What Records the IRS Can Require: IRC 6001 and the Audit

In an audit, the IRS does not have to prove your deduction is wrong. You have to prove it is right. That starts with records, and the law on records is short enough to read in a minute.

The statute

IRC 6001 says that every person liable for any tax "shall keep such records, render such statements, make such returns, and comply with such rules and regulations as the Secretary may from time to time prescribe." It also lets the IRS, by notice served on a person or by regulation, require the records it deems sufficient to show whether that person is liable for tax.

That is the whole statute, apart from a sentence about employers and charged tips. The detail lives in the regulation.

The regulation: Treas. Reg. 1.6001-1

Four parts of the regulation matter in almost every individual audit.

• The general rule, paragraph (a). Anyone subject to income tax must keep "such permanent books of account or records, including inventories, as are sufficient to establish the amount of gross income, deductions, credits, or other matters required to be shown" on the return. Notice the word "sufficient." The test is whether the records establish the number, not whether they are pretty.
• Wage earners and farmers, paragraph (b). Individuals whose income is wages or farming must keep records that will enable the IRS to determine the correct amount of that income, but need not keep the full books required by paragraph (a) for it.
• Notice requiring records, paragraph (d). The IRS may require any person, by notice served on them, to keep specific records. This is the legal basis for the Inadequate Records Notice examiners sometimes issue after an audit.
• Retention, paragraph (e). Records must be kept available for inspection and "retained so long as the contents thereof may become material in the administration of any internal revenue law."

What "sufficient" looks like in practice

The IRS's small business recordkeeping guidance lists the supporting documents it expects to see:

Item	Documents the IRS lists
Gross receipts	Cash register tapes, deposit information for cash and credit sales, receipt books, invoices, Forms 1099-MISC
Purchases	Canceled checks or other proof of payment or electronic transfer, cash register tape receipts, credit card receipts and statements, invoices
Expenses	Canceled checks or other proof of payment, cash register tape receipts, account statements, credit card receipts and statements, invoices
Assets	Purchase and sales invoices, real estate closing statements, canceled checks identifying payee, amount and proof of payment

The IRS notes that a combination of documents may be needed. A credit card statement proves you paid $412 to an office supply store. The receipt proves what you bought. Together they prove a business expense. Alone, either one may leave a gap.

Travel, gifts and vehicles are different. The IRS points those to Publication 463 because section 274(d) imposes stricter rules. See strict substantiation under section 274(d).

Electronic records count

The IRS says plainly that all requirements that apply to hard copy books and records also apply to electronic records. Scanned receipts, accounting software and bank downloads are fine if they are complete, legible and retrievable. The IRM refers to Rev. Proc. 97-22 and Rev. Proc. 98-25 for electronic and automated records (IRM 4.10.3.19).

One caution: if you keep books in software, an examiner may ask for the data file, not just reports. Know what is in it before you hand it over. See answering a document request.

How long to keep records

The regulation's standard is "so long as the contents may become material." The IRS translates that into practical periods tied to the statutes of limitations:

• Generally, 3 years.
• If you file a claim for credit or refund after filing, 3 years from the date you filed the original return or 2 years from the date you paid the tax, whichever is later.
• 7 years if you claim a loss from worthless securities or a bad debt deduction.
• 6 years if you do not report income you should have reported and it is more than 25 percent of the gross income shown on your return.
• Indefinitely if you do not file a return or if you file a fraudulent return.
• At least 4 years for employment tax records after the tax becomes due or is paid, whichever is later.

Property records follow a different rule. The IRS says to keep them until the limitations period expires for the year you dispose of the property. That means basis records for a house or investment can be decades old and still matter. If you received property in a nontaxable exchange, keep records for both the old and the new property.

Record retention agreements for automated records

Businesses with large automated systems have an option most people never hear about. The IRM explains that taxpayers who maintain automated records can enter into a record retention agreement with the SB/SE Area Director or the LB&I Director, Field Operations. The agreement limits the records you must retain to those specifically identified as needed to perform audit procedures (IRM 4.10.3.19).

That is a planning tool, not an audit defense, but it matters in an exam. If you have one, follow it to the letter. The IRM lists failure to comply with a record retention agreement as a basis for an Inadequate Records Notice.

The IRS already has some of your records

Remember that the IRS receives W-2s, 1099s, 1098s and other information returns from third parties. Your records should reconcile to those, not just to your own return. If a payer reported more than you did, your books need to explain the difference before an examiner or the matching program asks. See CP2000 responses for how mismatches play out.

What happens when records fall short

Three things, usually in this order.

First, the deduction is in trouble. When records do not establish an expense, examiners disallow it. The IRM's own report-writing guidance uses this exact example: to support a disallowance of business expenses, the examiner incorporates IRC 162(a) and IRC 6001, lack of substantiation, into the explanation (IRM 4.10.8.12.4).

Second, income gets reconstructed. If your books cannot be relied on to show income, the examiner may use an indirect method like a bank deposits analysis. See bank deposits analysis.

Third, a notice may follow. The IRM describes Inadequate Records Notices as placing taxpayers on notice that their recordkeeping is deficient and must improve, and says a follow-up examination may result (IRM 4.10.3.19). If the follow-up finds you still are not substantially complying, the IRM says additional enforcement measures, such as penalties, are warranted.

There is a fourth possibility that works in your favor. For many ordinary expenses, if you can prove an expense happened but not its exact amount, the law allows a reasonable estimate. That is the Cohan rule, and it has limits. See the Cohan rule and reconstructed records.

Building a system that survives an audit

1. Separate accounts. One business account, one business card. Commingling turns every personal deposit into an audit question.
2. Capture the receipt when you spend. A phone photo with a one-line note about business purpose beats a reconstruction three years later.
3. Reconcile monthly. Books that tie to bank statements are books an examiner can rely on.
4. Keep basis records forever, practically. Closing statements, improvement invoices and brokerage confirmations.
5. Back it up. Electronic records only help if you can produce them.

The law requires prudence and care, not perfection. Section 6001 does not demand a perfect filing system. It demands records sufficient to prove what you reported. Keep those, and the audit becomes a matter of showing your work.