You are being audited. These are some of the most dreaded words an individual or business will ever hear from a state or federal tax auditor. They invoke fear, panic, and sometimes anger.
Most of all, they create a need for documentation. Every number could be scrutinized. That means documentation must be produced to support the amount of each expense and the business purpose of the item.
Some of us are meticulous in our documentation, but if you are like most taxpayers, you have pockets of misplaced or destroyed data. Even worse, you may be in a situation where documentation was completely destroyed by a fire or flood. If you don’t have documentation, does that mean your deductions are automatically disallowed? Not necessarily.
It is not uncommon for documents to be lost or discarded by business owners and employees. It happens. Blame and shame have no place in a tax audit. Arguing about who and what to blame does not help the company combat an aggressive auditor.
The task at hand is getting through the audit in a way that achieves the best possible result for the business. Business owners and executives need not spend time agonizing over what could have been done with documentation. Lots of businesses have been guilty of the “shoebox method” of accounting or careless records retention. Focus on getting through the audit and using better records retention procedures in the future.
Particularly in a situation where documents and records were destroyed in a fire or flood, the lack of information is unavoidable. Rather than focusing on what isn’t available, it is advisable to concentrate on how to gather anything available and utilize it to the best advantage of the taxpayer during the audit.
Digging Up the Documents
As soon as I’m notified of an audit, I begin a “financial intervention”. The client must gather any and all documentation that may be available. In the case of a disaster, there may be absolutely nothing left. However, in the case of lost or discarded documentation, there is often some sort of documentation to be found. Any available information must be harvested and preserved.
Documentation will include both paper records and digital records. Where there are gaps in documentation, computer data may help fill in some of the blanks. To the extent that spreadsheets or accounting program data can be obtained, the information can help the case.
Paper documentation can include bank statements, canceled checks, deposit slips, credit card statements, and expense receipts. When any of these items are missing, it is advisable to look for outside sources of data.
Banks can produce old bank statements and check copies. There is usually a price for this information, but it is critical to an audit and must be obtained if the original records are unavailable.
Credit card companies are generally cooperative in producing copies of old statements. Vendors who have provided products or services to a company may also be willing to provide documentation such as invoice copies to help support business expenses.
I urge clients to get creative when thinking of how or where to get documentation that may support the income and expenses of a business. Anything at all that may help to support a deduction is fair game, and may help in the audit.
Recreating the Accounting Records
When solid documentation is received from sources such as banks, credit card companies, and vendors, the process of recreating the books and records is fairly straightforward. A forensic accountant can use an accounting program or a spreadsheet to accumulate data and recreate the financial statements for the periods in question.
What happens, though, when there are gaps in the data? Small gaps in documentation should not be an issue for an auditor, who will look for “substantial compliance.” For example, an annual expense can be reasonably estimated based upon documentation for eight or nine months.
The real problem occurs when there are large gaps in data. The documentation is simply gone and can’t be obtained through another source. What can a company do? There are several ways to help substantiate deductions during an audit.
- Oral explanations or testimony can be used to support deductions. If the taxpayer is credible and the explanation is supported by the facts, the deduction can be allowed. However, I don’t like to rely on this option if there is any other way to prove business expenses.
- Affidavits from people or businesses that can support your deductions can be helpful. Suppose you remodeled your office, but the documentation was destroyed in a fire. A letter from the contractor who did the remodeling may be sufficient to support your deduction of the amount paid to the contractor.
- Use data from other months, quarters, or years to prove patterns in numbers. For example, a company may spend the most on advertising in the third quarter each year, but is missing documentation for the year under audit. Documentation from other years shows that the third quarter advertising expense is consistently double that of the other quarters. It is therefore reasonable to believe that the same thing happened in the year under audit.
- Ratio analysis may help a forensic accountant estimate expenses. For example, one company’s cost of goods sold (cost to produce the items being sold) rarely deviates from 35% of sales. If documentation for the year under audit is missing, we can use this 35% estimate to determine a reasonable amount for cost of goods sold.
- Available industry data also may be used to estimate a reasonable level of expenses. This method is more speculative than others, but may be necessary if no other method of calculating expenses is feasible.
These are not the only ways to prove income and expenses, but are among the most common. It is important that the taxpayer make every effort possible to gather documentation that supports reported income and expenses for the year under audit. While other methods may be used to substantiate the numbers, documentation will be the most compelling proof.
Working with an expert who is familiar with methods used to recreate books and records is also a critical part of the audit process. Utilize an advocate who can be creative and aggressive to calculate numbers that are useful and believable, and which help the taxpayer achieve the best result possible from the audit.