Reconstructing lost business records is an art that may enable taxpayers to complete a missing income tax return and eliminate worries about how to pay off the IRS because they were self-employed and, for whatever reason, no longer have any records. Both income and expenses have to be reconstructed and reported as accurately as possible.
The IRS Just Wants to Get That Guy!
No. When the IRS files a substitute return for a taxpayer, it knows the tax liability (coupled with penalties and interest) upon which they then pursue collection is, in most cases, highly inflated. It is the taxpayer’s responsibility to file a correct tax return. It is the taxpayers’ responsibility to assert the items of income and deduction relevant to their tax situation in any given year. When the IRS files a substitute tax return, what they really want is for the taxpayer to submit the correct return, even if the original records supporting income and deductions no longer exist.
Thus, the taxpayer needs to recreate or reconstruct its business records. Sustainable reconstructions of income and expenses should be well-reasoned. While any given taxpayer may feel the IRS already has enough knowledge about their income, bank and credit statements, Forms 1099, as well as the assets a taxpayer owns and the taxpayer’s lifestyle, are considerations in reconstructing income.
Additionally, there are income and lifestyle considerations. The taxpayer should not cut any corners here. Some industries are known to have a lot of cash transactions. If the return is examined (audited), the IRS might consider the taxpayer’s monthly outgo for living expenses was much higher than the income on the tax return supports.
For example, a taxpayer with $2,000 a month mortgage payments and net income of only $20,000 (before itemized deductions) coming into the household has to be getting the funds to be making $24,000 in mortgage payments from somewhere. Gifts, loans, savings and other income are the four most common possibilities. If the first three are ruled out, then some income must be missing.
What the IRS Can Provide
The taxpayer should obtain Wage and Income Transcript through the local IRS office, the Taxpayer Advocates Office or any tax professional (EA, CPA or tax attorney) authorized to practice before the IRS. Forms 1099, as well as W-2s and other information is recorded on the Wage and Income Transcript. Joint filers should obtain a Wage and Income Transcript for each spouse.
Wage and Income Transcripts are identified by social security number and name. They show all the information that has been reported to the IRS about a taxpayer’s income as well as other items, including some of the deductions for the year in question, for any given year. (These items are helpful in reconstructing expenses.)
Reconstructing Income
Although banks often charge a fee for researching and copying old bank account records, they will usually provide the records.. This is the starting point for reconstructing business income. It is also a key element in reconstructing business payments made as well as auto mileage, if applicable.
Bank deposits represent income unless it can be shown they are loan proceeds, wages already reported on a W-2, gifts, and the like. Some self-employed individuals may have received cash payments not deposited into the bank account or have taken “cash back” from the deposits. These items should be added to the deposit total reflecting income. (When a separate business bank account is maintained, self-employment income is much easier to segregate.)
If business assets were disposed of during the year in question, gain or loss on them needs to be reported. At this point, consultation with a tax professional may be in order.
If the taxpayer had stock transactions or cancellation of debt that has been reported to the IRS, it will show up on the transcript. If the taxpayer no longer has the basis for the stock transactions, the brokerage firm may be able to provide it. Also, most tax professionals can provide guidance on this.
Ready for the Next Step
Using information from the IRS, bank and credit card statements, and reflecting upon a taxpayer's own lifestyle and living expenses can trigger a well-reasoned reconstruction of a taxpayer's income when the business records are otherwise missing. The next step is to use those same records to reconstruct the the taxpayer's adjustments to income and deductions.
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