A tax audit creates fear and anger in individuals and business owners. It also creates a need. The need for documentation to prove income and expenses when the auditor is scrutinizing them. While some people are meticulous in retaining documentation, other taxpayers have pockets of misplaced or destroyed data. Even worse, the documentation may have been destroyed by a fire or flood.
It is not uncommon for documents to be lost or discarded by business owners and individuals. However, time should not be spent agonizing over what should have been done with documentation. The appropriate focus is getting through the audit.
As soon as a taxpayer is notified of an audit, a “financial intervention” must begin. The taxpayer should gather any and all documentation that is available. In the case of a natural 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. Taxpayers should gather bank statements, canceled checks, deposit slips, credit card statements, and expense receipts. Missing data could be recovered from banks, credit card companies, and companies with which the taxpayer did business.
When solid documentation is received from sources such as banks and credit card companies, the process of recreating the taxpayer’s books and records is fairly straightforward. However, gaps in data are best filled with the help of a forensic accountant.
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.
• Affidavits from people or businesses that can support your deductions can be helpful.
• Use data from other months, quarters, or years to prove patterns in numbers.
• Ratio analysis may help a forensic accountant estimate expenses.
• Available industry data also may be used to estimate a reasonable level of expenses.
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.
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.
Sequence Inc. Forensic Accounting has offices in Milwaukee and Chicago, and provides litigation support, tax controversy asisstance, fraud detection, and fraud prevention services nationwide.