We've often mentioned the importance of adequate documentation to
substantiate a business deduction. Ideally you should have a canceled
check and an invoice marked paid with the serial number of the item
purchased. While that may be viable for certain big-ticket assets,
realistically, that's not often the case for most expenses. And the IRS
knows that. There are many other ways to document expenses that are
acceptable. However, you should be able to show that payment was made
(e.g., a canceled check) and the nature of the item purchased (e.g., an
invoice with a description of the item).
entertainment, auto expenses and charitable contributions. There are
separate rules for these items, and they're very strict. We won't deal
with them here. They'll be detailed in an upcoming report.
check. The check should have the payee and should show the cancellation
on the back. Why the cancellation? In the case of large or unusual
purchases, the IRS may check that the payee actually cashed the check.
not returned. Many businesses (and individuals) no longer have their
checks returned. The IRS will accept images of the check. In order to be
accepted as proof of payment, the statement must exhibit a high degree
of legibility and readability. If your bank doesn't send you hard copies
of the images, you should be able to download PDF copies of the checks.
Don't rely on the bank to save statements and check images. After a
certain period of time you may not be able to retrieve them without
cost. Download statements and images each month. (That's good advice for
other statements where you may no longer receive hard copies such as
telephone bills, etc.) You may also be able to show proof of payment by
an invoice marked "paid",
a check register or carbon copy of the check,
and an account statement that shows the check number, date, and amount.
account statement prepared by a financial institution showing check
clearance will be accepted as proof of payment if the statement shows:
the check number,
the amount of the check,
the date the check amount was posted to the account by the financial institution,
and the name of the payee.
cards. If payment is made using a credit card, the IRS requires that
you have an account statement that shows the amount of the charge, the
date of the charge (i.e., transaction date), and the name of the payee.
If payment is made using a credit card, the IRS requires that you have
an account statement that shows the amount of the charge, the date of
the charge (i.e., transaction date), and the name of the payee. Most
likely your credit card company is already mailing you these statements
monthly. Cards specifically designed for business like American Express
business credit cards will also provide year-end summaries. Note, this
will only provide proof of payment.
Electronic funds transfer. If
you transfer funds electronically, the IRS will accept an account
statement prepared by a financial institution showing an electronic
funds transfer as proof of payment if the statement shows:
the amount of the transfer,
the date the transfer was posted to the account by the financial institution,
and the name of the payee.
You must have an invoice or other documentation showing what you
purchased. A canceled check without an invoice or some other document
showing the item purchase could be a problem. Statements from a supplier
may be substituted, but only if they show the item. Fortunately, since
most businesses are computerized, a supplier could generate a duplicate
invoice if an agent insisted on seeing one. But it's best not to rely on
that. When paying invoices, write the check number and amount paid on
the invoice and the invoice number on the check so that you can cross
reference them later if necessary.
Save all invoices. Don't
assume the IRS will accept a check written to the telephone company
without an invoice. The check could have been for payment of your
What about independent contractors? Even for small
jobs, ask for an invoice. In addition, make sure you give the party a
Form 1099, if applicable. No 1099? You could lose the deduction or be
subject to penalties. What about those cash payments to some
contractors? No invoice and no record of payment probably could mean no
Cash register tapes. You go to the local hardware
store to purchase some fasteners for the business and get only a cash
register tape with no details of the items purchased. Will it fly? If
the total is relatively small and it's not a common occurrence, and
agent should accept it. Write a description of the items on the slip--1
gallon paint for repainting wall; bolts for shelving. Fortunately, most
stores now print the detail on the tape.
Caution on tapes. Many
businesses, including major big box retailers, use heat sensitive tape
to print receipts. The life can vary widely from less than 1 month under
poor conditions (the glove box of your truck) to several years under
good conditions. Don't take a chance. Make photocopies of the tapes.
for purchase. The business purpose of most of your purchases may be
obvious. An agent is unlikely to question a laser printer cartridge, a
computer, a book on how to use a computer program, etc. But be prepared
for questions if the invoice or tape shows the purchase of items that
normally wouldn't be business related or could be personal as well as
business. For example, the purchase of a book with no clear business
relationship, power tools by a computer consulting business, etc. Don't
take a chance on remembering the reason several years later when you're
audited. Write the business reason on the receipt or attach a
description to the receipt.
Avoid personal purchases through the
business. It's convenient to use a company check or credit card to
purchase personal items. Resist the urge. Your accountant may spend time
making the entries to adjust your expenses. If he doesn't or misses
some that an agent catches, the agent might increase his scrutiny of all
your expenses. You could be liable not only for additional taxes and
interest but also an accuracy-related penalty. In flagrant cases the IRS
may claim fraud, particularly if other indications are present.
made to cash. While you should try to avoid them at all cost, that's
nearly impossible. The larger the amount, the more careful you should
be. Be sure to indicate on the check what the purchase was for. This is
one time when an invoice can be critical. An invoice marked paid in full
would certainly help your position.
