A few months ago, one of my clients (let’s call him Mr. Jones) received one of those “love letters” from the IRS requesting more information about his return, and the IRS wanted to meet with Mr. Jones in person to discuss the situation.

Mr. Jones (a small business owner) was asked to report to the local IRS office with all of his records. The IRS was questioning the legitimacy of various business deductions. The IRS was doing what the law allows it to do: require the taxpayer to show that those deductions were valid.

It turns out that Mr. Jones lost the audit and ended up owing the IRS a significant amount of money: the additional tax, plus penalties and interest for late payment of that tax. Why did Mr. Jones lose the audit? Mr. Jones made two “classic” taxpayer mistakes:

MISTAKE #1: “NO RECEIPT, NO DEDUCTION”

Mr. Jones missed out on several deductions simply because he did not have the proper documentation to prove the deductions. What do I mean by “documentation”?

Well, if the IRS requires you to account for a deduction on your tax return, you must be able to provide written proof that the deduction actually happened. The easiest way to prove a deduction is to keep: a) The receipt or invoice, and b) The proof of payment, which can be a canceled check, cash receipt or credit card statement.

Mr. Jones reported numerous deductions for which he simply did not have documentation. No receipts, no canceled checks, no nothing. Turns out Mr. Jones was one of those “cash guys.” Maybe he knows what kind of person I’m talking about: he never wrote a check in his life, he just had a wad of bills in his pocket. He paid for everything in cash and never kept any of the receipts from him.

Every year he sat down with his wife and “remembered” how much he spent on different things. There is no way to test any of this, of course. He just had an “intuition” of how much money he had spent, and he had run his business for so many years that he “knew” how much it cost to buy certain things.

Well, this is the kind of taxpayer the IRS loves! It really is true: If you can’t prove you paid for something (with receipts, bills, canceled checks, etc.), then you risk losing that deduction in the event of an audit.

One of the most common questions I get from clients is this: “I know I paid for something, but I don’t have a receipt. Should I report the deduction anyway?” My answer is usually this: “You only need a receipt if you get audited.”

At first, people don’t know if I’m joking or not. Well, I make that comment with my tongue firmly planted in my cheek, but there really is a lot of truth to it. If you don’t have the documentation to prove a deduction, you can still report the deduction (if you want), because you only have to prove the deduction if you are audited.

But if you are audited knowing there are deductions not documented on the return, be prepared to lose the deduction. That seems fine to me?

And here’s the other big mistake Mr. Jones made:

MISTAKE #2: FALSE DEDUCTIONS

It turns out that Mr. Jones was not completely honest with me about some of his deductions. He reported deductions that simply weren’t actual deductions. Here’s an example: Mr. Jones owned several rental houses. These rental houses, of course, required maintenance and repair work. Many times, Mr. Jones would do the work himself instead of paying someone else to do it.

Well, Mr. Jones would estimate what he would have had to pay someone else to do the work he did himself, and then claim that amount as a deduction, even though he didn’t actually pay anyone to do the work.

In other words, Mr. Jones deducted the value of his time, which is not deductible. This is an important point: you can never legitimately deduct the value of your time for the work you did. You have to pay someone else to do the work.

If you ever receive a letter from the IRS requesting additional information, you will have nothing to worry about doing the exact opposite of what Mr. Jones did. If he can properly document his deductions and assuming he has no false information, he will pass the audit with flying colors.