Reconstructing Tax Records: How to Prepare for a Tax Audit
Whether you’re a CPA, EA, tax preparer, or tax attorney, you likely work with a variety of clients in all sorts of tax scenarios. Even if you specialize in individual or corporate tax preparation, the chances are good that you’ve encountered a wide variety of clients with varying tax needs.
Some clients do a great job of keeping records. They make sure to catalogue everything properly, maintain detailed spreadsheets, store copies of all receipts electronically, and generally speaking make your job easy when tax time rolls around.
Other clients are the complete opposite. They fail to keep any records at all, despite claiming massive numbers of expenses and various deductions. Of course, you warn these clients that maintaining appropriate records is important not just for the sake of accuracy, but also due to the need for adequate records in the event of an audit by the Internal Revenue Service. The last thing you want is to have a client audited whose records are lacking, right?
Unfortunately, this is precisely the scenario that many accountants are faced with. Of course, there’s a lot that you can do when filing taxes to minimize the likelihood of an audit. In some cases, however, an audit occurs at random, or for any number of other reasons outside of your control. And when it does, your client will be looking to you to help them prepare for it.
As you’ve likely experienced in the past when working with clients undergoing an audit, it’s often the clients who keep the worst records that expect you to do the most for them in helping them to prepare. An audit is an understandably stressful time for any client, too, and they’ll be looking to you to provide them with expert advice and guidance throughout the process.
With all of this in mind, there’s no question that keeping yourself up to date on the rules and procedures surrounding an audit is critical. In fact, many clients faced with an audit will come to see their accountant as more crucial than ever to their overall financial picture — and they’ll expect you to know what to do. That’s why it’s a good idea to ensure that you devote some of your annual tax CPE hours each year to audit-related topics.
We’ve put together this detailed blog post as a refresher on the details of preparing for an audit and reconstructing records. It is indeed possible to help clients without adequate records prepare for and survive an audit. It takes a lot of work, though — and the more up to date you are on the process, the better. Below, we’ll cover the following topics in greater detail:
- The Cohan rule
- The importance of attempting to reconstruct records
- 1.274-5A guidelines
- The tax audit process
- Record keeping tips, including how long to maintain records
- Tips for reconstructing records
That said, we highly recommend signing up for a 2018 tax seminar that focus at least in part on the audit process. There are a lot of details to consider, and addressing all of them in adequate detail in a single blog isn’t possible.
Tax Records and the Cohan Rule
We’ve already established that not every client keeps excellent records. Some clients, in fact, fail to keep virtually any records at all. So what happens when these clients are audited? Do they have to retract all of their claims for deductions and pay taxes and penalties under the assumption that no deductions whatsoever were claimed?
Not necessarily. The reality of facing an audit with inadequate or incomplete tax records is actually far more complicated than this black and white picture of the audit process. And it’s due in large part to a court case from nearly a century ago.
In 1930, a federal case appeared in court between George M. Cohan and the IRS. This case, now commonly referred to as Cohan vs. IRS, is incredibly significant for anyone facing an audit with incomplete expense and accounting records.
To gloss over the details of the case, suffice it to say that Cohan was a Broadway theater manager who came into the business when his father passed away. Over the years, Cohan had claimed a substantial number of deductions, but had failed to keep track of any records. These costs were quite substantial, as Cohan would sometimes travel for work, often bringing an attorney along with him.
When Cohan was audited, he ended up in court as a result of attempting to claim these deductions for which he had no records. In total, he had claimed roughly $55,000 of expenses over the course of three years. Adjusted for inflation in 1920’s dollars, this is quite a bit of money. The IRS refused to allow these deductions given Cohan’s lack of documented evidence.
Meanwhile, the court hearing the case questioned whether it was right to disallow Cohan all of these deductions, as it was clear that he had spent quite a bit of money. Rather than throw out the expense claims altogether, the court decided that a reasonable approximation of deductions could be allowed. Cohan provided other evidence which allowed for these reasonable approximations of his expenses, and thus his deduction amounts were effectively reconstructed.
As a result, the “Cohan rule” was born. In a nutshell, the Cohan rule is simply the idea that a court will allow a taxpayer to deduct an estimated amount of expenses, so long as it’s clear that the taxpayer is entitled to the deduction — but can’t establish the exact amount of that deduction.
Of course, the picture isn’t quite as rosy as it might appear at first. For one thing, the IRS doesn’t always adhere to the precedent that was set by this decision. Additionally, various laws have been changed and revised over the past century. As a result, there are cases where the Cohan rule doesn’t apply.
Attempting to Reconstruct Records First
So, if a taxpayer doesn’t have adequate records, can they simply “claim the Cohan rule” and deduct whatever they want?
The short answer is no — things aren’t that simple. Before a taxpayer is allowed to use the Cohan rule, they must attempt to reconstruct their tax records to the best of their ability. Only after this attempt has been made can the Cohan rule be used. Additionally, in using the Cohan rule a taxpayer must adhere to the treasury regulations set out in §1.274-5A. At the end of the day, the burden is placed on the taxpayer to provide a reasonable reconstruction of the expenditure that was ordinary and necessary, and which was incurred during a given tax year.
