Why Should I Care?
Whenever I meet with a customer for tax planning, they usually ask one of two questions:
How likely is it that I will be audited?
Will taking advantage of the tax planning strategies you recommend increase my likelihood to be audited?
What this tells me is that many taxpayers are very afraid of the IRS. That's not unreasonable, surely we all know someone who has gotten themselves into tax trouble. Most people want to be ethical in the way they conduct their business, and they view part of my job - as their CPA - as making them bulletproof when it comes to the IRS. However, when tax season rolls around, I rely on my customer's summaries and representations to prepare the tax returns.
There are a few things I wish every business owner understood about business taxes:
Different deductions have different recordkeeping requirements, and those recordkeeping requirements are always the responsibility of the taxpayer, never the tax preparer.
If you meet those recordkeeping requirements, you have nothing to fear in the event of an audit.
Not every notice or letter from the IRS means you are being audited. And, since they are frequently computer-generated, the likelihood the IRS will send you mail is pretty high. The key is to respond quickly, and never to ignore IRS correspondence.
All that is to say, whether you like it or not, you are responsible for keeping records to support your deductions. This article is meant to help you understand some of the unusual business recordkeeping requirements.
This article does not address the deductibility of expenses, since the record keeping requirements are a prerequisite for deductibility. This means you should meet the recordkeeping requirements for all expenses, regardless of whether or not you think they will be deductible.
What Records to Keep:
Business Bank Account Activity & Classifications:
I'm hoping you have a separate bank account for your business. If not, you should open one as soon as possible.
The IRS does not specify how you should account for the bank activity and will accept manual check registers, ledgers, spreadsheets, or accounting software.
Deposit records should identify the source of funds and whether the funds are business income, personal funds, or loans.
Disbursement records should identify the payee, business purpose (category), and any other information that helps document the business expenses.
The business bank account should not be used to pay personal expenses, but business profits can generally be withdrawn by check or electronic transfer to a personal account. Cash withdrawals should be carefully documented as owner distributions.
Travel Expenses:
There are special rules for meals, travel, and lodging expenses.
For these expenses, you must maintain records of:
The amount of the expense
The time and place of travel
The business purpose of the expense
The business relationship between the Taxpayer and the persons provided meals
There are a few documentary evidence exceptions:
When the expense (other than lodging) is less than $75
A Self-Employed taxpayer who uses the per diem rates for meals and/or lodging
The taxpayers meals or lodging is accounted for under an accountable plan that uses the per diem allowance method
The taxpayer has a transportation expense for which a receipt is not readily available
Payroll Records:
Special rules apply to payroll records.
Payroll records must be kept for at least four years. Records include:
Employer identification number
Amounts and dates of all wage, annuity, and pension payments
Amounts of tips reported to the employer by the employees
Records of allocated tips
The fair market value of in-kind wages paid
Names, addresses, Social Security Numbers (SSNs) of employees and recipients
Employee copies of Forms W-2 & W-2c that were returned to the employer undeliverable
Dates of employment for each employee
Periods for which employees and recipients were paid while absent due to sickness or injury, and the amount and weekly rate of payments the employer or a third-party payer made to them
Copies of employees' and recipients' income tax withholding certificates (Forms W-4, W-4P, W-4, W-4S, and W-4V)
Dates and amounts of tax deposits made and acknowledgement numbers for deposits made by EFTPS
Copies of returns filed and confirmation numbers
Records of fringe benefits and expense reimbursements provided to employees, including substantiation
Documentation to substantiate any credits or deferrals claimed
You can see that there is a lot to these record-keeping requirements. These are only the federal requirements, and state requirements will likely vary. As such, I highly recommend all my customers use a third party payroll provider to streamline the payroll process and record keeping. I actually offer a robust set of people advisory packages if you're serious about streamlining payroll.
Business Asset Records:
Special rules apply to fixed asset purchases.
For fixed assets, the following records must be maintained until at least 3 years after the later of the return due date of date filed for the year of the asset's disposal.
Invoice or bill of sale
Acquisition Cost
Placed in service date
Description of asset
Description of intended use of the asset
These records are extremely important, because they influence your depreciation, amortization, and depletion deductions. These deductions are typically the biggest adjustment made between book and taxable income.
Business Automotive Records:
Taxpayers may have the choice between actual expenses or standard mileage, depending on how their business is taxed. I recommend clients keep both mileage and actual expense records, and your tax preparer can take whichever deduction is most beneficial to you.
