6.4: Record Keeping, Preparation, and Filing

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Learning Objectives

Identify sources of tax information.
Explain the importance of verifiable records and record keeping.
Compare sources of tax preparation assistance.
Trace the tax review process and its implications.

The Internal Revenue Code (IRC), the federal tax law, is written by the U.S. Congress and enforced by the Internal Revenue Service (IRS), which is a part of the U.S. Department of the Treasury. The IRS is responsible for collecting tax revenues.

To inform the public, the IRS offers over six hundred separate publications covering various aspects of the tax code. More than a thousand forms and accompanying instructions exist to file complete tax information, although most taxpayers typically file only about half a dozen forms each year. Additionally, the IRS offers online support (www.irs.gov) and telephone assistance to address questions and help with tax filing preparation.

By far, the majority of income taxes from wages are collected through withholding. For most taxpayers, wages represent the primary form of income; therefore, most of their tax payments are withheld or paid as wages are earned. Still, everyone has to file to summarize the details of the year’s income for the IRS and to calculate the final tax obligation. In 2021, the IRS collected 160,824,340 individual tax returns, representing $2.1 trillion in tax revenue. [1]

Keeping Records

The individual filer must collect and report information on tax forms and schedules. Fortunately, this is not as difficult as the volume of data would suggest. Employers are required to send Form W-2 to each employee at the end of the year, detailing the total wages earned, as well as taxes and contributions withheld. If you have earned other kinds of income, your clients, customers, retirement fund, or other source of income may have to file a Form 1099 to report that income to you and the IRS. The bank or brokerage firm also reports interest and dividend income on Form 1099. The information on the W-2 and Form 1099 is reported to both the IRS and you.

Incomes may be summarized and reported to you, but only you know your expenses. Tracking expenditures, such as charitable gifts and medical expenses, is important if they are allowed as deductions, so data should be collected throughout the tax year. If you do not keep detailed records, you will have to search your banking history to identify deductible expenses for the tax year. Financial software applications can make this task easier; most allow you to flag deductible expenses during your initial setup.

You should also keep receipts of purchases that may be deductible. Credit or debit card statements and bank statements provide convenient backup proof, but save receipts in case the IRS questions the accuracy of your return. The receipts are your primary evidence of expenditures.

Tax Preparation and Filing

After you have collected the necessary information, you fill out the forms. Most taxpayers need to complete only a few schedules and forms to supplement their Form 1040. Most taxpayers have the same kinds of taxable events, incomes, and deductions every year, and generally file the same kinds of schedules and forms.

The IRS offers several electronic filing (e-filing) options (www.irs.gov/filing/individuals/how-to-file#partner), available to filers depending on their specific tax situation, including the IRS Free File Program. You may prefer to consult a professional tax preparer. Professional help is useful if you have a relatively complex tax situation, such as unusual sources of income or expenditures that may be deductible under certain circumstances. Some taxpayers use a tax preparer simply to protect against making a mistake. Filing errors, no matter how innocent, may prove costly to fix. Fees for tax preparers depend on how complex your return is, the number of forms that need to be completed, and the type of professional you consult.

Professional tax preparers may be Enrolled Agents, Certified Public Accountants (CPAs), lawyers, personal financial planners, or tax consultants. You may have an ongoing relationship with your tax preparer, who may also be your accountant or a financial planner advising you on other decisions. You might also use a tax preparer only to help you prepare and file taxes. Tax preparers may be independent practitioners who work during tax season or employees of a national chain that provides year-round tax services.

Generally, there is no standard certification to be a professional tax preparer. An enrolled agent (www.irs.gov/tax-professionals/enrolled-agents/enrolled-agent-information) is someone who has successfully passed training courses from the IRS or previously worked for the IRS. A CPA has specific training and experience in accounting. When looking for a tax preparer, your lawyer, accountant, or financial planner may be a suitable option or be able to make a recommendation. If your information is fairly straightforward, you may minimize costs by using a preparer who simply does taxes. If your situation is complex (especially if it involves other entities such as businesses or trusts, or unusual circumstances such as a gain, gift, or distribution) you may want to consult a professional with a range of expertise, such as an Enrolled Agent, CPA, or a lawyer who specializes in taxes. Many professionals also offer a “guarantee;" they will help you if the IRS questions the information on your return.

Whether you prepare your tax return by yourself or with a professional, you are the one who must sign the return and assume responsibility for its details. You should review your return with your tax preparer to ensure you understand and can explain the information accurately. You should question anything that you cannot understand or that seems contrary to your original information. You should also know your tax return because understanding how and why tax obligations are created or avoided can help you plan for tax consequences in future financial decisions.

Tax Preparation and Filing Software Apps

You may choose to prepare the return yourself using a tax preparation software app. Many are available, and several are compatible with personal financial software apps, enabling you to download or transfer data from your financial software directly into the tax software. Software applications are typically designed as a series of questions that guide you through Form 1040 and the supplemental schedules, prompting you to fill in the data based on your answers. Once you have been through the “questionnaire,” it tells you which forms were completed, and you can file them electronically with the IRS. Most programs also allow you to enter data directly into the individual forms.

Many tax preparation software packages are available, and most are reviewed in the business press or online. Start with an internet search for "free tax filing" or "free tax software," and compare the results to your personal goals and needs.

