CHAPTER 3
Recordkeeping for Business Income and Deductions
- General Recordkeeping
- Specific Substantiation Requirements for Certain Expenses
- Records for Depreciation, Basis, Carryovers, and Prepaid Expenses
- How Long You Should Maintain Records
Recordkeepingis a tiresome and time-consuming task. Still, you have little choice but to do it. Records show whether your business is producing a profit or a loss. The information in your records can enable you to prepare financial statements, such as profit and loss statements and balance sheets, which may be required by your lenders or investors. From a tax perspective, you need records to determine your gain or loss when you sell property. And as a general rule, you must be able to back up your deductions with certain clear proof, such as receipts, canceled checks, and other documentation. If you do not have this proof, your deductions may be disallowed or force you to litigate in order to win your position (a costly and time-consuming activity). Certain deductions require specific evidence. Other deductions are based on more general means of proof.
For further information on recordkeeping, see IRS Publication 334, Tax Guide for Small Business (for Individuals Who File Schedule C or C-EZ); IRS Publication 552, Recordkeeping for Individuals; and IRS Publication 583, Starting a Business and Keeping Records.
General Recordkeeping
The tax law does not require you to maintain books and records in any particular way. It does, however, require you to keep an accurate and complete set of books for each business you operate. Statistics show that this can be an awesome task.
According to the IRS, it takes a mere 45 minutes for recordkeeping to prepare a Schedule C for a sole proprietor. However, what “recordkeeping” means for this purpose is not explained. According to the House Small Business Committee, more than half of small businesses said they spent more than 40 hours each year dealing with taxes, and 40% said they spent more than 80 hours (which is more than two 35-hour work weeks).
Set up your books when you begin your business. Your books are based on your choice of tax year and accounting method, as explained in Chapter 2. In the past, when you kept your books in paper ledgers, you needed to choose a bookkeeping method—single-entry or double-entry. If you are a service business, single-entry bookkeeping may be sufficient. Today, with software and online accounting solutions, you don't need to know about bookkeeping methods; you merely input income and expense items, and the program does the rest.
Your books should be set up with various accounts in order to group your income and expenses. The broad categories of accounts include income, expenses, assets, liabilities, and equity (or net worth). Within these accounts you can keep various subaccounts. For example, in an account called Expenses you can have subaccounts for advertising, bad debts, interest expense, taxes, rents, repairs, and more. In fact, your subaccounts should reflect the various income and deduction topics discussed throughout this book.
Technology for Recordkeeping
More and more businesses are using computers, tablets, and smartphones to maintain books and records rather than having bookkeepers make handwritten entries. Computer-generated records save time—an important commodity for the small business owner—and generally are more accurate than handwritten entries.
The IRS accepts computer-generated records if they are legible and provide all the necessary information. You are required to keep a description of the computerized portion of your accounting system. You must keep this documentation as long as you keep the records themselves. Your document should show:
Applications being performed
Procedures used in each application
Controls used to ensure accurate and reliable processing
Controls used to prevent the unauthorized addition, alteration, or deletion of retained records
Use recordkeeping software that facilitates recordkeeping both for tax purposes as well as for financial matters. Using software and cloud-based solutions such as Intuit's Quickbooks Online, Online Simple Start, Quickbooks Pro, and QuickBooks Self-Employed; Sage 50 Pro, Sage One, and other Sage products; FreshBooks; Kashoo; GoDaddy Online Accounting; Xero; Wave; or AccountEdge enables you to forward data to your tax professional as well as transfer information into tax return preparation programs at tax time, saving you both time and money. There are a growing number of accounting options that integrate seamlessly with your sales activities, eliminating the need to input data more than once. For example, Shopify has partnered with Xero and Bigcommerce has partnered with various QuickBooks solutions. There are also stand-alone apps and apps accompanying accounting solutions to facilitate mobile accounting (including the ability to invoice and process payments on the go). As your business grows (and the number of users for your accounting solution exceeds your current licensing limit), you likely will move to more a sophisticated accounting product that can accommodate your needs.
Your books alone do not entitle you to deductions; you need supporting evidence. This evidence includes sales slips, invoices, canceled checks, paid bills, time sheets for part-time help, duplicate deposit slips, brokerage statements on stock purchases and sales, and other documents that help to explain a particular entry in your books. Certain deductions—travel and entertainment expenses and charitable contributions—require specific types of supporting evidence, as explained later in this chapter. The IRS considers your own memoranda or sketchy records to be inadequate when claiming deductions. Keep these records and documentation in an orderly fashion. Use files or other storage facilities to retain receipts and other evidence.
