Audit Defense: The time to prepare for an audit is before the return is filed

By of MillarLaw A Professional Corporation On Sunday, April 15, 2018

A recent Tax Court case illustrates how a taxpayer should anticipate an audit by maintaining proper books and records. The case involved the deductibility of losses as “ordinary losses” as opposed to “passive losses” by an owner of a private jet. The specifics of the case are unnecessary to this discussion but the general principle applies in all tax audits. The general principle is that the taxpayer has the burden of proof. The Tax Court will presume the findings of the IRS are correct so the taxpayer has an uphill battle.

“The IRS’ determinations in a notice of deficiency are generally presumed
correct, and the taxpayer bears the burden of proving them erroneous. Rule
142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).” and See. “Deductions are a matter of legislative grace; the taxpayer bears the burden of proving entitlement to deductions allowed by the Code and of substantiating the amounts of claimed deductions. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); sec. 1.6001-1(a),”

To meet the burden of proof a taxpayer must produce credible evidence that support the claimed deduction. Credible evidence usually means books and records prepared at the time. The absence of books and records will result in denial of the deductions and a potential Negligence penalty.

“Negligence” includes “any failure to make a reasonable attempt to comply” with the internal revenue laws. Sec. 6662(c). “Negligence” also includes any failure to keep adequate books and records or to substantiate items properly.
The time to produce the books and records is at the time of the audit examination. By taking the time to prepare adequate and contemporaneous books and records taxpayers can more often than not succeed in audits.

In the course of my career the most expensive tax cases to litigate are those where the taxpayer had no credible records. These “poor records” cases often result in bad outcomes for the taxpayer.  As taxpayers you can make your life simple or complex by documenting your income and expenses and providing that documentation to your tax return preparer prior to preparation of the return. The choice is to be prepared and avoid examination or be unprepared and face disallowance of deductions, penalties and interest.