If you are self employed, you probably don't like the process of maintaining receipts and other proof. Bookwork's no fun.
Many people who are self employed find it so boring to keep records, that they haven't done it for years.
The problem with this “rears” it's head in two circumstances:
1. When the returns haven't been filed and need to be re-created.
2. When a return has been filed and is being audited.
Lets look at the second problem and ask whether the small business owner can prove business expenses during the audit even if there are no receipts or even cancelled checks?
There is an old case called Cohan V. Commissioner, 39 F. 2d 540 (2d Cir. 1930) that states that the IRS will accept most expenses despite the fact that the receipts are missing.
The business owner needs to present a reasonable basis upon which he or she recreated the expense.
So if you have very few records and you are being audited, here are two examples where this “Cohan Rule” may help you:
a. Mileage Log – This can be recreated using anything that creates a reasonable basis for the miles. A calendar along with a signed affidavit is a good example. If you keep a calendar of which job site you visited each day – this would work even though you didn't keep a mileage log.
b. Subs or employee cost – recreating what is necessary to have performed the individual jobs can form a reasonable basis for the expense. Carpet doesn't get laid by itself.
In recreating a reasonable basis for expenses it is important to understand how critical the business owner's testimony can be. If the business owner is willing to swear under oath about the expenses and how they were arrived at despite a lack of documents, that can be powerful.
So..what happens if you lose the audit because you have few records and you failed to appeal timely?
You can ask the IRS to reopen the audit to re consider the expenses. This is called an audit reconsideration.
If you own a small business and you haven't kept records, it won't devastating if an audit takes place as long you can logically estimate the expenses using some reasonable basis. Calendars, Memory, Comparables from other businesses and Affidavits will help.
If you have lost an audit but know that the IRS didn't get the numbers right, you may want to consider asking the IRS to re-open the Audit so that you can provide a “reasonable basis” for the items that were disallowed.