Finance Tax Time

After emerging wounded and bleeding from a recent IRS Field Audit, I picked up some clues as to how budding Internet Entrepreneurs can survive the ordeal with some semblance of financial health.

1. Make your paper trails complete.

You may think that a simple receipt will suffice. Hah! Be prepared to show not only a receipt but a logical trail showing what you purchased, what it does, how it was absolutely necessary in your business, and where the purchase shows up on your bank statements or credit card itemizations. Then provide an explanation of why it didn’t generate the income you thought it would (the reason you bought it in the first place). In addition to the self-reproach and frustration you encountered when the system you bought didn’t perform as promised, you now have to endure the humiliation of a Revenue Agent shaking their head over your gullibility in ever believing the sales hype Why DID I buy that thing anyway?)

2. Perfect your memory.

If you put $100 cash in your bank account, document exactly where it came from and why, because 3 years from now you will be asked for details as to why this unimportant sum should not be considered unreported income. A few garage sales a year and you have business income my friend, and that means self-employment taxes. Apply this advice to every deposit made outside your regular paycheck or retirement income. If you can’t remember what on earth it was, come up with a reasonable explanation and stick with it, through the doubtful head shakings and accusatory stares. Saying “I don’t remember” opens up a whole new can of worms.

3. Annotate your check register receipts.

Bought some books to build your business, for classes, for help with income tax? Having the clerk write out what you bought as simply “books” is too generic for an eagle-eyed Revenue Agent. And a ClickBank or PayPal receipt is meaningless unless you can document what was bought and why it was a business necessity. When you stock up on paper and printer ink at the local office supply store, make sure you pick a register that’s been recently filled so you don’t end up with an unreadable tape (and ink fades over 3 years) that will not pass muster, no matter how detailed your explanation. And just why do you buy so much ink? IRS agents don’t have home businesses and have no concept of how fast an inkjet printer gobbles up its supplies when you print out an e-book or two or five.

4. Web finances.

We have all experienced the nightmare of the first year on the Internet - the truckloads of money we cough up to buy e-books, software, and gadgets, plus put up websites that are going to make us a fortune. Did you make a huge profit your first year? Like most of us, you probably spent a lot more than you earned! Think that you can deduct those expenses? Forget it. These are start-up costs and even if some of them pass the scrutiny they receive (What exactly is an Auto-Responder? SEO costs money?), they’ll have to be amortized over 5 years. Who knows if we’ll even be on the net 5 years from now? Who knows if the people and sites we bought from will still exist in 3 years when “more detailed documentation” is demanded?

5. Giving is a two way street.

Next time you slip a $5.00 bill to the homeless guy at the end of the off ramp, make new friends by holding up traffic for 15 minutes while you have him complete a dated receipt including what he is planning on doing with the money. Don’t just put $20 into the Church offering plate, write a check and make sure you get a copy of it after cancellation. Never use those untended drop-off Goodwill boxes — a list of your donations is meaningless without a signed and dated receipt. And just how much do you think those used clothes and household furnishings are worth anyway? A lot less than they will eventually sell for, that’s for sure. Don’t just sponsor your grandkids in their walkathons or hand over cash for cookies - get an explanation of when you gave, how much, and what the money is being used for. Remember that it’s your word against theirs in a situation where your word is absolutely worthless.

6. Make Map Quest your friend.

If you do a lot of driving for business, charity, self-employment, or to a second job, be prepared to justify every mile through independent verification. Your odometer may differ from an internet estimate but you can’t be trusted so use an outside source, however inaccurate. To be in really good shape, take screen shots of online research (there go the printing costs again) to prove the figures you claim.

Let’s face it. The IRS flips a two-headed coin and we always choose tails. The bottom line is simple: if you show income and pay taxes on it, they will never, ever, question it. If you overpaid because some of that income was excludable, they’ll ignore it. But find yourself in the unhappy position of losing money over the year, as 90% of all would-be home entrepreneurs do, then your life becomes an open book before the eyes of an eager auditor with redlining foremost in mind, trained to ferret out every weakness in your armor.

We can all only hope to eventually make “guru” status and move to the Caribbean to hang on to our new Internet fortune!

Virginia Bola is a licensed clinical psychologist with deep interests in Social Psychology and politics. She has performed therapeutic services for more than 20 years and has studied the effects of cultural forces and employment on the individual. The author of two interactive workbooks: The Wolf at the Door: An Unemployment Survival Manual and Diet With An Attitude: A Weight Loss Workbook, she also issues a monthly ezine, The Worker’s Edge, and various mini-courses on weight control, she can be reached at her Social Psych Blog http://drvirginiabola.blogspot.com
as well as at her weight control information site http://www.DietWithAnAttitude.com/index2.html

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Congress has passed legislation that is supposed to
result in a more “sensitive” Internal Revenue Service. You
know, not such a lean, mean, tax-collecting machine.

Hmmm . . . . What do you think?

A few months ago, one of my clients (let’s call him Mr.
Jones) got one of those IRS “love letters” requesting more
information about his return, and the IRS wanted to meet
with Mr. Jones in person to discuss the situation.

Mr. Jones (a local small business owner) was required to
show up at the local IRS office with all his records. The
IRS was questioning the legitimacy of several business
deductions — and so the IRS was doing what it is allowed by
law to do — demand that the taxpayer prove that those
deductions were valid.

