Many Americans often ignore or quickly say "No" when asked whether they want a receipt, but not small-business owners. Is this because they spend hours upon hours organizing them during the year and look forward to turning them into their accountant? Um, not necessarily. Savvy business owners simply know how to keep receipts because if they don't, their tax return could be in peril. The reality is: Receipts are audit protection and we have to take that seriously.
This past year Betty Ong, a real-estate broker in Northern California, was another casualty of tax court and lost to the Internal Revenue Service. Ong deducted thousands of dollars for travel, meals, entertainment, automobile and cellphone expenses, but like many small-business owners, didn't keep the strict substantiation requirements of the IRS. While Ong was able to produce books and records proving the expenses were incurred, she failed to show receipts, notes and documentation that the expenses were business related. In the words of the court, the only evidence she presented to support the business purposes of her expenses was her "own broad self-serving testimony and uncorroborated notes."
Sadly, Ong is just one of many business owners who didn’t keep proper records and lose in audits or tax court every year. The reality is that you may be entitled to these deductions, but if you don't follow the rules, you could be left out in the cold. Here are some basic tips:
1. Keep all receipts.
This point cannot be overstated. I was recently helping a client with an audit in which the IRS agent asked for every receipt to support my client's travel expenses taken during the year. It's true that you could argue what's called "the Cohen Rule," that you can use "other credible evidence," or rely on IRS Publication 463 which says that you don't need to keep receipts for expenses under $75, but why get into a fight? Arguing with the IRS can cost you a lot more time and money than just keeping your receipts.
2. Make notes on receipts about their business purpose.
This is an especially great idea for dining and entertainment expenses. It can be easy to remember why you bought a fax machine (Do people still buy fax machines?), but it could be a lot harder to remember who you went to dinner with at Red Lobster three years ago and what the business purpose was.
3. Scan receipts and keep them at least six years.
Yes, the IRS can come knocking for documentation and audit you up to six years back in some cases. However, hoping that the ink on your Home Depot receipt hasn't faded away is a whole other issue. The IRS allows taxpayers to scan receipts and store them electronically. But keep a back-up, because crying about your hard drive crashing isn't going to help you any more than "My dog ate my receipts."
4. Take a picture with your smartphone.
With today's technology, it's easy to say "Forget the receipt, I'll just make a note on the receipt and then take a picture of it". This is a great idea and there are a whole host of apps for the iPhone and Android that can help you better track your expenses.
5. Keep a daily business journal.
A daily journal for your business may sound like overkill, as if you weren't all busy enough. However, it can be simply accomplished by keeping a good calendar in your Outlook or Google Calendar. I was in an audit representing a taxpayer about two years ago, in which the auditor actually asked for a printout of my client's Outlook calendar to substantiate various deductions being claimed. Several good legal and other reasons to keep a detailed schedule of your day exist, even if you add these details at the end of the day.
6. Don't rely on credit-card statements and canceled checks.
These are important, yet insufficient without receipts. The IRS may see that you spent $422 at Staples, but it doesn't know what you bought. It could be movies and useless technical gadgets, and not the computer paper and supplies you expensed them under. For bookkeeping purposes, these records are fantastic, but the detail is critical for an IRS auditor.
7. Stay away from cash.
Using cash for expenses seems to be the absolute death-nail for my clients trying to keep good bookkeeping records and documentation for an audit. Cash is hard to track, easy to spend, and nearly impossible to reconcile with receipts. Stick to debit and credit cards to better track your expenses and then combine them with receipts.
It's no secret that audits will continue to only increase and the rules will be only more strictly enforced. The best course of action for small-business owners is to be prepared with a better set of books and receipts for all of their expenses, staying one step ahead of the "tax man."
Mark J. Kohler is a CPA, Attorney, Radio Show host and author of The Tax and Legal Playbook: Game Changing Solutions For Your Small Business Questions and What Your CPA Isn’t Telling You: Life Changing Tax Strategies from Entrepreneur Press.