When Claiming Fake Deductions is Legal

Google has a neat feature called Alerts. This feature allows you to get a daily update on any topic you desire. The setup process is so simple even an accountant like me can do it without a problem. Once set up Google scans the internet, news and social media for mentions of your selected topic/s.

I follow a few topics which rarely get an update. I also have an alert of my tax practice: Tax Prep & Accounting Services, Inc.

The name of my practice is generic for a reason. I wanted something simple like General Mills or General Electric or General Motors. While most accounting firms want to spray paint their names across the logo, I wanted a name a buyer would feel comfortable purchasing without changing the name. You see, I was thinking about my exit before I even opened the doors.

Thirty years later I’m still holding on without a sell date in sight. I also get a daily Google Alert on a dozen or so items Google thinks fits my criteria of interest relating to my business name.

Accounting Today is an industry newspaper with a Tax Fraud Blotter. It usually tops the list provided by Google when an alert is issued.

On an alert received Saturday was the clickbait title: Look Ma—Phony Deductions!

The title bothered me because phony deductions, or more to the point, unsubstantiated deductions, are not always illegal!

I clicked to the Tax Fraud Blotter and discovered, as I knew I would, there was more to the story than the headline. The phony deductions were illegal. But the topic of legally claiming unsubstantiated deductions is real.

A Story from the Underground

If you were a tax professional, what would you do in a case like this? A regular client starts a business and has questionable recordkeeping from Day 1. Then he expands his business and has almost no records at all.

There are only a few things you can do. First, you can fire the client.

Remember, as a tax professional you sign the tax return under oath that the return is “true and accurate to the best of your knowledge” under penalty of perjury. If you sign a tax return as the paid preparer and the return doesn’t pass the sniff test you can face some serious fines, some as high as $25,000 a swing!

Second, you can throw up your hands and tell your client, “You can’t file an inaccurate return so I guess you don’t have to file at all.”

This is another really bad idea.

Third, you can prepare the return with the information at hand and hope for the best.

Each of these choices has issues. Firing a client because they’re stupid they didn’t keep accurate records doesn’t solve the problem.

It’s illegal NOT TO FILE your tax return by the due date, plus extensions. You are required to file even if you can’t pay. Lack of funds is not illegal; non-filing is!

If you refuse to touch the return somebody else will have to or the client is out in the cold. So if you don’t do it, somebody will or your client is heading for the hoosegow.

Telling a client they don’t have to file their tax return if they didn’t keep pertinent documents is also a bad idea.  I don’t know the IRS penalty off the top of my head, but it includes a baseball bat and something about “behind the woodshed.”

And last, hoping for the best is not sound tax advice.

Super Accountant to the Rescue

If you’re a taxpayer reading this you might want to put your fingers in your ears for a few sentences.

There is an easy way to file the above mentioned tax return for a disordered client and you get to charge extra for the service. A lot extra!

Last summer I wrote about the Cohan Rule. Now with tax season racing straight for us at warp speed, it’s a good time to review an extreme case which will allow you to file an accurate return “to the best of your knowledge” and avoid preparer penalties.

The example client we used above for our thought experiment is a real client. He runs a liquor store. His records are a mess to be polite. When we ask for more documentation we get an annoyed, “We gave you everything. It’s in there.”

No it’s not!

Last tax season it was so bad I had to junk the entire return except for three things: the bank statements showing deposits and checks written, supplier printouts for cost of goods sold and property taxes paid by going to the county to get proof of what was paid and when. From these few items I had to reconstruct a tax return, avoid preparer penalties and stay out of jail.

What would you do in a case like this? The client is a good guy, just a bit light when it comes to recording business income and expenses. Dumping him on the street would almost certainly end in the return never getting filed for years until the IRS lowered the boom. Then it would hurt him really bad and certainly end his business, putting him and his employees on the unemployment line.

You already have a good idea what I’m going to do. I’m going to make up numbers. But how?

You can read the Cohan Rule post I wrote back in August. The Reader’s Digest version states you can deduct reasonable expenses ordinary and necessary to a business (Section 162(a)) with the exception of meals, entertainment, recreation, amusement, gifts and certain listed property (Section 274(d)) for unsubstantiated expenses.

In the case of our friendly client, we also had to reconstruct income!

