Real Life Stories/ Personal audits: Exactly what does “we want to see the backup” mean?

The following is a true story …

A few years ago I was referred a client who was already under audit for returns filed in the mid-2000’s. It is my understanding that the audit had been handled by the preparer of the tax returns under audit. I will refer to this person as the “Prior Representative.” It would be an understatement to say the audit was not going well before I was brought in. It should go without saying that you should treat the Revenue Officer conducting the examination with professionalism and courtesy. Such had not been the case here. Big mistake …

You see, as is the case in many audits, the Revenue Officer had issued a Form 4564 Information Document Request (IDR). The IDR requested the following items:

  1. General ledger and all journals for your Schedule C business for the year ending December 31, 20XX, including the chart of accounts
  2. Copies of your financial statements if one was prepared
  3. Work papers used to prepare return, including trial balance and adjusting entries
  4. Copy of prior and subsequent Federal income tax returns
  5. Copies of State Tax Returns
  6. Copies of prior audit reports from either state or federal agencies
  7. Copies of Forms 940, 941, W-2, and 1099’s issued during the tax year
  8. Copies of current Forms W-4’s
  9. Copies of sales tax returns incorporating the taxable year
  10. Bank statements and deposit slips for all business and personal accounts including checking, savings or brokerage accounts, for the period December 31, 20XX thru January 31, 20XX
  11. Copies of bank reconciliations, if prepared
  12. Documentation of all nontaxable income
  13. Copies of any 1099’s you received
  14. A tour of the business facilities during the regular operating hours the day of the first appointment
  15. Please be prepared to specifically explain and show your invoices, cancelled checks and any other supporting documentation to verify the following account

    a. Other Deductions

    i.      Outside Services – $XXXX

    ii.      Materials & Supplies $XXXX

    b. Advertising – $XXXX

    c. Contract Labor – $XXXX

  16. Any other documents, records, or information which may be helpful to explain your tax return and expedite the examination

Now, pay particular attention to Items 15 and 16, above. I will refer to the documentation requested in IDR Items 15 and 16 collectively as the “Backup.” Apparently the Prior Representative provided credit card statements to the Revenue Officer rather than the Backup taking the position that that was all that was required and that the taxpayer therefore did not need to produce any Backup since the credit card had been used to PAY for the Backup (i. e., the invoices and other supporting documentation). Furthermore, it appeared that in reliance on the Prior Representative’s advice, the taxpayer did not keep the Backup in an organized manner, if at all.

Well here was the problem. The Revenue Officer did not feel the credit card statements were proper substantiation in and of themselves. Why? Because the credit card statements only identified a vendor. So for example, the credit card statement might read “Acme Widget Supply, $5,000.00.” A particular invoice was NOT identified. WHAT was purchased was not described. NO particular job of the taxpayer was identified. There was no way for the Revenue Officer to tie the credit card statements to the taxpayer’s specific claimed deductions. For all the Revenue Officer knew, items that had no relationship to the taxpayer’s business were being purchased. Long story short, there was no way to directly connect the credit card entries to the specific deductions being claimed. This opened the door for the service to challenge these deductions. It was a mess ladies and gentlemen and required a lot of “reconstructive accounting” that should not have been necessary in the first place. None of which was aided by the hostile environment created by the Prior Representative.

As I often tell my clients, you do not need to be mean and unprofessional in order to be an advocate for your client. Credit card statements are good, but they do not tell the WHOLE story. You need the Backup. Why? Because in an AUDIT, you need the WHOLE story, not just the chapter headings …

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