronologically.
If relevant receipts or evidence are missing from your records, seek replacements before the audit. Perhaps a merchant can provide a copy of a missing invoice. Or perhaps third parties who have knowledge of the situation can provide notarized statements—third-party testimony can carry considerable weight with the IRS.
Be prepared to explain any aspects of the return that the auditor is likely to question. Read the sections of your return that are being audited, and/or pay a tax pro to do so. What might make an auditor think, This doesn’t make sense? Example: If you live in an expensive city, are self-employed and claimed $60,000 in income with $45,000 in expenses, be ready not only to prove that those expenses are legitimate but to explain how you managed to survive on just $15,000 in income. You could bring investment company statements to prove that you withdrew money from your savings to pay your bills…or bank records from both your account and your brother’s account showing that he gifted you money to help you through the lean year.
Read relevant IRS publications before your audit. IRS Publication 1, Your Rights as a Taxpayer, provides useful background for any taxpayer facing an audit. If your business is being audited, read the IRS’s Audit Technique Guide (ATG) for your sector. These aren’t easy reads, and some guides are out of date in places, but they can provide a sense of what IRS auditors are looking for when they examine businesses like yours. Enter “IRS.gov” and “Audit Techniques Guides” into a search engine to find these on the IRS website.