Building an Elegant Tax Return

I will show you how I built this client’s tax return without triggering an audit. The odds of the client getting audited are slim as I told the IRS exactly what I did. Past experience leads me to this conclusion because I’ve never had a client audited when I disclosed what I am about to show you.

Our victim, ahem, client had a box of stuff to go through. I added the whole thing up once his retainer cleared the bank.

The numbers were well outside the expected norm. (Remember, a tax professional can’t just file a return based on client provided information. If the numbers are unusual the tax professional MUST quiz the client further to ascertain if the data is correct. Unusual items remaining on a tax return should be disclosed with the original return. The disclosure should include the item in question and how the number claimed was arrived at.)

I pay special attention to local clients. If they have a business I make a note when driving past their establishment if I’m in the area. Clients miss a lot of serious tax benefits I find from a simple drive-by.

Our client in question had a small shop. I expected that since it was a liquor store. The footprint of such establishments is generally small compared to sales.

I also had his prior year return to build from. The numbers were substantially different.

I plugged the numbers I had as a starting point. My software compares the current year to the prior year. It was a crazy mess.

To construct a return I’d be willing to sign off on I started with known variables. The client was slow to get me bank statements so I had him sign a power of attorney allowing me to pull his bank records.

With the whole year of bank transactions in hand I added all the deposits for the year to arrive at Gross Revenue. I asked the client if he had ever deposited personal cash or checks to fund company expenses. He said, “No, well, maybe once. Okay, but, yes. No! Now that I think of it, maybe.”

There is a price for bad records. It’s called double taxation. If you can’t prove any of those deposits aren’t business income you have to report it as income! My disclosure to the IRS will list my position as such for good reason. The IRS uses the same formula!

I also asked if any income wasn’t deposited. I got an answer identical to the last question. Facepalm.

The revenue looked reasonable compared to the growth in his company.

Next I used the power of attorney to get a printout of the cost of goods sold from his main supplier. This was another number I could hang my hat on with reasonable comfort.

The COGS allowed me to back out an expected revenue number. It was close so we will stick to what we originally calculated by adding all deposits.

Property tax records are easy to find online so that was one expense I was also comfortable with.

Now came the hard part. I had three months of rent receipts and the landlord wasn’t kicking him out so I multiplied one payment by twelve.

I asked the client if he ever took money from the business account for something other than a business expense. By the way his mouth was catching flies I took it as a “no”. I couldn’t add all the checks cleared and allocate between expenses. (Since some items are not allowed under the Cohan Rule I don’t use the bank statement for a total of deductible expenses when I have no substantiation unless I have no choice. That and I know how small business owners like to take cash here and there for personal expenses even if they say they don’t.)

Deep Science

Now we are going to get extremely scientific; we’re going to guess.

Advertising, utilities, office supplies, and other expenses still are allowed under the Cohan Rule.

For our client today I took his information from prior returns and compared the expenses as a percentage of revenue and COGS. Example: If in the past three years he has advertizing expenses of 12% of revenue and 27% of COGS, I will use the percentage that gives the lower number as a deduction.

I want two reference points whenever possible. I use the lower deduction because it’s not my job to put my neck on the line if you don’t care enough to keep good records.

I move to each deduction normal for the type of business involved.

As I work through the return I keep detailed records of how I arrived at the numbers I report and attach it to the tax return and keep a copy in our permanent file.

I’ve used the same process for clients who get audited but lose their documents between filing and the audit. A home or business fire or theft is an understandable reason for a client to lose their documentation, hence the need for the Cohan Rule.

We scan a lot of stuff in when preparing a return, but time is limited so we don’t copy every receipt for our records. That is the client’s obligation.

However, if we see documentation we note this fact in our records. Our contemporaneous record acknowledging we saw the paperwork and actual receipts are frequently enough for the taxing authorities to accept the numbers we report. Must be my honest face.

The Flower Girl

Virtually every number on the above client’s tax return is a guess. The IRS would have to use the same methodology to come to an estimated return. We just beat the IRS to the punch and documented each step we took.

And that is how claiming fake deductions is legal.

Now before you say a word, I can hear you thinking.

For any client willing to pay me a bit extra to see if my guess is a better result than the actual numbers, NO!

My guess will always be conservative and probably overstates your tax liability. The Tax Court has clarified what they allow and don’t when invoking the Cohan Rule. And they always lean in favor of the government. So do I in such instances.

But good try. I like the way you think.

 

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