Generally, for each vehicle you should maintain:
Invoice or bill of sale, acquisition cost, placed in service date, description, description of intended use, and VIN number
Sales tax paid (if paid after purchase)
Total business miles for the year
Total commuting miles for the year
Grand total miles for the year
Business deductions for automotive expenses are frequently challenged in audits. Your best shot at passing without an adjustment is to maintain contemporaneous records with with a manual mileage log, or software.
Contractors:
Depending on the nature of payments you make to non-employees (contractors), you may be required to file forms from the 1099 series. The most common are 1099-MISC and 1099-NEC.
Generally, these forms are required to be filed for all persons or entities to which you pay more than $600 during the tax year.
There are a many exceptions, but generally you must file the forms for all contractors you pay over $600 unless the payments are made to a C-Corporation or an LLC taxed as a C-Corporation
For each contractor, you must obtain a completed Form W-9. Failure to obtain a W-9 (or a substantially equivalent form) may require you to withhold on these payments.
Charitable Contributions:
For each charitable contribution, you must obtain a written acknowledgment from the charity, and you must receive it by the date of filing or the date of the return, including extensions.
The specific recordkeeping requirements are the same fore businesses as for individuals.
For more information, see my article on Recordkeeping Requirements for Charitable Contributions or download the chart below from my deskbook.
Receipts, Generally:
We discussed earlier the requirement for maintaining business bank account records. However, the IRS requires that all electronic records contain sufficient detail to to identify the underlying source documents and substantiate the tax and information returns.
This means that you also must be able to produce receipts for each transaction. In practice, I have rarely seen auditors require this much detail, especially when the accounting is good. However, the IRS can require this granular documentation. Typically they will only ask for these details for large or unusual items.
I personally file all my receipts in one folder, and if I am ever audited, I'll wait for them to request the receipts before I sort them all out
How Long to Keep the Records:
I'll give it to you straight: what I recommend you do and what the IRS requires you to do are different.
I recommend that all my clients keep all their documents indefinitely. However, most clients are unwilling or unable to do so. In that case, I recommend a 10 year retention policy. Generally, 10 years after an assessment the statute of limitations for collection has expired.
As such, I'll cover some of the general IRS requirements. That is, how long after filing the initial return was due or filed (whichever is later) are you required to keep the documents that support the return. You'll also hear these referred to as the "statute of limitations." Until the statute expires, the IRS can assess additional tax.
3 Year requirement: For any tax return where the IRS says you owe more tax
Later of 3 Years, or two years after tax was paid: For any tax return where you amend and try to claim a credit or refund
6 Year requirement: For any return where you omit more than 25% of gross income (substantial understatement)
7 Year Requirement: For any tax return where you claim a loss for worthless securities or a bad debt reduction
Unlimited requirement: For any tax return that is fraudulent OR unfiled tax returns
If those requirements make you head spin, you're not alone. I find myself revisiting these rules all the time.
Here's the problem: you'll notice that the recordkeeping requirements can change based on IRS determinations. You never know when the IRS will decide that you omitted income or committed fraud. This is why I recommend that you maintain all records indefinitely.
How to Keep the Records:
You can keep the records in whatever way you like, so long as the records contain the information required by the IRS.
However, I highly recommend that most businesses adopt an accounting software. The primary reason to adopt an accounting software is the reporting functionalities.
The sooner you get into a professional accounting package, the better. As you use the software you build up a longer history and can start to get great analytics and insights into your business. You can see relationships between your income and expenses, compare different time periods, track KPIs, and just generally understand your business finances better.
Additionally, it makes the process of getting financial together easier, and so usually I see my customers start to get more serious about their finances and they start making better, more proactive business.
In the event of an audit, it also makes it easier to create a plan of action for collecting source documents and formulating responses.
Conclusion
I hope you have a better idea of what records you need to be keeping as a business owner, and a greater appreciation of just how complicated all these rules can be.
Don't be disheartened, if your systems aren't up to the standards I outlined in this article, create a plan. Start with the biggest deductions on your tax returns, and decide how you're going to get in compliance going forward.
We can't change the past, but we can always protect our future selves.
As always, I'm happy to help if you need assistance with your accounting or taxes. You can pick a time to meet with me and discuss your needs here.
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