One of the easiest ways for taxpayers to lose an audit with the IRS is to fail to substantiate their expenses or time. You may have closely followed the arcane and often confusing tax laws, but failing to keep adequate records of your time spent on an activity, receipts detailing your expenses or logs describing the type of work you did or the places you traveled can easily cost you the tax benefits to which you’re entitled.
This is especially important for taxpayers who own and operate their own businesses. The IRS requires expenses incurred by an employee or business owner to be documented through “adequate records” when those expenses are incurred. At the same time, a taxpayer must prove that he or she is actually participating in a trade or business by keeping adequate records that reflect the time spent working in that trade or business. Those records must show the amount, the time and place, and the business purpose of the expense, or in the case of someone proving participation in the business, the time spent working.
What exactly does that mean? Case law and IRS regulations indicate that “adequate records” can be a diary, an account book, a trip sheet or a log book. Technology has improved, so records retained digitally, through a logging program, also qualify. Expenses and time spent must be documented in those records contemporaneously, meaning “within a reasonable period of time” or “at or near the time” the expense was incurred.
Consider the following example: On occasion, a business owner may take a client or a prospective employee to dinner. Contrary to what many taxpayers think, keeping a receipt of the dinner, even if it is itemized, isn’t enough to survive an audit, though you should always retain those records. Entertainment and meals have historically been ripe for abuse by taxpayers, so Congress has constructed strict guidelines on deducting those expenses.
To deduct such expenses, a taxpayer must record (1) the amount and description of each expenditure; (2) the time and place the entertainment or meal was provided; (3) the business purpose of the activity, including any benefit derived from the meal or entertainment; and (4) the nature of the discussion with each participant, and the business relationship with each person entertained or fed. Even then, the meal or entertainment can’t be “lavish or extravagant” – something determined on a case-by-case basis.
Your business should also have an “accountable plan” – a written set of policies that describes the responsibilities of the employee to record such expenses pursuant to IRS rules. Without it, if your business is audited, you could lose such business deductions and/or your employee could be required to treat those reimbursements to him or her as includable income.
What about substantiating for individual income tax purposes? Now, more than ever, even an individual taxpayer should maintain his or her receipts, for every itemized or “above the line” deduction taken. For example, the law allows an individual to deduct certain payments made to charities or nonprofit groups. Cash donations are the easiest to substantiate – all you need is a receipt from the charity and a bank record. But donations of tangible property are a bit more difficult.
For one, the individual will not only need a receipt, but also have to prove the value of the property donated. Often, a local charity will allow a donor to assign a value to the items donated. Your honesty as a taxpayer will come into play if you overestimate the value of donated goods, especially if you can’t prove their value. So, what to do?
Document each item donated. If you donate clothing, note the brand, material, age and condition of the garment. If you donate something of greater value, like artwork or other expensive items, you’ll likely need an appraisal. Contributions of property for which a deduction of $5,000 or more is claimed require a qualified appraisal to be attached to the tax return. Contributions of a vehicle worth more than $500 require a contemporaneous written acknowledgement by the donee organization, which must be attached to the tax return of the taxpayer-donor.
Appropriate documentation isn’t just for expenses incurred. If you’re involved in a business activity as an owner, you have to prove you are “materially participating” in a trade or business during a tax year. There are a variety of tests for proving this, and they mostly involve spending a certain number of hours working in that business during the year. The most common test to prove material participation is to work 500 or more hours in the business, and show that the work is regular, continuous, and substantial.
But the IRS can ask for proof that you actually worked. You probably won’t have receipts, so how do you prove material participation?
Unlike the requirements for substantiation of expenses, proving hours of participation in an activity does not require contemporaneous daily time reports or logs. Reasonable proof, such as notes scrawled in a journal or entries in appointment books or calendars can be sufficient. Other options are credit card bills, records of emails sent, telephone records, building entry logs from key-card swipes and even records from automated highway toll passes, like “EZ Pass.” Of course, the IRS and the courts will view contemporaneous reports as more authoritative than journals, which may be seen as self-serving in some cases.
Maintaining the proper documentation is a good practice and may be something a business owner is already doing. While the effort can be burdensome, it will pay dividends in the event of an IRS audit.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
