The Inflation Reduction Act allocates $80 billion to the IRS so that it can increase the number of audits. As of June 25, 2022, the IRS returned to the office (that’s right… they were still not in the office), and they expect to increase audit activity. Self-employed individuals and small business owners can be particularly at risk when being audited, because they don’t have an office staff to keep all of their records in order.
Your best defense against an audit is to maintain good documentation of your expenses. Many people assume that a bank statement or credit card statement is sufficient documentation, and they are shocked to discover that their auditor wants more. Generally, to get an IRS auditor to accept an expense, you need to provide a bank or credit card statement AND a receipt or invoice for the expense.
If you Google around about documentation requirements, a lot is made of the “Cohen Rule,” which is a rule set down by the Tax Court that if a taxpayer doesn’t have adequate records, they can still claim expenses if they are reasonable and credible. Here’s the catch: Your IRS auditor won’t care about the Cohen Rule. They’ll disallow your expenses and let you take it up with Tax Court. Most taxpayers would prefer to avoid heading to court to argue their expenses.
The same can be said about a lot of auditor overreach. Auditors will frequently ask for documentation that is technically not required. Your documentation might technically be sufficient, but you still find yourself fighting an uphill battle. This can feel very unfair, but remember that the auditor will take the position that the place to argue tax law is in Tax Court.
We advise that you keep EVERYTHING. Our favorite app for document storage is Dext*, but any document storage system that you use consistently works. The important thing is that you have the documents.
Stay tuned for some pitfalls that we’ve encountered in recent audits we’ve defended.
Audit Pitfalls Part 1 here.
Audit Pitfalls Part 2 here.
* This isn’t a paid advertisement for Dext, and we don’t get any kickbacks from them. We really do just like them!