Turns out that Mr. Jones lost the audit and ended up owing
the IRS a significant amount of money — the additional tax,
plus penalty and interest for late payment of that tax.
Why did Mr. Jones’ lose the audit? Mr. Jones made two
“classic” taxpayer mistakes:

MISTAKE #1: “NO RECEIPT, NO DEDUCTION”

Mr. Jones lost several deductions simply because he didn’t
have the proper documentation to prove the deductions.

What do I mean by “documentation”?

Well, if the IRS requires you to substantiate a deduction on
your tax return, you must be able to provide written proof
that the deduction really happened. The easiest way to
prove a deduction is to hang on to:

a) The receipt or invoice, and

b) Proof of payment, which can be a canceled check, cash
receipt, or credit card statement.

Mr. Jones reported numerous deductions for which he simply
didn’t have the documentation. No receipts, no canceled
checks, no nothing. Turns out that Mr. Jones was one of
those “cash guys”. Maybe you know what kind of guy I’m
talking about — he never wrote a check in his life, just
carried a wad of cash around in his pocket. He paid for
everything with cash, and never kept any of his receipts.

Every year he’d sit down with his wife and
“remember” how much he spent on different things. No way to
prove any of this, of course. He just had a “feel” for how
much cash he had spent, and he had run his business for so
many years that he just “knew” how much it cost to purchase
certain things.

Well, this is the kind of taxpayer that the IRS loves!
It really is true — if you can’t prove that you paid for
something (with receipts, invoices, canceled checks, etc.),
then you run the risk of losing that deduction in the event
of an audit.

One of the most common questions I am asked by clients is
this: “I know I paid for something, but I don’t have a
receipt. Should I still report the deduction.”

My response is usually this: “You only need a receipt if
you get audited.”

At first, people don’t
know if I am joking or not. Well, I do make that comment
with my tongue planted firmly in cheek, but there really is
a lot of truth to it. If you don’t have the documentation
to prove a deduction, you can still report the deduction
(if you want), because you only have to prove the deduction
if you get audited.

But if you do get audited, knowing that there are
undocumented deductions on the return, be prepared to lose
the deduction. Fair enough?

And here’s the other major mistake that Mr. Jones made:

MISTAKE #2: BOGUS DEDUCTIONS

It turns out that Mr. Jones wasn’t completely honest with me
about some of his deductions. He reported deductions that
simply were not real deductions. Here’s one example:
Mr. Jones owned several rental houses. These rental houses,
of course, required maintenance and repair work. Many
times Mr. Jones would do the work himself rather than pay
someone else to do the work.

Well, Mr. Jones would estimate what he would have had to pay
someone else to do the work that he did himself, and then
he would report that amount as a deduction, even though he
didn’t actually pay anybody to do the work.

In other words, Mr. Jones deducted the value of his time –
which is non-deductible.

This is an important point — you can never legitimately
deduct the value of your time for work you did. You have to
actually pay someone else to do the labor.

If you ever get a letter from the IRS demanding
additional information, you’ll have nothing to worry about
if you do exactly the opposite of what Mr. Jones did. If
you can properly document your deductions and assuming you
have no bogus information, you’ll pass the audit with flying
colors.

Wayne M. Davies is author of 3 tax-slashing eBooks for small
business owners and the self-employed. For a free copy of
Wayne’s 25-page report, “How To Instantly Double Your
Deductions” visit http://www.YouSaveOnTaxes.com

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The odds are low that your Internal Revenue Service (IRS) tax return will actually be audited. As it is, it is virtually impossible for IRS to examine each and every tax return due to time and personnel constraints. Also, the greater your income, the more chances you have for being audited. After all, it doesn’t make financial sense for IRS to audit somebody’s tax return whose income is, say for example, $5000 per year.

Still, nobody is immune from IRS audits and the last thing you want is to spend your time and energy in your audit.

Here are some of the steps you can follow to minimize your chances of being audited.

1. Use a computer to prepare your tax return: Not only will your tax return look cleaner to read, but you will also minimize your chances of making a mistake on your return.

2. Always check your figures: Once you are done with your tax return, always make sure all the amounts that you entered in your tax return document are correct. If the amounts are not correct, it is always easier to fix the problem now than to hope that IRS won’t find out. Remember if IRS does find out, you will spend a lot of time and energy in fixing your problems.

3. Sign your return: Even though this is a no-brainer, many people simply forget to sign it. One of the most obvious reasons is that we spend a couple of days finishing and reviewing the tax return and in the end, we forget signing our own tax returns.

4. Use electronic filing: If you file your return on a hard copy, do remember there will be an IRS employee who will enter the numbers you provided in their computer system. Obviously, this is a time consuming effort. Also, the IRS employee himself can make a mistake when entering the data into the computer system. It is better to file electronically so that there is no margin for introducing errors.

5. Provide proof if you have large deductions: If you have a large deduction such as an expensive medical treatment, you can provide receipts, checks and medical bills. Large deductions can turn on the IRS audit flag and it is always good on your part to show as much proof as you can. You may use disclosure Form 8275 for this purpose.

6. Use care for business expenses : One of the biggest advantages of a business is that you can claim deductions. However, not every expense can be counted as a business expense. The laws can be complicated and it is always better to see a tax attorney for this matter.

The best step you can follow is, just be honest about your financial aspects. If you are honest, you don’t have to be afraid of anything if an IRS taxman knocks on your door.

Copyright 2006 Divyesh Dave

Divyesh Dave is an online entrepreneur and currently runs a financial based website. For more information, visit http://www.bajika.com and his financial blog at http://ezdough.blogspot.com/

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