Keep your files in a safe place. If you use desktop solutions, be sure to back up files regularly (online solutions do not require backup because data is automatically stored in the cloud). Consider using a service that enables you to automate your backup (e.g., every day at 2 a.m.). For example, store paper files in a fireproof safe. If you lose files with receipts because they were not stored safely, you may lose deductions and face penalties as well. If you “lose” records before or during an audit, you may be charged with a hefty negligence or accuracy-related penalty. If, despite your best efforts, files and records are lost or destroyed by a casualty (such as a fire, storm, earthquake, or flood), you may be permitted to reconstruct records if you can prove those records existed before the casualty. Of course, reconstruction takes considerable time, and it is probably impossible to reconstruct all of your expenses. Therefore, take special care to safeguard your records.
Electronic Imaging Systems
Storage of receipts and other records in paper form makes retrieval of wanted items difficult. This is especially so for large companies, but it can be problematic for smaller businesses as well. Recognizing the problem, the IRS now allows books and records to be maintained by electronic imaging systems.
If an electronic imaging system is used, it must ensure accurate and complete transfer of the hard copy or the computerized books and records. It must include:
Reasonable controls to ensure the integrity, accuracy, and reliability of the system
Reasonable controls to prevent and detect the unauthorized creation of, addition to, alteration of, deletion of, or deterioration of records
An inspection and quality assurance program evidenced by regular evaluations of the electronic storage system
A retrieval system that includes an indexing system
The ability to reproduce legible hard copies of electronically stored books and records
In the past, most small businesses could not undertake the expense of using an electronic imaging system for their books and records with the technology that was available. However, today's technology allows you to use an alternative imaging method that is acceptable to the IRS. You can transfer data to a DVD—you burn the information onto the disk and cannot alter it thereafter. You can scan the information to be transferred into your computer and then transfer it to the disk.
Specific Substantiation Requirements for Certain Expenses
The law requires businesses to maintain books and records, and to provide special substantiation for certain deductions. There is a negligence penalty that can be imposed for 20% of an underpayment resulting from the failure to keep adequate books and records or to substantiate items properly.
Travel and Entertainment Expenses
The tax law imposes special substantiation requirements for claiming travel and entertainment expenses. If you fail to satisfy these requirements, your deduction for these business expenses may be disallowed. There are 2 types of records you need in order to claim deductions for your travel and entertainment expenses:
Written substantiation in a diary, log book, or other notation system containing certain specific information, and
Documentary evidence (receipts, canceled checks, or bills) to prove the amount of the expense.
The IRS accepts certain electronic or faxed information to be treated as documentary evidence (e.g., a faxed statement attesting to a “ticketless” airline ticket is considered documentary evidence). Sites such as Shoeboxed.com can be used to scan receipts and create electronic records. Smartphones and other mobile devices may be used for written substantiation in lieu of a logbook. You may be able to use an app for your smartphone, to track travel and entertainment costs and transfer data to your PC or your accountant (see Chapter 8 for some app suggestions). There are other apps, such as ProOnGo, that can be used to keep records and send them to QuickBooks Online edition. There are a number of apps for tracking business car mileage (see Chapter 9 for some suggestions).
There are a number of elements to substantiate for each business expense. In general, to substantiate each item you must show the amount, time, place, and business purpose for the travel or entertainment expense or the business relationship with the person or persons you entertain or provide gifts to and, in some cases, a description of the item. The exact substantiation requirements depend on the type of business expense.
In all cases, you are strongly advised to use a written or electronic daily log or diary to record expenses. As you will see, you need written proof of your expenses (or an electronic log that can be turned into written proof), and this proof must be recorded “contemporaneously” with the expenses—generally meaning at the time you incur the expense or as soon as is practical thereafter to record it. Use a separate credit card for business expenses. The monthly statement from the credit card company is also useful in substantiating these expenses.
Travel
You must show the amount of each separate expense for travel, lodging, meals, and incidental expenses. You can total these items in any reasonable category. For example, you can simply keep track of meals in a category called Daily Meals. You must also note the dates you left for the trip and returned, as well as the days spent on the trip for business purposes. You must list the name of the city or other designation of the place of the travel, along with the reason for the trip or the business benefit gained or expected to be gained from it.
