Challenge That IRS Substitute Return!
Reconstruction of Business Expenses for Missing Receipts
Nov 8, 2009
After (or along with) reconstructing a taxpayer’s income in order to complete a delinquent income tax return, comes the task of asserting all the deductions and adjustments to income to which the taxpayer is legally entitled.
The IRS, in its process of filing substitute returns, knows most taxpayers have adjustments to income, especially the self-employed. The self-employed can have office rent, utilities, merchandise, merchant account charges, advertising, payroll, all kinds of expenses the IRS knows they likely have. However, the IRS is not going to arbitrarily assign numbers to these expenses or use any kind of industry average. For one, two businesses in the same industry may operate in totally divergent ways, such that one has high expenses for advertising and the other low expenses for advertising.
What the IRS Can Provide and Usually Ignores
A Wage and Income Transcript can be obtained through the local IRS office, the Taxpayer Advocates Office or any tax preparer or tax professional (EA, CPA or attorney) authorized to practice before the IRS. For self-employed individuals and other businesses, the interest on loans relating to the business is often reported to the IRS, sometimes as mortgage interest. (Note: Any taxpayer filing jointly for the subject tax year should also secure a Wage and Income Transcript for their spouse.)
The IRS frequently ignores any tax credits of which they have record (such as foreign taxes paid through investment funds). The IRS has records of tuition fees and/or payments made, student loan interest reported as paid, mortgage interest and, often, real estate taxes. (While most of these are not business expenses, part of the mortgage interest and real estate taxes might be.)
Reconstructing the Business Expenses
After (or as) the income is determined, the business expenses need to be identified. The rule of thumb regarding business deductions is: Are they reasonable, necessary, ordinary and/or customary? This is refined by anything unique in a taxpayer’s business operations. For example, not all farmers use creamery wastes to feed their animals. However, those that do may have higher auto expenses than those who do not because they daily travel to get the fresh nutrients for their animals.
The bank and credit card statements will contain charges for various purposes of services, supplies and equipment. Categorize them, log them and find receipts when possible. A multi-faceted example of this would be a self-employed individual’s contributions to the Little League. On the surface, they could appear to be charitable donations only deductible on Schedule A (itemized deductions).
In reality, they may reflect payments required to sponsor a team in the business’s name. The business name was on all of the uniforms and published in the programs and newsletters. This is advertising, and a legitimate business deduction. And, recalling all of this, the taxpayer can get duplicate receipts from the Little League secretary!
Inherent in the dates presented in bank and credit card statements is the structure of recreating mileage logs, if applicable. If the taxpayer drives a diesel-fueled vehicle and can document his or her average miles per gallon, then the taxpayer should get the local average diesel fuel price and the vehicle’s total miles during the subject tax year. The taxpayer can divide and multiply these, as logical, to arrive at fuel expense.
The bank and credit card statements used to reconstruct the income are just as important in reconstructing the expenses. They are documentation in themselves for bank service charges and fees paid by the business. (Note, however, without a separate business bank account, no more than one-half of the total fees is likely to be allowed in an IRS examination.)
Does the Taxpayer Owe That Much Money?
Probably not. A taxpayer logically working through what secondary records are available can reconstruct both income and expenses for a tax year for which the business records have been lost or destroyed.
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