We’ll come back to some tips for attempting to reconstruct tax records below. For now, let’s assume that no such reconstruction is possible. If this is the case, the taxpayer can attempt to use the Cohan rule in accordance with the guidelines set forth in §1.274-5A. Let’s take a closer look at what those are.
Treasury Regulation §1.274-5A Guidelines
Treasury regulation §1.274-5A lays out various guidelines that a taxpayer must follow if they’re attempting to use the Cohan rule to claim deductions during an audit.
First of all, the loss of records must be due to circumstances beyond the control of the taxpayer. This means that there is a difference between a taxpayer who simply opted not to keep any records at all, versus one who has incomplete or missing records but who has made attempts to keep track of expenses. This makes sense, of course. If the Cohan rule were allowed for any situation where expense records are missing, there would be little incentive to bother keeping such records in the first place. Instead, tax records must have been lost as the result of a fire, flood, or other event which the taxpayer couldn’t have foreseen.
Assuming the taxpayer meets these criteria, they may then substantiate a deduction using the reasonable reconstruction of various expenditures. However, there are guidelines and limitations on what these expenditures can entail.
Specifically, the following limitations are commonly recognized as applying in cases where the Cohan rule is enacted:
- A taxpayer may not claim expenses under the Cohan rule related to travel away from home, including the cost of lodging, meals, and so on.
- Any expenses related to entertainment, recreation, or other similar activities are ineligible.
- Gifts as defined under §274 cannot be claimed under the Cohan rule.
In other words, while Cohan was allowed to deduct expenses related to travel, the tax code has since been amended to specifically disallow this sort of claim.
But what’s actually involved in the tax audit process? How do things proceed from beginning to end? What can the taxpayer expect? Let’s take a closer look.
The Tax Audit Process
In layperson’s terms, a “tax audit” is the process used by the IRS to determine whether a taxpayer has properly reported their income. This includes an investigation into whether earnings, investments, deductions, exemptions, and credits have all been accounted for and reported properly. Congress has determined that the IRS has the authority to inspect financial records in order to determine whether a return was accurately filed or not.
When an audit begins, the taxpayer in question will receive an Information Document Request (or IDR) form from the IRS. IDR 4564 will clarify which areas of the taxpayer’s tax filing history are questionable. Initially, the burden of the audit is placed upon the taxpayer. However, if the case goes to court, some of the burden of proof is shifted to the IRS (under specific circumstances).
At the end of the day, the audit process comes down to whether or not the taxpayer can substantiate the various claims they’ve made, which ultimately amounts to the taxpayer needing to provide the records requested by the IRS. With this in mind, let’s look at some tips for record keeping, timeframes for keeping records, and how to reconstruct records when necessary.
Tips for Record Keeping and Record Keeping Timeframes
As an accountant, it goes without saying that record keeping is essential. It would be a mistake, however, to assume that your clients understand the importance to the same degree that you do.
Giving your clients solid and substantial reasons for why they need to keep records can sometimes give them the impetus they need. Specifically, some important reasons you might offer to your client could include:
- Monitoring their business’ progress
- Having access to business records for decision making purposes
- Identifying income sources and accompanying expenses
- Preparing tax returns faster and more easily
- Substantiating income and expense declarations
How long should clients keep records? Time estimates can vary from business to business. However, it’s generally a good idea to keep invoices, receivables, checks, and payables for at least five years. Payroll records should be kept for at least six years, and contracts for three. In the case of corporate records, contracts should be retained for a minimum of seven years, leases for six, and tax returns, bills, statements, contractor 1099s, and auditor reports should all be kept permanently.
Tips for Reconstructing Records
Assuming you’re faced with the need to reconstruct records for clients, where should you begin?
The task can definitely feel overwhelming. However, it’s important to start with the records the client does have. Clients will sometimes fail to recognize that they actually do have access to valuable records.
For example, the client may have a copy of an oil change receipt or vehicle service which records their vehicle’s mileage on a specific date in lieu of having kept mileage records. Online purchasing history may be accessible through the company with whom the purchases were made.
If the client has kept an appointment book, this can be useful for reconstructing records related to travel, services provided to clients, the number and types of services rendered, and so on. Using such summarized counts of services, the taxpayer could then attempt to apply an average or standardized cost across the total number of services to determine an estimate of total receipts.
2018 Tax Seminars and Further Training
There’s much more that could be said about how to prepare for a tax audit and reconstruct records. However, it’s beyond the scope of this blog post. In order to bring yourself fully up to speed on the circumstances, regulations, and guidelines surrounding an IRS audit, it’s a good idea to sign up for a 2018 tax seminar that’s either dedicated to the topic or includes some amount of audit-related content.
Basics & Beyond™ offers a wide range of tax CPE seminars and webinars both in person and online. Our 2018 tax seminars are informative, affordable, and relevant. Additionally, all of our presenters are highly qualified and knowledgeable accounting professionals with considerable experience in offering instruction related to various tax and accounting topics. Sign up for a seminar today!