How does the IRS handle returns for which documentation is lost/destroyed?

I have a very small business I run from my home. Over the course of a tax year, paper receipts for the various expenses accumulate in a folder, and electronic records likewise accumulate.

Suppose my house burns down at the end of a tax year, and all this stuff is lost. How would I handle my tax return the following spring? Does the IRS say “just give us your best estimates,” or would they totally disallow any deductions for which documentation no longer exists?

Just off the top of my head, I would say that any documents you had could be backed up by somebody else’s documentation, whomever was also involved in the transaction. So replacement documentation is available. It would be your call to either retrieve new documentation, or consider the amount involved too trivial to bother with and eat the assessmnt. It would also be the IRS’s call to waive a requirement of documentation on your self-reported deductions for trivial amounts. Especially those which are recurrent deductions consistent with patterns in prior years .

I don’t know for sure, but I was told a story by a friend which may shed some light.

He had had a house fire the night before he was to appear at an audit for his business. He arrived at the audit and apologized to the IRS agent for being late as he had just lost his house in a fire. The auditor sighed wearily and said let’s get started.

The auditor then proceeded to ask him a series of questions about different amounts on his business return while staring down at the paperwork. My friend sat there reading the answers off of his business records. After 10 minutes or so of this the Auditor looked up, realized my friend was reading from records, and said, “Wait, I thought you said you lost everything in a fire?”

After my friend explained that his business records were at the office, not his home, the Auditor cheered up and everything went smoothly.
Based on this my guess is if you did lose your records they’d expect you to do your best to replicate them and then decide if they believed your numbers or not. If they didn’t it’s like any other situation where you disagree with the IRS. You negotiate and possibly end up in court letting the lawyers fight it out.

I’ve dealt with some of these cases.

First, you file the return using the best information and estimates you can. The odds of being audited are pretty slim and that may be the end of it. (To that extent, it’s almost more important to be on time than to be right. Don’t attract attention.)

If you’re audited, you

  1. Find what you can - get copies of receipts, invoices, statements, etc. from banks and vendors. Some of them keep more than you’d think. One of my clients got five years of receipts from Best Buy, Home Depot and Lowe’s.
  2. Estimate what you can - use ratios from the prior years, perhaps, or count the number of trips, that kind of thing. There’s a long and court-tested allowance for using reasonable estimates, but obviously one person’s definition of reasonable may be different than the next.
  3. Beg for mercy. A disaster is a reasonable cause for all kinds of penalty waivers and IRS auditors mostly have sympathy for you. Partly it depends on how well documented the disaster is. A flood or fire they’ll know about, but if the disaster is “a box of receipts fell off the back of a truck” they might question that.

Have you actually had a case where that happened (or was claimed to have happened)?

Yep, though not phrased exactly that way. He moved from Indiana to Washington and claimed that his box of receipts went missing on the way. It’s certainly plausible enough and I have no real reason to doubt him, but there’s no evidence either way.

And how it turned out in terms of the audit: the auditor basically accepted that gaps in current year income/expense could be filled in using numbers from the prior year. This was partly established from records like bank statements (business and personal) that we were able to get copies of.