Money Talk: The tax record defense

The most frequent reason Internal Revenue Service auditors deny any rural building business (or its owner/operator) a tax deduction is not because it is not allowed, but because the amount of the deduction cannot be substantiated. Although the government is reducing the need to keep records of income thanks to a mandate to credit card companies to report all transactions to merchants and the IRS, beginning next year, adequate documentation to substantiate every business deduction is extremely important.

The question of what records a builder or contractor needs to keep is also extremely important. Even though our federal income tax laws require only that every business keep “complete and accurate records,” they do not define their requirements.

When it comes to expenditures, ideally the building business should have a cancelled check and an invoice marked ‘paid’ for any item purchased. A cancelled check without an invoice, or some other document showing the item purchased, could be a problem.

Every cancelled check should have the payee and should show the cancellation on the back. Why the cancellation? In the case of large or unusual purchases, the IRS often checks that the payee actually cashed the check. And because, today, many checks are not returned by the bank, the IRS will accept check images.

While an invoice is usually required to show what was purchased, statements from a supplier may be substituted, but only if they show the item. Best advice, save all invoices and don’t assume the IRS will accept a check written without an accompanying invoice.

Other documentation that might be used in addition to or in place of an invoice, include contracts for services, leases on equipment or shop or office space, warranties, etc.

What about payments to independent contractors? Even for small jobs the building business should have an invoice. What’s more, the independent contractor should receive a Form 1099. Without a Form 1099, the deduction could be lost and the building business penalized.

While there is no requirement to keep receipts for an expense of less than $75, it is necessary to record all information about the expense; how much, to whom payment was made and what type of expense it was, the date paid, etc. Another good strategy: Keep a record of every deposit made to all bank accounts. Record all money coming in, whether taxable or not. At a minimum, note in the check register the source of each deposit.

A building business accepting credit or debit cards, or other electronic payments will, in 2012, find that payment processors will begin sending them — and the IRS — reports of amounts paid during each calendar year. If a payment is made using a credit card, the IRS requires production of an account statement that shows the amount of the charge, the date of the charge (i.e., the transaction date) and the name of the payee.

Since this is only proof of payment, always keep the original charge card receipts from any business expense. The monthly statement gives no information about what was purchased.

Although it is common and convenient to use a business check or credit card to purchase personal items, keep in mind that one misclassified expense deduction may increase scrutiny of all business expenses. Above all, avoid checks made out to ‘cash’. The larger the amount, the more they should be avoided. If unavoidable, always indicate on the check what the purchase was for. This is one time when an invoice can be critical.

It is not unusual for an employee to purchase office supplies, small equipment, shop supplies, etc. Records are especially critical when it comes to an employee/shareholder paying company expenses out of their own pocket.
If these situations cannot be avoided, the correct procedure is to have the employee file an expense report and attach the documentation. The building business should then cut the employee a check for the amount documented.
Without the expense report the building business can’t take the deduction because it didn’t pay for the item; the employee/owner can’t take the deduction because it is not a valid deduction.

Today, if there is no receipt or proof of payment the courts — not the IRS but the courts — may allow the deduction based on an estimate. But there has to be some basis on which the court can make an estimate.

In general, the rule of thumb is that canceled checks and other documents should be held for three years. Technically, it is three years from the date the tax return was filed. If the IRS suspects that income was under reported, they can go back six years. If it believes fraud is present, there is no time-limit.

For assets such as autos, equipment, etc., documentation should be retained for at least three years after the asset is disposed of. Longer retention periods can apply to employment records. Ideally, using a 7-year holding period for most records should be considered.

In fact, no record should be disposed of simply because it is no longer needed for tax purposes. Those records should be retained until the builder or contractor checks to see if they must be kept longer for other purposes. Insurance companies and creditors, for example, may require some records to be kept longer than the IRS does.

As more and more building businesses turn to their computers to keep track of financial matters, the IRS continues to expand programs for electronic filing of tax returns. Fortunately, a building business with assets of less than $10 million must comply with the record retention requirements for machine-sensible records only in a few rare situations. A machine-sensible record is data in an electronic format intended for use by a computer.

Unfortunately, keeping electronic records doesn’t relieve the builder, contractor or building business of its responsibility to retain hardcopy records. Hardcopy records may, of course, be retained in microfiche or microfilm format. The IRS has also approved scanning to relieve the need to keep original documents.

And don’t forget the new information reporting provision requiring expanded information reporting on payments made from businesses to corporations, and on payments businesses make for goods. While businesses do not need to file information returns on these payments until January of 2013, the IRS already plans to exempt business transactions conducted using credit and debit cards. These transactions will already be covered by reporting requirements on payment card processors.

Records and record keeping can take a variety of forms and shapes. Remember, however, that records are not only about making the IRS happy, they also play an important role in managing every building operation to profitability and success. How, after all, can any builder, contractor, building business owner or manager monitor the progress of his or her building business and guide it to increased profits and success?

The IRS has authority to compute the operation’s income when a builder or contractor — or a business — has kept either inadequate or no books or records. The methods used by the IRS for reconstructing income vary, depending on the facts and circumstances, but are rarely favorable to the errant taxpayer.

Other articles in the October 2010 issue of Rural Builder

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