While this may sound like a great deal of recordkeeping, as a practical matter, hotel receipts may provide you with much of the information necessary. For example, a hotel receipt typically shows the dates you arrived and departed, the name and location of the hotel, and separate charges for lodging, meals, telephone calls, and other items. A sample log for travel expenses can be found in Chapter 8.
Entertainment
Again, you must list each separate expense. Incidental expenses, such as taxis and telephone calls, may be totaled on a daily basis. You must list the date of the entertainment. For meals or entertainment directly before or after a business discussion, list the date and duration of the business discussion. Include the name and address or location of the place of entertainment, as well as the type of entertainment if it is not apparent from the name of the place. Also list the place where a business discussion was held if entertainment took place directly before or after the discussion. Again, state the business reason or the business benefit gained or anticipated and the nature of the business discussion. Include the names of the persons entertained, including their occupations or other identifying information, and the names of those who took part in the business discussion. If the deduction is for a business meal, you must note that you or your employer were present at the meal.
Again, a restaurant receipt typically supplies much of the information required. It shows the name and location of the restaurant, the number of people served, and the date and amount of the expense. Be sure to retain these slips as your proof. A sample log for entertainment expenses can be found in Chapter 8.
Gifts
Show the cost of the gift, the date it was given, and a description of the gift. Also show the business reason for the gift or the business benefit gained or expected to be gained from providing it. Include the name of the person receiving the gift, his or her occupation or other identifying information, and his or her business relationship to you.
A canceled check, along with a bill, generally establishes the cost of a business item. However, the check alone does not prove a business expense without other evidence of its business purpose.
If you do not have adequate records and your return is questioned, you may still be able to deduct an item if you can prove by your own statement or other supporting evidence an element of substantiation. Where receipts are destroyed, you may be able to reconstruct your expenses. You must, of course, show that you actually maintained records and how the records were destroyed (for example, in a fire, storm, or flood). The IRS may require additional information to prove the accuracy or reliability of the information contained in your records.
Car Expenses
Show the number of miles driven for business purposes (starting and ending odometer readings), the destination, the purpose of the trip, and the name of the party visited (if relevant). Simply jot down the odometer reading on January 1 to start a good recordkeeping habit. Or use an app that simplifies recordkeeping for your car mileage. Include notations of expenses for gas, oil, parking, tolls, and other expenses. Recordkeeping shortcuts and tips, and a sample log for keeping track of car expenses, can be found in Chapter 9.
Recordkeeping Relief
You do not need receipts, canceled checks, bills, or other proof of the cost of a travel or entertainment expense in the following situations:
You use a standard rate (such as a standard mileage rate for car use or a per diem rate for meals and lodging). Per diem rates are explained in Chapter 8; the standard mileage rate is explained in Chapter 9.
The expense is less than $75. However, you cannot use this exception for lodging (you must have documentary evidence for lodging regardless of amount).
You have a transportation expense (such as a taxi fare) for which a receipt is not readily available.
The Cohan Rule
While the IRS says that deductions will be disallowed if you do not have adequate substantiation, you may be able to rely on a special rule developed by the courts. The Cohan rule, named after noted songwriter/showman George M. Cohan, is based on approximation. A court may agree to approximate your expenses if your records are inadequate to establish actual expenses and you have some way to show your approximate expenses. A court cannot be compelled to use the Cohan rule; it must be persuaded to do so because of special circumstances. The Cohan rule is only a last resort for claiming unsubstantiated travel and entertainment expenses. The Cohan rule has been used for some expenses other than travel and entertainment expenses (e.g., research expenses, licensing fees, and building sign replacements).
Charitable Contributions
Cash contributions of any amount must be substantiated by a written acknowledgment from the charity, a bank statement, or other permissible method (which depends on the amount of the donation). Presumably, a credit card statement showing the date of a contribution and the amount is also acceptable proof. Cash contributions of $250 or more require a written acknowledgment from the charity (the bank statement is not sufficient).
If a property donation is valued at over $5,000, you may also be required to obtain an appraisal by a certified appraiser and keep a record of this appraisal.
Records for Depreciation, Basis, Carryovers, and Prepaid Expenses
For some tax items you must keep a running account, because deductions will be claimed not only in the current year but also in years to come.