If the IRS free online filing option does not work for you, you have many other choices. Some popular programs include TurboTax, TaxSlayer, and FreeTaxUSA, but there are many others. Compare features and reviews before selecting a tool.

These tools can be useful because they automatically calculate unusual circumstances, limitations, or exceptions to rules using your complete data. Some programs even prompt you to include additional information based on the data you submit. Overlooking exemptions is a common error that software programs can help you avoid. The programs include all the necessary forms and schedules. If you prefer to file hard copy versions, you can download and print them directly from the IRS website or request that they be sent to you by calling the IRS. Once your return is completed, you must file it with the IRS, either by mail or by e-file. The latter option has become increasingly popular.

Following Up and Handing Audits

After you file your tax return, the IRS will process and review it. If you are owed a refund, it will be sent to you; if you make a payment, it will be deposited into your account. The IRS reviews returns for accuracy, based on redundant reporting and its “sense” of your data. For example, the IRS may investigate any discrepancies between the wages you report and the wages your employer reports for you. As another example, if your total wages are $23,000 and you show a charitable contribution of $20,000, that contribution seems too high for your income, although there may be an explanation.

The IRS may follow up by mail or by a personal interview. It may simply request verification of one or two items, or it may conduct a full audit—a thorough financial examination of your return. In any case, you will be asked to produce records or receipts that will verify your reported data. Therefore, it is essential to save a copy of your return, along with the records and receipts used to prepare it. See the IRS website (www.irs.gov/businesses/small-businesses-self-employed/irs-audits) for information on audits and recommendations for the number of years to save your tax data.

If you have a personal interview, your tax preparer may accompany you to help explain and verify your return. Ultimately, however, you are responsible for it. If you have made errors, and if those errors result in a larger tax obligation (if you owe more), you may have to pay penalties and interest in addition to the tax you owe. You may be able to negotiate a payment schedule with the IRS.

Each year, the IRS randomly chooses a certain number of returns for review and possible audit, even where no discrepancies or unusual items are noticed. The threat of a random audit may deter taxpayers from cheating or taking shortcuts on their tax returns. Computerized recordkeeping has made it easier for both taxpayers and the IRS to collect, report, and verify tax data.

Filing Strategies

Most citizens recognize the need to contribute to the government’s revenues, but they want to avoid paying more than necessary. Tax avoidance is the practice of ensuring that you have no excess tax obligations. Strategies for minimizing or avoiding tax obligations are perfectly legal. However, tax evasion, fraudulently reporting tax obligations by understating incomes and gains or overstating expenses and losses, is illegal.

The definition of expenses and the way you claim them can affect your tax rates. You may be able to deduct more expenses if you itemize your deductions than if you do not, or it may not make a difference. Also, there is some discretion in classifying expenses. For example, suppose you are a high school Spanish teacher. You also tutor students privately. You buy Spanish books to improve your language skills and to keep current with the published literature. Are the costs of those books an unreimbursed employee expense related to your job as a teacher, or are they an expense of your private tutoring business? If it is a cost of your tutoring business, you may be able to fully expense it from your business income.

There are many ideas about how to avoid an audit or what will trigger one, such as certain types of income or expenses, or filing earlier or later. In truth, with the increased sophistication of computerization, the review process is much better at noticing discrepancies and choosing audits randomly. Time and effort (and cost) invested in outsmarting a possible audit are usually wasted. The best protection against a potential audit is to have verification, such as a receipt, a bill, or a canceled check, for all the income and expenses that you report.

Summary

Tax code information is available from the Internal Revenue Service.
Verifiable records must be kept for all taxable incomes, expenses, and other taxable events and activities.
Professional tax assistance and tax preparation software are readily available.
The Internal Revenue Service reviews tax returns for errors and may conduct an informal or formal audit process to follow up.
Tax avoidance is the legal practice of minimizing tax obligations.
Tax evasion is the illegal process of fraudulently presenting information used in calculating tax obligations.
Tax avoidance strategies can involve timing income and/or expenses to take advantage of changing tax circumstances.

Exercises

Read the article Policy Basics: Where Do Our Federal Tax Dollars Go (www.cbpp.org/research/federal-budget/where-do-our-federal-tax-dollars-go). In 2023, what were the federal government’s three largest expenditures of tax dollars?
According to the IRS.gov article How to choose a tax return preparer (www.irs.gov/taxtopics/tc254), when should you look for a professional tax preparation service provider, and what fees should you avoid paying?
Gather a current sample of the kind of records you will use to calculate your tax liability this year and verify your tax return. List each type of record and identify exactly what information it will give you, your tax preparer, and the IRS about your tax situation. What additional records will you need that are not yet in your possession?
Do searches online to compare and contrast tax preparation software. What are the chief differences among the top three or four programs? Also, check out the IRS Free File program (www.irs.gov/filing/individuals/how-to-file#partner). Would you qualify for Free File?
Use your spreadsheet program to create a document that shows monthly cash flows for income and expenses to date, for which you have written records. If you continue to develop this document for the remaining months, how will it help you prepare your tax returns?
Research how you can reduce your tax liability and/or avoid paying taxes when you file this year.

^[1] IRS, "SOI Tax Stats - Individual Statistical Tables by Filing Status", Tax Year 2021, https://www.irs.gov/statistics/soi-tax-stats-individual-statistical-tables-by-filing-status#_grp3. www.irs.gov/statistics.

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