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Questionable Deductions

reThis article is written by Ben Rucker, a former special IRS auditor.  The video, of course, is of Lee Phillips.

#21 on Lee’s formalities checklist is “Do you have a resolution documenting the business purposes for any questionable deductions?”

Large, Unusual, or Questionable deductions (LUQs) on your tax return are a red flag for IRS audits.  The IRS knows that running a business is expensive and there will be large amounts that will be deducted from your taxable income, but wants to make sure that those expenses are warranted and you aren’t just trying to weasel out of paying taxes.
There are some things you can do to minimize your risk either of being audited in the first place or ending up with big adjustments when you are audited because of questionable deductions.  IRS auditors are trained to watch for LUQs.  As it says in IRS Examination Techniques:
Compare the total deposits to the gross income of the taxpayer by considering non-taxable deposit sources such as loans, checks to cash, transfers between accounts, gifts and inheritances, and insurance proceeds and by identifying large, unusual, questionable (LUQ) deposits and withdrawals which warrant further audit action. 
The biggest way to avoid LUQs on your return is to break down the numbers on your tax return as much as you can.  If you have a large number that shows a total of different smaller expenses, itemize each of the issues separately.  For example, what if you have a large travel expense? Within that number, you could have lodging, airfare, and meals & entertainment. Break the one big number down to three separate categories.
It isn’t just the fact that a deduction is large that makes it questionable.  In order for an expense to be deductible, it needs to be ordinary and necessary for the business.
Most expenses you’ll deduct will be obvious to you, but sometimes they are not to someone outside your particular subset of your industry.  This is where something called the NAICS code becomes very important.  NAICS stands for “North American Industry Classification System” and it is a numerical code assigned to your industry and listed on your tax form.  The IRS conducts random audits of returns with different codes so they can better assess whether certain deductions are ordinary and necessary in that field.  Lee used to get audited all the time because his accountant had put in a code for a retail store and he had these huge travel business expenses as a professional speaker going all over the US talking about legal issues.
Answer the questions you think the IRS would have so they don’t have to ask you.  As Lee explains in the video above, if you have an unusual but necessary business expense, it is good to have a resolution and an entry in your minutes explaining why you needed it for the business.  If there was a specific reason for it, then the resolution will say the company approves it and explains what the basic business reason was.  You want to document more for anything that could be seen as questionable than you usually would for obviously ordinary business expenses.
By Ben Rucker, Tax Specialist
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