IRS audit is one of the most dreaded and misunderstood subjects. The first step to relieving such stress is to keep proper records. They must be kept in such a way that the IRS can quickly and easily distinguish deductible and nondeductible expenses.  If an IRS auditor will have to sit there and watch you sift through several boxes of documents to prove each and every daily deduction, then he/she will most likely disallow ALL deductions due to “failure to keep proper records.” Title 26 USC § 7203 – Willful failure to file return, supply information, or pay tax:  In addition to the 20% Civil Penalty for Accuracy, there may be Criminal Penalties of up to $100,000 plus 5 years imprisonment (for each year).
Listed below are some of the tax court cases that explain proper record keeping. 
Most business owners (and many accountants) do not fully understand the IRS concept of proper records. As a minimum, some of those taxpayers were saddled with a large amount of assessment by the IRS auditors. As a maximum, some have lost their houses, businesses and/or freedom. Over the years, the most common tax returns that we’ve seen from other tax preparers are:
  • Fabricated Figures: The IRS auditors are most likely to refer these frivolous tax returns to Criminal Investigation Division, FBI and/or U.S. Department of Justice. Criminal penalties are usually charged. Unfortunately, even when the preparer fabricated the tax returns, the taxpayers are ultimately held liable, even if they know nothing about taxes.
  • Summary of Expenses: This is the most common method for small “mom and pop” businesses (such as nail salon, dry cleaner, restaurants, etc.). In this method, the business owners summarize activities for the day, week, month or year. This “Tally” of sales and expenses may be useful to the business owners to ensure profitability but it does nothing to defend an IRS audit. It is not uncommon for the IRS auditors to disallow most, if not all of the expenses. Civil Fraud Penalties are usually assessed.
  • Quick Books/Peach Tree, etc.: This is the most common method for more sophisticated or higher volume businesses (such as construction, retail, law office, medical clinic, etc.). Many business owners hire bookkeepers, accountants, former IRS agents or even CPA’s to keep their records in one of these popular accounting software. In this case, the taxpayers fall into a false sense of security, thinking that they have a) Good software and b) Good professionals. First, the software is only as good as the information entered into it. Hence, the term GIGO (Garbage In, Garbage Out). Second, many of these bookkeepers/accountants come from large organizations and the accounting techniques that may be overlooked in the large organizations are not allowable to small businesses. Third, these accountants are used to having all of the necessary documentations automatically delivered to them -They do not have to hunt down the business owners to ask for the missing information. Consequently, it is not unusual for the IRS auditor to assess millions in additional taxes. Fourth, former IRS agents are used to sit on the other side of the table. Just because they switch their chairs to sit on your side of the table doesn’t guarantee that they ‘d know what to do. Think about it, a construction inspector is not necessarily a good builder. Furthermore, inter-company transactions and loans are considered as income if not properly documented. Negligence Penalties may be assessed but Civil Fraud Penalties and even Criminal Fraud Penalties may also be assessed, especially when the assessments are substantial (for example, over $100,000).

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