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Proof of Income
Dec 6, 2011
As our business client, we want to keep you well informed. This time we want to talk about proof of income. We want to focus on how to prove it to the IRS auditor. The mission of the IRS auditor is to ensure that all taxpayers accurately report all income and expenses. Most of the time, the process is fairly straightforward since most people pay for their business expenses with checks and credit cards. This is true whether you are a customer paying, or a business collecting, money. In those cases, the auditor just has to make sure you are entitled to the income and deductions you are claiming; “yes, no,” and they’re done.
However, when you present them with cash items, whether income or expense, they will scrutinize them. It’s almost as if cash transactions are “suspect until proven legitimate.” We have already touched on proof of cash expenses in a previous post. Now we have to address how to prove cash income (and perhaps even more importantly, proving what is not income).
The first step in having an iron-clad accounting system is to keep records of everything. Whether you sell goods at parties in private homes or you have a store in the French Quarter, you need to document all transactions. Whether you are a one-man master carpenter or a 300+ crew commercial builder, you need to document all transactions. A computer tech working out of the house or a nation-wide computer service “squad,” you need to document all transactions. Pop’s Whittle Creations or Walmart, you need to document transactions. You get it…documents rule..
Documenting is fairly easy to do with a “traditional” retail operation. Today’s registers usually have the capability to at least give you the “Z” tapes at the end of each day or shift—most can give you a monthly summary, too. Depending on how advanced your system is you could also get reports that basically prepare your sales tax returns for you, break down all payments received by time and type (cash, ck, cc, gc, etc.), and even generate deposit slips to take straight to the bank. All this makes for an “easy” audit since income activity is diligently documented by your system.
The same goes for service businesses. Whether in old-fashioned paper or in electronic formats, most service businesses have pre-numbered invoice books, a file for each client or job, a receipt log of all payments received (maybe even copies of checks and cc slips), and duplicates of bank deposit slips. If you use an off the shelf program to handle your invoicing, you can get extremely detailed information pertaining to any customer or job at the click of a few buttons. This would again be considered an “easy” audit since everything having to do with customers is right there.
But what if on weekends you sell goods door to door that you make with your own raw materials, and you inherited your grandparent’s restaurant (dinner only) with no working cash registers, and are a tree-trimmer after all hurricanes but mostly offer your awesome pressure washing and general maintenance expertise to the many “investors” out there trying to fix up homes all around New Orleans, except during January 1st – April 15th because you are also a “mobile tax preparer on wheels” and deal with a lot of cash on the spot payments? How do you prove to an IRS auditor that even though you may have deposited $50,000 in your checking account last year, your income was only $45,000 (or $55,000, for that matter)?
Follow the steps above. The auditor will not accept the excuse, “I didn’t know.” If you don’t have a computer, or you’re watching every penny so you can’t go out and order fancy invoices from the printer, or you are your own everything—including bookkeeper…whatever your situation, here are a few suggestions for keeping track of your income, just like the “big boys” do:
* When you first bid on a job, give potential customers an estimate or proposal clearly marked as such. You may even want to have caption like, “this is not an invoice” on the document. If estimates are not marked as such, the auditor could make the claim that they are invoices for work you’ve done but not reported on your tax return. You can find blank proposal books at office supply stores and maybe even hardware stores.
* Buy a sequentially numbered invoice book so that each of your customers receives a detailed invoice describing the services or goods they received from you. It is important that the invoices be sequentially numbered and that there be no gaps. Any invoices that you void or refund should be clearly marked. Write up a new invoice, when necessary.
* Give a credit memo or refund slip to all customers to whom you give refunds, especially if you make these in cash or if you reduce an original invoice by that amount. Make sure you cross-reference the original invoice number on the credit memo. Otherwise, if you can’t retrace to the original transaction, the auditor may disallow the credit because it will seem like there is no corresponding invoice to take the credit from.
* Buy a duplicate payment receipt book and give a receipt to every single customer; no matter how they have paid you. Again, the receipts should be numbered, if possible. A payment receipt is the record that signifies you have received the money for the job. Always give a receipt. If you always follow that procedure and there are one or two occasions when you did not, you are more likely to have your “history” come to your rescue, as the auditor would most likely consider that to be an isolated incident rather than the norm, and perhaps not give you a hard time about it.
* If at all possible, we highly recommend that you look into at least buying a stand-alone invoicing program, easily available for under $50 at most office supply stores. You may even want to set up a “mobile office” with a laptop and USB printer powered with a car adapter for around $500--you don’t need the best computers on the market for this purpose. Most invoicing software offer all the features discussed above (estimates, invoices, credit memos, and receipts). They will save you time inputting data, may offer e-mail options, let you digitally backup and may even help you in collecting your receivables. Most important, though, it makes your business look more professional than the other guy, and that’s the edge you need to keep growing.
Finally, perhaps the hardest time you will have with cash-related transactions is proving that cash you have deposited into the business is not income. Try not to pay for services or goods with cash or checks written out to “cash.” If you do, make sure you receive a receipt from the person providing you with the goods. Otherwise, the auditor may disallow the expense and claim the cash is money you took out of the business for your own personal use. This could increase your income and make your tax liability higher than what it should be.
Along the same lines, if you put your own cash into your business, you can’t just tell the auditor, “oh yeah, that $15,000 was from my cash in the safe” and expect the auditor to say, “oh, okay, let me take that off the taxable income, then” without having some solid documentation. If you have a cash deposit that is not business income you should have the following (signed and dated appropriately):
* A letter from a friend or relative who gave you the cash.
* If a loan from a friend or relative, have a written repayment agreement.
* A log where you have tracked the inflows and outflows of that cash in your safe.
* Documents given to you by an attorney if the cash was an inheritance.
* A cancelled note receivable stating the cash is from a debt that was repaid to you.
* Statement from casino showing when and how much you won in cash.
* Letter or receipt for other situations (raffle, bingo, lotto, video poker, W2-G, etc.)
Dealing with cash is becoming less commonplace as we keep advancing technologically. Because of its nature, cash transactions will continue to be examined closely in the future. Don’t forget to tell us about the cash transactions you had during the year. Just because you paid with or received cash doesn’t mean you lose your deduction or that you don’t have to claim it as income. As always, a little preparation goes a long way. Get that documentation when the transaction occurs, not years later when it may be too late.
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Category: Bookkeeping
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