I received an email from a small business owner who asked: "Is it true? If I don't have good records, will I really pay more tax than I could/would/should have?"
Or how about this one: "If I don't have receipts, does it really matter? If I get audited, will the IRS nail me for not substantiating my deductions?"
The answer to both of those questions is an emphatic "Yes!" And if you think I'm just making this stuff up to scare you, well, think again. And here's the proof that the IRS does really nail the average Joe for not having receipts.
I'd like you to meet an average Joe, although his name is really Mike -- Michael Robert Cottrell. Mike was self-employed and made about $5,700 in self-employment income one year. He didn't report that income because he thought, "I have at least that much in expenses, so my expenses offset my income and I really didn't make any profit. So there's really no need to report the income or the expenses."
Well, Mike got audited by the IRS, and when the IRS told him to prove those deductions with a paper trail, Mike was unable to do so. He literally had no records whatsoever to document his claim that his net profit was zero.
He admitted to receiving the $5,700 in income, but then proceeded to claim that about 50% of that income was spent on materials, 25% went toward subcontracted labor, and the rest went to pay other miscellaneous expenses and debts.
The IRS said, "Prove those deductions." Mike said, "I don't have any records. They were lost when I moved." The IRS said, "Sorry, Mike. No receipt, no deduction."
End result: Mike was nailed by the IRS with a tax bill to the tune of $1,625. Because he didn't have any written record of his deductions, his deductions were disallowed.
There you have it. It does happen. And it can happen to you, if you choose to Be Like Mike.
NOTE: The information about Mr. Cottrell is a matter of public record -- Michael Robert Cottrell T.C. Summary Opinion 2003-162.
Yes, there are a few exceptions to the "No receipt, no deduction" rule. (And be sure to visit this blog in the coming weeks for details on these exceptions.) For example, you can deduct your vehicle expenses based on mileage rather actual expenses. This is known as the Mileage Rate method, and you do not have to keep receipts to use the Mileage Rate method -- but you do have to keep a mileage log, i.e. a written record of your business mileage.
But generally speaking, it's best to cultivate the habit of keeping your receipts and filing them in a well-organized record keeping system. Otherwise, you take the risk of running afoul of the IRS, and that will not bode well for you on Audit Day.