Thorough record-keeping and legitimate business expenditures are very important for navigating IRS audits with ease. Whether you're running an established business or embarking on a new venture, meticulous documentation of both income and outlays is essential. This ensures you're maximizing your entitled tax deductions and are well-equipped to substantiate your reported figures should the IRS ever scrutinize your returns.
What's the Best Method?
It's important to note that there's no singular method for maintaining business records. The IRS affirms on its website that businesses can adopt any system that effectively showcases their financial activities. However, sticking to strict guidelines is imperative when it comes to deducting valid expenses for tax purposes. Certain expenses, such as those related to automobiles, travel, meals, and home office usage, necessitate special attention due to specific record-keeping prerequisites or limitations on deductibility.
Ordinary and Necessary
The criteria for deducting business expenses rely on their "ordinary and necessary" nature, requiring that they primarily serve the purpose of generating profit.
Case Study
In one recent case, a married couple claimed business deductions that the IRS and the U.S. Tax Court mostly disallowed. The reasons: The expenses were found to be personal in nature and the taxpayers didn’t have adequate records for them.
In the case, the husband was a salaried executive. With his wife, he started a separate business as an S corporation. His sideline business identified new markets for chemical producers and connected them with potential customers. The couple’s two sons began working for the business when they were in high school.
The couple then formed a separate C corporation that engaged in marketing. For some of the years in question, the taxpayers reported the income and expenses of the businesses on their joint tax returns. The businesses conducted meetings at properties the family owned (and resided in) and paid the couple rent for the meetings.
The IRS selected the couple’s returns for audit. Among the deductions the IRS and the Tax Court disallowed:
Travel expenses submitted to the court were reconstructed travel logs, rather than records kept contemporaneously. The court noted that the couple didn’t provide “any documentary evidence or other direct or circumstantial evidence of the time, location, and business purpose of each reported travel expense.”
Marketing fees paid by the S corporation to the C corporation. The court found that no marketing or promotion was done. Instead, the funds were used to pay several personal family expenses.
Rent paid to the couple for the business use of their homes. The court stated the amounts “were unreasonable and something other than rent.”
Retirement Plan Deductions
The court invalidated these deductions citing reasons such as inadequately maintained records, lack of genuine business activities, and unreasonable rental amounts. Nonetheless, the couple successfully defended deductions related to their sons' contributions to 401(k) accounts, as documented evidence corroborated their involvement in the business.
Lessons Learned
This case underscores the importance of segregating personal and business expenses, along with the necessity of diligent record-keeping. Employing a dedicated business bank account and maintaining meticulous records not only facilitates accurate tax reporting but also serves as a safeguard in the face of IRS audits.
Contact Us
Feel free to reach out if you require assistance in establishing robust business record-keeping practices by scheduling a meeting with your VAAS Tax Consultant. We look forward to working with you.