Proof of Purchase Does not Prove Expense
As business owners, you are able to take expenses and deductions that reduce your taxable income, but what happens if you are audited? You may be thinking that the possibility of your business being audited is low, but the IRS has set a goal to audit 50% more small businesses in the upcoming years, making the risk relevant to you. The IRS wants to know the Who, What, When, Where, and Why for every aspect of your business. This leads to credit card and bank statements not being an acceptable form of evidence for proving business expenses, which is why we will go into detail explaining the steps you need to take to ensure all your ducks are in a row before you file your tax return.
What is a Qualifying Business Expense?
Let’s first start with understanding what a qualifying business expense is. According to the IRS, a qualifying business expense must be ordinary and necessary to your principal business service or product. Simply put, the expense has to be for your business. A family vacation to Florida or groceries for the week won’t pass IRS rules. Some everyday business expenses to watch out for include materials, supplies, bank fees, travel, meals, and professional fees. Your business activity will determine which costs are more likely to occur, so be in contact with an accountant to be sure you are taking all possible expenses.
Why Does the IRS Nix Credit Card and Bank Statements in an Audit?
Now for the fun stuff. Why does the IRS not allow credit card or bank statements in an audit? The IRS requires that all businesses must have adequate support for expenses, a term known as the burden of proof. When you use credit card and bank statements as proof of purchase, there is not enough detail that describes what items were bought and if they were qualifying expenses. For example, if you went to Home Depot for supplies, the credit card statement would just show that the purchase was at Home Depot. The individual items bought would not be known without an actual receipt. The IRS is nosey and wants to ensure that all expenses relate to your business, especially if you report a significant amount in the travel category.
What Documentation is Needed?
There are a few different ways you can go about staying in compliance with the IRS. The first is to keep all receipts and documents supporting your purchases. As tedious as it seems, throwing all receipts into a file can save you the hassle and large tax bill in the case of an audit. If you are technology savvy, you can even scan in receipts for an electronic version and toss out the physical receipts. According to Publication 583, the IRS does allow electronic versions of receipts as adequate proof. The most common form of proper documentation that small businesses will utilize is paper receipts. However, other documentation such as invoices for products or services, check copies, and bills should be kept. Consider having a folder for each year to organize your taxes. The IRS and most state agencies have the ability to go back three years and audit your tax returns, so anything after the three-year mark can be tossed.
What if I Don’t Have Separate Business Accounts?
Are you a single-member LLC or a sole proprietor? If so, you might have difficulty keeping track of businesses expenses and receipts if you don’t have separate business cards or a bank account. When you report income on Schedule C of the 1040, your personal tax return, the government doesn’t require you to file for separate business identification. This means that you can report expenses that were run through your personal checking account or credit card. If this applies to you, it is even more critical that you keep track of receipts. The IRS is more likely to nix your business expenses as personal if you can’t produce the proper burden of proof. Not only can the government come after you and issue you a hefty tax bill, but insurance agencies generally go for your personal assets when your business is sued if there is comingling of expenses. To mitigate this risk, keep track of all business receipts, open a separate account and be on the lookout for our future blog that goes into detail on this.
Whether you’ve already received an IRS audit letter questioning business expenses or you are trying to get ahead of the game, contacting an accountant is in your best interest. Star Taxes and Books can walk you through proper documentation rules and regulations to keep you in compliance with Uncle Sam. If you are on the other side and have already received a letter, Star Taxes and Books is there to assist each step of the way and remember that proof of purchase does not prove the expense.