In the event that your tax return is audited, the key to ensuring that you are allowed all the business deductions you claimed is good recordkeeping. We understand that most business owners don’t want to spend time on tax records; it’s an extremely tedious process keeping tax records in good order. The question for you as a business owner is: Is the endured tedium worth the pain of lost (or missed) deductions? We think so, and we’ll offer some suggestions later on how to make it a little easier to maintain good business records.
Keeping good records does not mean you have to become a tax professional. In fact keeping good records is nothing more than good business. Poor recordkeeping is more than a tax problem in the making, it prevents the business owner from answering, with any degree of certainty, the two most important questions he/she should know at all times:
- How much money did I make last month/quarter/year?
- What is my business worth today?
All of the numbers included in your tax return are your responsibility. You create the numbers, not your tax professional. Your tax professional depends on you for the numbers and documentation to support those numbers. You are required to have adequate support for your tax return. When you sign your tax return, you attest to its accuracy under penalties of perjury. Moreover, you are required to read your return. You cannot avoid penalties by claiming that you solely relied on your tax professional. Furthermore, if you take your tax records to your tax professional during tax season and they are not well organized, or incomplete, one of the following things are likely to happen.
- Your tax return will take longer to prepare. Your tax professional will need to spend time to put your records in order before preparing the return.
- Your tax return will cost more. Most tax professionals cannot afford to spend time during the busiest time of the year to organize your recordkeeping without charging you for the time it takes to do so.
- Filing your return will be delayed. Faced with the prospect of having to organize your recordkeeping before preparing the tax return, even the most conscientious tax professional will be inclined to give your tax return lower priority than those of other clients whose records are already in good shape. Often these returns are the ones that end up on extension.
The recordkeeping suggestions may be a little painful, but they will be good for you.
Generally, you are allowed to deduct all “ordinary and necessary” business expenses. The deduction depends on your ability to prove a profit motive. That is, you are not in business unless you are trying to produce a profit. When you are trying to make a profit, you may deduct your “ordinary and necessary” business expenses.
Ordinary and Necessary
An “ordinary and necessary” expense is:
- Helpful or appropriate and
- Customary, usual or normal in your business field
The courts have deemed all “ordinary” expenses as “necessary.” However, an expense could be “necessary” but not ordinary and therefore not deductible. All expenses must be reasonable in amount and not lavish. No personal, family, or living expenses. You may not deduct personal, family, or living expenses. Allocations maybe necessary to establish the dollar amount of business expenses. In other cases, if there is any personal taint whatsoever, no business deduction is allowed.
Why is Documentation Needed?
Documentation is the key to sustaining your tax position. Without documentation, you end up losing all of your bona fide deductions. IRS states in its official publications that you must maintain records that support accurate tax returns. The records should be made at or near the time of the expense when there is accurate recall. Such records must be permanent, accurate, and complete. Failure to meet the adequate documentation standards of the Internal Revenue Code can result in disallowance of your valid deductions.
IRS thinks you might cheat on your taxes; accordingly, you are assumed guilty until you prove that you are innocent. The burden of support is on you: you have total responsibility for proving your deductions. It is not the job of IRS examiners to help you keep records. Failure to meet the record keeping requirements costs you bonafide deductions.
Failure to meet some record keeping requirements can also lead to fraud penalties. You are now required to answer questions concerning your automobile mileage records under penalty of perjury. Congress has instructed the IRS to ask for fraud penalties when taxpayers don’t have good records of automobile use. When fraud penalties are assessed, they are in addition to any other penalties. Failure to keep good records results in penalties, among other things, equal to:
- 1/2 of 1% a month delinquency penalty during the period that you fail to pay the proper amount of tax.
- 20% of underpayment attributable to negligence or disregard of the rules or “did not have a reasonable basis for the deduction.
- 75% of any underpayment attributable to fraud.
Also remember, you may not deduct interest paid to the IRS, if it was due to a business deduction on your Schedule C
In Order to Meet the IRS Records Requirements
Build a documentation system. The documentation system should contain three distinct records. Regardless of how you conduct your business, whether as a corporation or as a sole-proprietorship, you need three separate and distinct types of tax records:
- Permanent Files
- Regular Files
- A Daily Diary
These records include your prior years’ tax returns, stock purchases and sales, equipment purchases, and sales and similar entries. Generally, you want to keep any record that relates to more than one tax year in your permanent file. If you purchase property, your permanent files should include the purchase documents, closing statements, deeds, and other expenses related to the purchase.
Regular files include time sheets for part-time help, receipts, invoices, canceled checks, bank statements and other corroborative evidence such monthly/quarterly/yearly Profit & Loss statements and Balance sheets from whatever accounting system you use.
Your daily diary — which can be your appointment book — is the focal point of your documentation system. This is especially true if you operate a personal service business. The smaller your business, the more important this document becomes. Your daily diary should include:
- All of your appointments
- Where and when you travel
- Where you go by automobile
- Where and when you entertain your business contacts.
Use Three-part Checks
Keep a separate business checkbook and use three-part checks. Regardless of your business form, whether a corporation or sole-proprietorship, the three-part check is necessary to build good, easy-to-use records in your regular files.
- Send part one, the original check, to the vendor.
- Staple the yellow copy (part two) of the check to supporting evidence such as receipts or invoices and file alphabetically in the vendor file.
- Put part three in a numerical file for later viewing by IRS and reference by you.
Record Retention Periods
As a general rule, you must keep records in sufficient detail to establish the amount of income, deductions, and credits shown in any tax or information return. You must keep them available for IRS inspection for as long as the contents may become material in the administration of any tax law. Keep documents for 3 open tax years. If the expenditure was for the purchase of property or a business asset, keep supporting documents for as long as the asset is owned plus 3 open tax years after disposition of asset.
Three-Year Rule: Generally, all income taxes must be assessed within three years from the date the return was filed, or due, whichever is later,
Six-Year Rule: If you omit an amount in excess of 25% of gross income shown in the return, a six-year limitation period applies.
Extension by Agreement: The statute of limitations can be extended by a written agreement between you and IRS.
No Limitation Rule: If you fail to file a return, or file a fraudulent return, there is no statute of limitations.