Taxpayers always wonder about whether or not they can deduct expenses when they don’t have a receipt. Generally, yes, you can… but you want to proceed with caution if you’re going to try this. The IRS and the courts have some tax deduction receipts rules you want to follow.
The other thing you want to understand, however, is where and how the IRS will look at your tax deduction receipts if push comes to shove. So let’s talk about all this stuff in terms of the typical small business owner.
Tax Deduction Receipts and the Cohan Rule
Here’s maybe the first thing you want to know. There was a tax court case Cohan v. Commissioner, 39 F. 2d 540 (2d Cir. 1930). It set a precedent, now commonly referred to as the “Cohan rule,” that says you can deduct expenses even without a tax deduction receipt if you can provide a reasonable estimate of what these expenses were.
That’s the good news. And you want to know this tax deduction receipts rule. In an audit you may want to pull this rabbit of your hat.
Exceptions to the Cohan Rule
However, Congress has passed some exceptions to the Cohan rule [IRC § 274(d)] related to the following items:
- Travel expenses
- Entertainment expenses
- Gift expenses
- Expenses for “listed property” (passenger automobiles, computers, etc.) [IRC § 280F(d)(4)]
You can’t finesse your way through an IRS query into expenditures falling in the above categories by smugly referencing the “Cohan rule.” You’re going to want receipts for all your expenditures that fall within the above four categories. And you’ll want to also append any additional relevant information to the tax deduction receipt.
For example, if you spend money on travel or entertainment, you’ll want not only the receipt but to document in detail why the expenditure should count as a business expense.
Cohan Rule vs. Tax Deduction Receipts
Let me also just say this: It’s still always better to save receipts than rely on the Cohan rule for claiming deductions. If you’re audited you’ll likely have to argue and negotiate with the auditor about what’s a “reasonable” estimate, whereas if you’re organized and save your receipts you’ll easily get the full deductions you’re entitled to.
And be aware that taxpayers who try to rely on the Cohan rule often lose their case (see, for example, Sam Kong Fashions, Inc., T.C. Memo. 2005-157, Stewart, T.C. Memo. 2005-212, and Harlan, T.C. Memo. 1995-309) because part of the Cohan rule is that a court can “bear heavily if it chooses on a taxpayer whose inexactitude is of his own making.”
A first relevant side note: businesses that don’t have organized bookkeeping systems almost always tend to “crash and burn” once they’re in an audit, even if they haven’t done anything wrong.
A second relevant side note: if keeping records of your receipts is overwhelming to you, we would highly recommend adopting a paperless recordkeeping system using products like the Fujitsu ScanSnap ix500 and Hubdoc. We’re not getting any sort of commission from saying that, by the way. We just think these are good products.
And this final note: Some printers use ink that fade over time. This perishability can cause real problems if you get audited.
Accounts the IRS Scrutinizes
Here’s something else you want to understand when you start worrying or thinking about tax deduction receipts. In an IRS audit, the auditor will scrutinize predictable line items in your tax return.
In small business audits, for example, the auditor will often first perform what they call a “BDA,” or bank deposit analysis. This “analysis” is essentially just the auditor adding up all of your bank deposits, comparing it against the (usually cash-basis) income you reported for the year, and then asking you to explain the difference.
This is why you really want to use an accounting system that allows you to track different types of cash inflows effectively and do bank account reconciliations. You don’t want to end up getting “caught” in an audit by paying income tax on bank deposits that were really just capital contributions or money being transferred between different accounts.
The IRS will also look at the four accounts mentioned above which don’t get protection via the Cohan Rule. (Cynically, a tax accountant might say this stems from the ease with which the IRS disallows deductions in these four categories.)
Further, the IRS will look at any other large expense deductions showing on your return. If education expenses, supplies expenses, or utilities expenses are sky-high, expect the auditor to carefully review those categories—and ask for most of the tax deduction receipts.
And this final related point: Even if you can provide a receipt for some expenditure, that may not be enough. If you show a receipt to back up a $123.45 deduction, the IRS may also require you to provide the $123.45 check or the $123.45 credit card charge slip you used to pay the expense.
Receipts and the Statute of Limitations
You’ll want to save your receipts and other tax documents for at least three years after the point a tax receipt documents something in your tax return.
For example, if you use a 2016 receipt for your 2016 tax return and you file your 2016 tax return on April 15th, 2017, you’ll want to save that receipt until at least April 15th, 2020.
The reason for this is that tax returns inside the statute of limitations are the ones that can be audited. And tax returns that can be audited are the ones that can trigger a query from the auditor to provide a receipt.
Note, too, that in some special cases (like criminal tax evasion or gross understatements of income), the statute of limitations stretches out to six years. For this reason, some people use a six-year rather than a three-year holding period.
Small-Business-Specific IRS Concerns
Much of the stuff mentioned above applies both to personal tax deductions and business tax deductions. But let me share a couple of documentation issues related specifically and only to small businesses:
First, the IRS considers the possibility that a money-losing business might just be a hobby in disguise. So if you find yourself in a business that’s fun, but often doesn’t make much money, you probably want to talk with a tax adviser about how to make sure you can legitimately claim losses in your business and minimize potential risk in an audit. Lots of this work, by the way, will revolve around you creating additional good documentation to support the stuff shown on your tax return.
Second, the IRS will look at the possibility that some expenditure was really personal rather than business in nature. So anything that might be personal, you want to do a good job of documenting. (Adding notations to a receipt that the toys you’ve purchased are for your waiting room or that the big screen TV you bought went into your conference room for video meetings would be examples of this.)