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Surviving a tax audit without records.

The most common reason tax deficiencies are assessed is that taxpayers fail to produce the records necessary to substantiate the deductions they claimed. This is not because the deductions were fabricated but rather because most taxpayers are not very good recordkeepers.

If your client doesn't have the documents necessary to claim any of the tax deductions allowed under the law, all is not lost. There are alternative methods of securing evidence that will establish what was spent. Obtaining this evidence is often time-consuming. However, when you consider the alternative--paying additional tax, interest and possible penalties--the time expended will be handsomely rewarded.

The alternative method of proving expenditures might include establishing the tax basis (cost for computing gain or loss) of inherited property by taking the sales price when the property was sold and reducing it by the increase in the Consumer Price Index (CPI) from the date it was inherited to the date it was sold. The question then arises, will the IRS accept this type of substantiation? The acid test in answering this question is: if you were sitting on a jury and saw this evidence, would you believe it?

Property Received by Inheritance or Gift

The tax basis for determining the taxable gain or loss on property received by inheritance that is then sold is the fair market value of the property on the decedent's date of death. For property received by gift, the tax basis is the donor's cost--a rather simple rule in theory. The decedent's Estate Tax Return (Form 706), if available, will have the date-of-death value; if not, four methods can be used to compute the tax basis: newspaper ads, local real estate board or broker records, assessed value or use of the CPI. Any one of these methods or an average of them, if more than one is available, can be used to determine value.

Classified Ads

If the property was acquired by gift, the deed will state when the donor acquired the property; if inherited, the value on the date of death is what must be determined. Classified ads in the real estate section of the local newspaper will reveal the price similar property was selling for on any particular date. Back issues are usually on file at the library or local newspaper. Quite often, back issues are kept on microfilm, so it shouldn't be too difficult to go back six months or forward six months, in case the taxpayer comes up blank for a particular date.

If there wasn't a piece of real estate offered for sale that is exactly like yours, you might have to find one as close as possible in description and extrapolate from that price. For example, if a farm with a house on 50 acres was offered for sale at $75,000 and one with 60 acres was offered at $85,000, it's more than reasonable to assume that an acre was selling for $1,000. If you are looking to determine the value of a farm with 100 acres, increase the $85,000 price by $40,000. The IRS requires documentation, so photocopy the real estate section.

Real Estate Brokers

If back issues of a newspaper are unavailable, try the local real estate board or broker(s). Quite often they keep historical data on property they have sold.

Assessed Value

The assessed value method could very well provide the most accurate value of all. Assessed values are based on a percentage of the market value. This information can be obtained at the office of the collector of taxes. By dividing the assessed value by this percentage and multiplying the result by 100, you can determine the market value. For example, if the assessed value was $2,700 and the property was assessed for 30% of the market value, the market value would have been $9,000 ($2,700 / 30% x 100).


It's not three strikes and you're out. When all else fails, use the CPI method. Since you know what the property sold for, the increase in the CPI between the acquisition date and the sale date will reveal the market value. If the CPI increased four times during this period, divide the sales price by four to determine the tax basis. CPI information can be obtained at the library or the U.S. Department of Labor in Washington, D.C.

Establishing the date-of-death selling price of an inherited stock or bond is quite simple if it is traded on a major exchange. If a stock or bond was received by gift, you might have the added task of having to establish the date when the donor acquired it. If this is the case, contact the transfer agent to obtain the donor's acquisition date. Either a back issue of a newspaper or a professional service will provide the selling price on any particular date. The only problem with using a back issue of a newspaper is that it won't reveal stock dividends or splits since the acquisition date, whereas a professional service will.

The Cohan Rule

George M. Cohan wasn't just born on the Fourth of July. His battle with the IRS gave taxpayers one of their most important victories--the right to estimate deductions.

In 1921 and 1922, Cohan deducted $55,000 in entertainment and travel expenses. On audit, he wasn't able to produce any documentation to substantiate these deductions. The IRS didn't allow any part of Cohan's deductions on the ground that it was impossible to tell how much was actually spent. Cohan appealed. The appeals court, in finding for Cohan, ruled that "absolute certainty in such matters is usually impossible and is not necessary."

Cohan established the rule of approximation: if it can be proved that something was spent, then the taxpayer can deduct travel and entertainment expenses. The court in Cohan instructed the IRS to "...make as close an approximation as it can, bearing heavily, if it chooses, upon the taxpayer whose inexactitude is of his own making."