Cash expenses. Some expenses
will be so small that an invoice or even a cash register tape is
impractical. You may also be paying in cash rather than by using a check
or credit card. Keep a diary showing the date, place, amount, and
description of the item purchased or service obtained. For example,
"11/20/12, Madison Hardware, $6.25, nuts and bolts for shelving".
standards for documentation. Any invoice, contract, etc. should be up
to industry standards. For example, a receipt from a local deli for
sandwich platters for the office party may be scribbled on an invoice
without a number (it should, of course, be dated). But an invoice for a
collision repair on the company truck should contain detailed parts and
labor, since the shop normally does that for insurance purposes.
documentation. You should also retain other documentation that might be
used in addition to or in place of an invoice. For example, a contract
for services, lease on equipment or office space, warranties on
equipment, service contracts, etc.
Petty cash. If you keep a
petty cash fund, slips showing expense reimbursements should be
sufficient to document the expenses. That's assuming the expenses are
small, as one would expect. Make sure that the nature of the expense is
clear from the slip. Employees should check that and, if not, write on
the slip the type of expenses and the vendor.
We're not talking travel and entertainment here. It's not unusual for an
employee to purchase office supplies, small equipment, shop supplies,
maybe even items to be used on the manufacturing floor that may be
critical. Officers and especially officer/shareholders often pay company
expenses out of their own pocket. While it's best to avoid such
situations, that's not always possible. The correct procedure is to have
the employee file an expense report and attach the documentation. The
company should then cut the employee a check for the amount documented.
For example, you need a color printer for a rush job. An employee buys
an inkjet printer with his own credit card. He should file an expense
report and attach the credit card slip and any other documentation from
This can be especially critical when it comes to an
employee/owner/shareholder. Without the expense report the company can't
take the deduction because it didn't pay for the item; the
employee/owner can't take the deduction because it's not a valid
deduction. Special rules apply to partnerships and there's an exception
if the business has a policy of not reimbursing. Talk to your tax
Cohan rule. The last resort. It's called the Cohan rule
because it evolved from a court case where the taxpayer was George M.
Cohan. Cohan claimed travel and entertainment expenses for which he had
no receipts. The court allowed him a deduction based upon the fact he
was able to convince the court he incurred expenses but did not have
proof of payment or the actual amount. Ironically, this rule cannot be
applied to travel and entertainment expenses any longer. Now if
required, no receipt, no deduction, no exception for those expenses.
does the Cohan rule work today? If you can show you definitely incurred
the expenses and are entitled to a deduction but don't have the
receipts or proof of payment, the court may allow a deduction based on
an estimate. But there has to be some basis on which the court can make
the estimate. For example, you have no receipts to prove your fuel oil
expense for 2012 because you inadvertently destroyed the bills. In
addition, the company went out of business. Clearly you incurred some
charges to heat your building. The court may estimate the expense based
on an average of fuel bills for several years.
This is a last
resort for a number of reasons. First, you may have to go to court to
get the deduction. Second, the court is almost assuredly going to try
and underestimate the amount of your deduction. Third, the rule will
probably not be applied if you have access to the documentation but
don't produce it (e.g., you could ask a vendor to produce the necessary
statements, even if it cost you). Fourth, you'll still have to convince
the court you incurred the expenses. It may believe your testimony; it
may not. You'll be on safer ground if you have some corroborating
Finally, the court is under no obligation to assist
you. Even if your records are destroyed through no fault of your own
(e.g., a fire), the court can require you to reconstruct. You'll fare
better if you can show the lack of records either isn't your fault or,
if it is, there are extenuating circumstances. For example, you normally
have excellent documentation but telephone and utility bills for one
year were inadvertently discarded.
Sometimes you can convince the IRS or the court you incurred the
expenses by producing witnesses. That may work, but if the witnesses
aren't convincing or the court believes the testimony may be biased
(they're employees or relatives), it doesn't have to accept their
testimony. And that happens in a high percentage of cases. Again, not an
approach to rely on.
Too much paper? In many cases you don't
have to save paper copies. Electronic versions of statements received
from vendors or others will normally suffice, but they must be readable.
You can also scan documents and save them as electronic copies. If the
documents are signed (e.g. a lease), you might want to retain an
original copy. And consider retaining hard copies of important asset
purchases. Talk to your tax advisor.
Retention time. You may have
heard hold canceled checks and other documents for 3 years, but it's
more complicated than that. Technically it's three years from the date
you filed the return. But if the IRS suspects you underreported your
income, it can go back 6 years. If it believes fraud is present, there
is no limit. For assets such as autos, equipment, etc. you should retain
all documentation for at least 3 years after the asset is disposed of.
And longer retention periods can apply to employment records. If you
need a single rule of thumb, use a 7-year holding period for most
records. But the best approach is to check with your tax adviser.
vital. Based on an informal analysis, it appears that more taxpayers
lose in Tax Court because they can't substantiate their expenditures
than for any other reason. While the IRS sometimes does show some
flexibility, it's generally a stickler for records and can disallow the
smallest expenditure for lack of them.
Kenneth Hoffman counsels
Entrepreneurs, Professionals and Select Individuals in taking control of
their taxes, and businesses. Discover how I can help you overcome your
tax and business challenges. To start the conversation or to become a
client, call Kenneth Hoffman at (954) 591-8290 Monday - Friday from 8:30
a.m. to 1:00 p.m. for a no cost consultation, or drop me a note.
you found this article helpful, I invite you to leave a commit and
please share it on twitter, facebook or your favorite social media site
and with your friends, family and colleagues. Thank you.