Recordkeeping is essential for any busines. As an accountant, I am often asked:
- What records do I need if I were audited by the IRS?
- Why do I need to keep evidence of income and expenses?
- How do I know if my recordkeeping is appropriate?
Disclosure: This post discusses the minimum requirements for income tax reporting only. There are many more requirements in an adequate recordkeeping system surrounding payroll, sales tax, property tax, etc. I highly encourage you speak with an attorney and a tax CPA regarding the documentation needed for such matters.
There are a number of variables to consider when building your busines’s recordkeeping system. As the owner of your busienss, you need to make sure your system is both adequate and appropriate for you and your business.
- An adequate recordkeeping system will substantiate your income and deductions reported to the IRS and other taxing agencies.
- An appropriate recordkeeping system helps you manage financial health.
Below I’ve described what is necessary for an adequate recordkeeping system. This information is necessary to reduce your income taxes and keep you out of jail. If you build an accounting system that only covers your compliance needs, aka a ‘CYA’ recordkeeping system, you are missing out on a lot of knowledge, and potential wealth, generated by an appropriate recordkeeping system. Make sure to read part II to better undstand the benefits of an appropriate recordkeeping system and tips to build one right for you.
An Adequate Recordkeeping System: CYA Compliance Reporting
An adequate recordkeeping system will provide the IRS and other taxing agencies appropriate information to substantiate your taxable claims.
The law does not require any specific records when proving support for income and deductions. You as the owner can build any recordkeeping system that is suited for your business. If you are the owner of more than one business, the IRS recommends you keep a complete and separate set of records for each business.
At a minimum, there are two components needed in your adequate recordeeping system:
- An accounting system that clearly shows your income and expenses (deductions).
- Records to substantiate your claims.
There are a number of accounting systems available to help you keep track of your income and expenses. Do a quick Google search, read reviews, and pick on that is right for you. We’ve chosen QuickBooks Online as our preferred accounting system. If you need one, we can get you set-up with one.
In addition to an accounting system that shows your income and expenses, you will need to maintain record of each and every individual transaction.
Expenses can be ‘deducted’ from your income which effectively reduces your tax bill. For the IRS to accept your deduction, you will need to prove to them that the expense took place and was necessary for business.
You’ll need to show the expense took place.
At a minimum, your bank and credit card statements may be accepted as proof of payment by the IRS. The following was copied from IRS Publication 583 and are the components needed to be accepted:
If payment is by check, then the statement must show:
- Check number
- Payee’s name
- Date the check amount was posted to the account by the financial institution
If payment is by electronic funds transfer, then the statement must show:
- Amount transferred
- Payee’s name
- Date the transfer was posted to the account by the financial institution
If payment is by credit card, then the statement must show:
- Amount charged
- Payee’s name
- Transaction date
You’ll also need to show the purchase was necessary for business.
Common examples of documents supporting business purpose are:
- Vendor invoices
- Purchase receipts
- Billing statements
- Copies of cancelled checks
There are special rules for travel, meals, entertainment, gift, and vehicle, deductions.
The IRS has special rules for travel, entertainment, gift, and car expenses. These underwent significant changes starting in 2018 and can be read in my blog titled, “What the Meal?!” For these items, in addition to the records listed above, you will need to demonstrate ‘essential character’ for for the deduction.
“Essential character” can be established via:
- A diary
- Travel itinerary
- Meeting notes
- Or similar records.
Holy cow! Who knew so many records were needed just to ‘cover your ass’?! Of course, doing so just keeps you from paying too much income tax and hopefully out of jail. The holy-grail of recordkeeping is actually leveraging your financial activity to make better, informed decisions that will ultimately improve the financial health of your business and result in:
- Higher owner pay
- Healthier cash balances
- Dividend payments
- Less time spent working in the business and more time with family
- Much more.
Read part II and learn how to leverage your business’s financial information, improve financial health, and ultimately make your dreams a reality.