For over 30 years, the Cohan Rule allowed taxpayers to deduct travel and entertainment without having to substantiate what they spent. Taxpayers were only required to establish that it was reasonable for them to have incurred these expenses. Since 1963, travel and entertainment expenses require substantiation. Cohan, however, still applies to other expenses where records are not available. Under the Cohan Rule, courts routinely allow deductions based on estimates for: petty cash and office expenses; delivery and freight charges; tips and Christmas gifts; cleaning and maintenance expenses; small tools and supplies; taxi fares; and fire, flood and theft losses.

Cohan doesn't mean you can stop keeping receipts and use estimates. To rely on Cohan, your client must have a valid reason for doing so, such as impracticality or destruction or loss of records. Taxpayers have had penalties asserted against them for not attempting to duplicate records that were lost when they moved and for periodically destroying all business records immediately upon the filing of their tax returns. One court held that the unexplained loss of corporate records carries a strong presumption that the records would have prejudiced the taxpayer's position.

If relying on Cohan, a tax examiner may indicate Cohan no longer applies, but that is true only as it affects travel and entertainment expenses.

IRS regulation 1.274-5T(c)(5) allows a taxpayer who establishes that the failure to produce adequate travel and entertainment records is due to circumstances beyond their control--such as destruction by fire, flood, earthquake or other casualty--to substantiate the deduction by reasonable reconstruction.

Improvements to a Residence

Very few taxpayers I ever represented who sold their homes ever saved any records regarding improvements they made. Landscaping expenditures, one tree or bush at a time, add up. If the amount spent cannot be documented, perhaps it can at least be established that an improvement was made. The family photo album could very well contain before and after photographs of improvements.

If the contractor who made the improvements to the home cannot be located, get a copy of the Certificate of Occupancy (this is the house's birth certificate, so to speak, and will show what it consisted of when it was built). This can be obtained at the county clerk's office. Records at this office will also reveal any changes in the house's assessed value as the result of improvements and any building permits that were issued.

These documents will establish what improvements were made. To establish the cost, obtain an estimate of what the improvement would cost now and back out the increase in the CPI since the improvement was made. Where small sums were spent, make reasonable estimates.

The key to getting the IRS to accept this type of proof is to establish that the taxpayer did, in fact, make an improvement(s). Court cases are won or lost based on which side has the better argument. While you might only have a substitute for actual records, the IRS' case is built around its not being pleased with such records. Who then has the better case?

Casualty Losses

A casualty loss is probably the most difficult deduction to establish because your records were probably destroyed along with the property. A police, fire department or insurance company report will establish the loss.

I was once able to establish the value of an expensive necklace that was stolen by using a photograph showing my client wearing the necklace and an appraisal from a jeweler of what a similar necklace would cost. While a statement of means is one way of establishing that the client could afford the item that was stolen or destroyed, a statement from a friend, relative or acquaintance will establish its ownership. By establishing that a loss occurred and the items were destroyed, you narrow your argument with the IRS to the dollar value of what was lost, not whether the taxpayer was entitled to the deduction in the first place.

Business Records

Where business records were lost or destroyed, duplicate bills can be obtained from major vendors, including telephone, utility, rent, credit card, oil company and others. A reasonable determination of business use of an automobile can be made by reconstructing a typical month's automobile use. If that month's use closely approximates an average month's business use, the IRS will accept such reconstructed records. A tough examiner, however, might require three consecutive months of reconstructed records.

If all income was deposited in a checking or savings account, income can be reconstructed from duplicate bank statements. The bank can also provide copies of canceled checks. A copy of the lease and a statement from the landlord will establish the rent deduction. Copies of current and past tax returns will provide a point of reference for determining profit percentages, as well as the types and amounts of recurring expenses. Copies of the returns can be obtained by filing IRS Form 4506, Request for Copy of Tax Form, at the IRS Service Center where the original return was filed.

David J. Silverman is an enrolled agent in New York City. This article was excerpted from his book, Battling The IRS: A Taxpayer's Guide To Responding To IRS Assessments and Notices, which may be ordered from the author (800-395-6983), for $19.95. Mr. Silverman is a contributing editor to Smart Money -- The Wall Street Journal Magazine of Personal Business.
COPYRIGHT 1993 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Author:Silverman, David J.
Publication:The National Public Accountant
Date:Dec 1, 1993
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