Business Records to keep for Taxes
If you are self-employed (filing schedule C sole proprietor or operating as an LLC), you likely have questions about the exact business records you should keep as requested by the IRS or your tax preparer. The first thing you should know is that it is your responsibility to maintain these records for a period of at least 3 years. You are expected to maintain complete and accurate records of your income and expenses and there are significant penalties if you fail to comply.
Taxable Income vs Deposits
As a business owner, it is imperative that you keep good records of your gross receipts. This is important because not all receipts are taxable income. Keep your business bank statements and a ledger of your business income. Bank transfers, loans, and gifts may all increase your bank balance but are not taxable and you will want to keep back up of such as proof. Taxpayers should keep a copy of the deposit slip and check to show the source of the deposit as the bank statement will only show the amount credited. Gifts should be documented by a statement from the Donor and gift tax return if necessary. As well, loans should be documented with promissory note showing repayment terms and reasonable interest rate.
For many taxpayers a single-entry system of accounting (tracking income and expenses) will be sufficient to create their income statement. You do not necessarily need complicated bookkeeping software with double entry accounting which incorporates asset and liability accounts. For simplicity, most taxpayers should opt to keep their books on the cash basis of accounting, which recognizes income when actually received and expenses when paid. This distinguished from the accrual basis which recognizes income when earned and expenses when incurred.
Expenses vs Deductions
You are responsible for keeping track of your business expenses and you are entitled to deduct all ordinary and necessary charges. However, not all expenses are deductible and many taxpayers fail to keep adequate proof of their write-offs. Bank and credit card statements show proof of payment, but only the cancelled check, invoice or receipt can show the deduction. If you purchase some computer supplies at Target with your credit card and don’t keep the receipt or pay someone by check without an getting an invoice first, your deduction may be jeopardy. Tax preparers don’t need receipts to prepare tax returns and won’t usually ask for them, but the IRS surely will if audited.
Certain expense categories have stringent recordkeeping requirements, namely travel, meals, and car expenses. It is a good idea to keep track of the who, what, when, where and why in a daily planner and mileage log. If you make payments for non-employee services in your business, you may have to report them to the IRS on information returns. For example, if you make a payment of over $600 to an individual, you will need to file form 1099-NEC with the IRS and send a copy to the payee. You should request the payees tax identification number on form IRS W-9 in advance of make any payments. Issuing a form 1099 and getting an invoice acts to substantiate the deduction.
LLC and Corporations
If you are operating your business as an LLC taxed as a separate return (Form 1120 series), make sure to open bank accounts and credit accounts in the name of the LLC. Remember you are an employee of the business required to take wages and if you pay for a business expense, make sure to reimburse yourself from the company. Keep track of your time devoted to the business so you can substantiate your required reasonable salary. Also keeps copies of your IRS EIN letter, payroll tax returns, State LLC formation and good standings, S-Corp approval letter and all other important company documents and policies you have adopted to show you are operating as a separate entity.
Consequences of Not keeping Records
If your tax return is selected for audit and you cannot produce the requested records, you will face significant penalties. At a minimum, you will be assessed a 20% negligence penalty and interest charges on top of the additional tax you owe. Another consequence of not keeping good records is that you likely will not file an accurate tax return, possibly resulting in an overstatement of taxable income. An amended tax return to correct an error may become necessary, costing additional tax preparer fees. It is important to understand that your tax preparer does not audit you or may not request to see your records. The preparer will generally rely on information provided by you unless something is known to be incorrect, but you should still maintain your records.