Whether an expense is for advertising, rent, or utilities taken on a Schedule "C", or an item deducted on a Schedule "A" such as donations, or mortgage interest on Schedule "E" is taken, substantiating such expenses to the IRS is important if it is asked of your client on the information document request (IDR).
One of the first thing an IRS examiner will do is to ask for books and records of a business, cancelled checks of a deduction and so on.
If there are any discrepancies between the amount claimed on the tax return and the actual documents, such as cancelled checks or receipts, the examiner will then make an adjustment to the tax return and will assess interest, and may also assess penalties such as the "Negligence Penalty", "Civil Fraud Penalty", or refer the case to the Criminal Investigation Division (CID) for criminal fraud!
Make sure to prepare for the audit and clarify any issues with your client before the audit date!
Example:
John Doe owns and operates a pizza store. He won the IRS Lottery. His 2008 tax return, 1040, Schedule "C", is being audited. The examiner requested John to substantiate the rent expense deduction of $36,000 taken on the return via the Information Document Request sent to John.
The following example may be prepared for any expense or deduction taken on a tax return :
| John Doe
2008 - 1040 - Sch. C
Rent
Per Return: 36,000
Per Audit: 33,000
Adjustment: $3,000
Issue: Did taxpayer properly deduct $36,000 of rental expense for his pizza store as instructed by Revenue Code Section 162??
Facts: John owns and operates a pizza store as a sole proprietor. He claims his income and expenses on a Schedule "C" of his 1040 tax return. In 2008, John claimed $36,000 in rental expense deduction.
Included with this work paper is a copy of the lease. Reference # A-101. (Please note that on the bottom of this work paper I included "Reference # 100. If you have to present more than one document, please use reference numbers.)
Cancelled Checks Inspected
| Check Number |
Amount |
| 1011 |
3000 |
| 1210 |
3000 |
| 1325 |
3000 |
| 1400 |
3000 |
| 1501 |
3000 |
| 1626 |
3000 |
| 1745 |
3000 |
| 1825 |
3000 |
| 1950 |
3000 |
| 2001 |
3000 |
| 2025 |
3000 |
| |
|
| Total: |
33,000 |
Taxpayer has a discrepancy of 36,000-33,000 = $3000
Taxpayer paid his December rent in January of the subsequent year but deducted the amount paid in the current period.
Rule of Law: IRC Section 162 states that "In general there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including.........in connection with such service. |
Argument: Taxpayers state that the $3,000 deducted is a mistake and agrees to the adjustment.
Conclusion: An adjustment of $3,000 will be made to rental expense deduction on Schedule "C".
Reference # A-100
|
The previous example is what I call an "IFRAC". Issues, Facts, Rule of Law, Arguments, and Conclusion. Practice it. It is very important especially if you and the examiner don't agree and you appeal the examiner's decision. The only thing that will be missing would be under arguments and that is "Government Argues" as you'll study under "IRS Appeals".
