In the US, if IRS comes calling, you can never have too many business records. I would think that this same rule would apply to all countries.
When Allen and I were audited a number of years ago, our accountant’s advice was to drown them in paper. In other words, have documentation for anything they had a question about. Her words saved us $45,000. We were flagged for audit because we closed our open shop and began to operate from our home. In order to be able to have room to run our business from home, we added a 2-story library with a cat-walk around three sides. Since our children were grown and not living at home, we lined their old bedrooms with bookcases and were using them as offices for our catalogers, a wrapping room, etc. Our basement family room was lined with bookcases and we wrote that off as well. We claimed 50% of our home as a write-off (we were actually using more) and that brought up the red flag.
I remember well the day the two auditors showed up at the front door. I was greeted with Congratulations, you have won the lottery, unfortunately, it is the tax lottery. Funny, huh? Just what we needed – an IRS comedian. They were there to do an on-site global audit on all our records for three years. This global audit was an option that IRS could arbitrarily determine. It was a true lottery in that the IRS would just pick someone who came up for some individual question and do a global audit. This meant that they wanted to see every piece of business-related paper. Over the course of a year, the auditor spent 175 hours going over our records and in the end decided we owed the government $60,000 in additional taxes. To make a long story short, we appealed and ended up paying the government $15,000.
We won a number of points because the auditor was new and making some very basic mistakes. The auditor informed us that we could not write off our library in its entirety because a picture had been seen of our grandchildren gathered around a Christmas tree in the library. We also had a small bar built into one corner, and we didn’t have bookcases on all four of the walls. Appeals ruled that “incidental use” was allowed in the library, and accepted that it was hard to put bookcases against a wall which had a 12-foot wide sliding door in it and a circular staircase next to the doors. We won the point because the IRS Appeals Officer had offered us a beverage while in the IRS office and we pointed out that was why we had a bar in our library so we could offer our visitors a beverage. The auditor also said we couldn’t write off our basement book room (even though there were over 3,000 books shelved there) because our daughter’s exercise bicycle was stored in the room. The Appeals Officer just laughed at this one and crossed it off.
IRS measured the space we were using and gave us a 54.8% write-off of our house instead of the 50% we were claiming that had triggered the audit in the first place. A fact that we delighted in noting on our tax forms for rest of the time we were in that house (“54.8% as determined by IRS auditor”).
Where we lost was on how we were writing off our book purchases. We were using a cash basis (and had been for the previous 25 years) which many bookdealers also use. IRS required that we use the accrual method. Accrual requires that you account for both expenses and income at the time they are billed. Cash basis meant we recorded expenses when we paid them and revenue when payment was actually received. So, if we had sold books in December that weren’t paid for until January, we counted them in the next year’s sales. IRS said we couldn’t do that because their rules state that if you maintain an inventory you must use the accrual method. That meant that even though we didn’t get paid until the next year, we had to include those orders in our sales for the current year.
However, we won on a couple of big points when they were readjusting our taxes from the cash basis to the accrual basis. The auditor had moved back cross-over sales (in the auditing period) from the year they were paid to the year the invoice was written. Since they were only auditing for three years, the auditor argued that we should pay taxes on what they moved but not be given credit for the year previous to the audit period, thus inflating our sales for one year. Also, even if you haven’t paid the debt, under the accrual method you can write-off expenses the year they are billed. The auditor didn’t want to give us credit for those expenses. Appeals said they had to give us the credit.
We lost on a point we knew we were going to lose on all along. Because we tend toward being obstinate when we feel something is obviously unfair, we wrote off the health insurance policies we were supplying for two of our daughters that work for us, as well as our own. Employee’s policies can be written off, our own could not because we weren’t incorporated at the time. The tax law has changed and you can write off some of the owner’s insurance now but it is a tax deduction that is being phased in over time. The write off will eventually be a 100%.
We won on business travel expenses. The auditor said we couldn’t write off our daily expenses in states we visited on a cross-country book buying trip, unless we bought books that day. The Appeals Officer agreed that just because we couldn’t find books we could mark up for resale that didn’t mean we weren’t conducting business. Therefore, if we had evidence of having been in a shop in a particular state (we had business cards from the shops we had visited) or had to drive through one state to get to a state where we could do business, we could write that day’s expenses off. The auditor also said that we couldn’t write off a trip if we stayed in someone’s home instead of staying in a hotel or motel room. We argued that if we had a friend in the same town where we buy books, the IRS should be glad. The Appeals Officer agreed and also agreed that we could write off the dinner we bought our friends for their hospitality.
We talked to three or four dealers that had been audited in other states and they were also initially told that they would have to change from the cash basis to accrual. At the end of their audits, their auditor’s said they could stay on cash basis as long as they were consistent but we weren’t so lucky.
All in all, we came out smelling like a rose when you consider the adjustments involved in changing us from cash basis to accrual. The good news for everyone is the “kinder and gentler IRS” global audits are no longer done, at least on an arbitrary basis. They can still do line-item audits. But, it’s important to keep in mind that because you never know which line they are going to question, you will need exhaustive records to back you up.
Records to keep for tax audit:
– Supporting documentation for business-related expenses, including all checks written, credit card charges, and cash receipts.
– All bank statements. IRS looks at these to see if your deposits are in line with what you are reporting as income (in other words, don’t claim $300,000 in sales and deposit $400,000).
– All receipts for any fixed business assets (e.g. bookcases, desks and chairs, computers, copiers, mailing scales, etc.)
– All sales invoices you have issued to customers.
– All sales-tax reports. Resellers are required by most States to collect and file sales tax reports.
– Resale tax numbers. You should have Resale Tax Numbers for all in-state customer on invoices where you have not charged tax. While we understand that this is not always easy, your State’s tax office probably will not be quite as understanding.