As tax time approaches, are you concerned about your record keeping should an audit happen?
When I created my corporation in 2004, I knew that there were advantages to having a business with which to run expenses through. I’d read Rich Dad, Poor Dad and The Cashflow Quadrant (multiple times by then!) and Robert Kiyosaki had written ad nauseum about the benefits of a self-employed person or business owner over a W2 employee when it came to taxes.
But armed with just that information didn’t seem enough. I wanted to know how to legitimately protect myself from a tax audit should that ever happen. As is often the case, I was introduced to a gentleman about 12 years ago that was probably one of the most strategic tax planners I’d ever met. He was a retired Navy man who had been doing tax prep for the past 35 years and actually enjoyed reading through the tax code and finding loopholes and other interpretations. His advice has served me well over the past decade and it’s worth sharing with our Money Savvy readers.
Here are the 5 things you must know to be audit proof at tax-time:
- Where did the income come from? It’s not enough to just know how much income you made, but also where the income came from. Was it consulting revenue? Product sales? Who paid you and in what form? (cash, check, credit, paypal, etc.) In an audit, your income will be combed through to make sure it’s all accounted for. The easiest way to do this is to connect your accounts to a system like xero.com that pulls in all of your data on a monthly basis and allows you to categorize it.
- Where did the income go? Seems simple enough, but you’d be amazed at the number of entrepreneurs that have no clue where all of their money went at the end of the year. Tracking your expenses is probably one of the most important things for an entrepreneur or owner of a company to do. Kiyosaki wrote about it in Rich Dad, Poor Dad — his take on it was ‘Mind your own business’. And by minding, he meant know the numbers of your business as intimately as possible.
- Who did you spend it with? If you’re tracking expenses related to meals & entertainment or meeting expenses, make sure you’re documenting who was with you that made it a business meal, or at the very least involved business chat. Probably a good idea to make a note or two about the context of the communication as well. The difference between a meal & entertainment expense and a meeting expense is generally there was a contract signature/business transpiring involved in meeting expenses where M&E are just that. The biggest discrepancy between the two is M&E expenses are only 50% deductible where meeting expenses are 100% deductible.
- Where did you spend it? Just as important as who you were with is where you spent the money. Just having information in your P&L that lists ‘Office Supplies’ but doesn’t have any particulars about where that was spent could be called into question in an audit. Spending cash on virtually anything and plugging it into a category will draw suspicion from an auditor. If you paid cash, notate where it was spent and what it went for.
- Do you have proof? Proof, essentially, is having a receipt for whatever you spent money on whether that’s a credit card slip, a paper receipt for cash, or a cancelled check. My tax guru told me he’d seen auditors zero out deductions that didn’t have a slip of paper with proof of the expense. The receipt is the best thing you can have, particularly if they’re categorized in the proper expense category folder. (By the way, just having your credit card statement is not enough according to my advisor — the receipt is the official record of expense and is needed to verify the purchase.)
If you find yourself in the middle of an audit and have access to all of the receipts from your expenditures, you’re more than likely golden. If you can detail the 5 things above, you’re absolutely golden.
And for what it’s worth, I recently read that .7% of returns were audited this past year, so you have a seriously good chance of not getting picked for review… but better safe than sorry!
Adam Carroll is an internationally recognized financial literacy expert and serial entrepreneur. He is the creator of the student loan documentary Broke, Busted & Disgusted, the author of Winning The Money Game and The Money Savvy Student, and he once jumped out of an airplane at 14,500 feet strapped to the back of a handsome Army Ranger.
