Taxpayer mistake that resulted in a large tax liability
A recent court decision once again underscored the importance of keeping accurate records for a small business.
Over a period of three years, a taxpayer owned and operated several restaurants. She maintained a bank account for each restaurant as well as multiple personal bank accounts. She employed a bookkeeper for a short time but did not maintain separate books for each restaurant. Her common practice was to use funds from one restaurant to pay expenses of the other restaurants. She was certain that the restaurants were not making money and (therefore) did not need to file tax returns for the three years in question.
Enter the IRS, which concluded that she should have filed tax returns and did not have “reasonable cause” for failure to file them. She then hired a tax preparer and filed delinquent returns for the three years. The IRS examined the returns, and then requested records to support the income and deductions claimed. When she could not supply the adequate records, the IRS used the “bank deposits analysis” method to calculate and re-create her income. Although she was sure that nontaxable loans from family members were included in the deposits, she did not have the records to prove it. In addition, the majority of her expenses were disallowed due to her inability to provide the records necessary to support them.
The IRS determined that she had a tax deficiency of $49,000, and owed penalties of $12,200 (for failure to file and pay tax), and $9,800 (accuracy-related penalty), for a total of $71,000 due. Keep in mind that these taxes and penalties are due for years in which the taxpayer was certain that she did not make any profit – but could not provide adequate records to prove her claim.
She pursued her claim of no tax due to the U.S. Tax Court, which issued a Memorandum in May, 2012 ruling in favor of the IRS. The end result is a taxpayer who has to pay $71,000 in taxes and penalties on what she believes (but can’t prove) to be on no income.
Here are some recordkeeping tips for owners of small businesses:
1) Keep business and personal records separate – both bank accounts and credit cards.
2) Use a coding system to keep track of expenses – helps summarize records at year end.
3) Perform record keeping tasks contemporaneously with the incurrence of the transactions – make bookkeeping a part of your regular routine.
4) Consider purchasing user friendly software – such as QuickBooks or Peachtree – to reduce the burden of manual record keeping.
5) Talk to a financial professional such as a CPA, for advice on setting up adequate record keeping systems.
Grossman St. Amour is well-equipped to help you avoid scenarios such as