Depreciation
Depreciation allows you to recover the cost of property over the life of that property by deducting a portion of the cost each year. In order to claim your annual deductions, you must keep certain records:
Costs and other information necessary to calculate your depreciation
Capital improvements to depreciable assets
Depreciation deductions already claimed
Adjustments to basis as a result of depreciation deductions
This information not only is necessary for depreciation purposes but will also be needed to calculate gain or loss and any depreciation recapture on the sale or other disposition of a depreciable asset. For full details on claiming depreciation, see Chapter 14.
The same recordkeeping rules apply not only to depreciation but also to amortization and depletion deductions.
Basis
Basis is the cost of property or some other value assigned to property. Basis is used for several purposes: It is the amount on which depreciation deductions are based, as well as the amount used to determine gain or loss on the sale or other disposition of property.
The basis of property can vary from its basis upon acquisition. Some items increase basis; others decrease it. Keep track of changes in basis. These can result from:
Depreciation deductions or first-year expensing
Casualty deductions relating to the property
Certain tax credits
Capitalized costs
One court has said that proof of capital improvements to increase basis includes such items as written records, canceled checks, construction permits, and before-and-after pictures.
S Corporation Shareholder's Basis
One of the most important records that must be kept for shareholders is their basis in corporate stock and loans they made to the corporation. This basis limits the amount of losses passed through to them that they can deduct. How items of income, loss, loan repayment, and other amounts impact this basis is explained in Chapter 4.
Carryovers
A number of deductions may be limited in a current year, but you may be able to carry over any unused portion to other years. In order to take advantage of carryover opportunities, you must keep records of deductions you have already taken and the years in which they were taken. What is more, you must maintain relevant records for the carryover periods. The following list details the types of carryovers for which records should be maintained and limits on the carryover period, if any:
At-risk losses. Losses disallowed because of the application of the at-risk rules (see Chapter 4) can be carried over indefinitely.
Capital losses. There is no limit on the carryover period for individuals. There is a 5-year limit on carryover losses for corporations.
Charitable contributions. Individuals who cannot fully use current charitable contributions because of adjusted gross income limits can carry over the unused deductions for a period of 5 years. C corporations that cannot fully use current charitable contributions because of the 10%-of-taxable-income limit can carry over the unused deductions for a period of 5 years. If the deductions cannot be used within that 5-year period (there is insufficient taxable income to offset the deduction in the carryover years), the deductions are lost forever.
Home office deductions. Individuals who maintain an office in their home and whose actual home office deductions are limited in the current year by gross income earned in the home office can carry forward unused deductions indefinitely. The unused deductions can be used in a future year if there is gross income from the home office activity to offset it. (There is no carryover if the simplified method is used to figure the home office deduction.)
Investment interest. Individuals (including partners, LLC members, and S corporation shareholders) may be limited in their current deduction for investment interest by the amount of their net investment income. Excess investment interest can be carried forward indefinitely. There is no limitation on corporations, so there is no carryover.
Net operating losses. When operating losses cannot be used in full in the current year, they may be applied against income in certain other years. The carryover period depends on the year in which the net operating loss arises. For example, a carryback for a small business arising in 2009 could have been 3, 4, or 5 years, while NOLs arising in 2016 usually have a 2-year carryback. Good recordkeeping is necessary to track these carrybacks and apply them in the correct order (see Chapter 4).
Passive activity losses. Losses disallowed because of the application of the passive activity loss rules (suspended losses) can be carried forward indefinitely. The same rules apply to credits from passive activities.
Cash basis and prepayment. Depreciation and carryovers are not the only tax items that may run beyond the current tax year. If you are on the cash basis and prepay certain expenses, you may not be allowed a current deduction for your outlays. You may be required to deduct the expenses ratably over the period of time to which they relate. Some examples of commonly prepaid expenses that may have to be deducted ratably include:
Insurance premiums. If your insurance premiums cover a period of more than 12 months, you may be required to deduct them over the term covered by the policy.
Prepaid interest. If you pay points or other amounts treated as prepaid interest to obtain financing to acquire real estate for your business, you deduct the prepaid interest ratably over the term of the loan. If you dispose of the property or refinance the loan before the end of the term, you can then deduct any unused portion of the prepaid interest in that final year.
Rents. If you prepay rents for a period of more than 12 months, you may be required to deduct the rents over the term of the lease.
Subscriptions. If you pay for subscriptions running more than 12 months, you generally have to deduct the cost over the term of the subscriptions. For example, if you pay in full the cost of a 3-year subscription to a business journal, you generally must deduct the cost over the same 3-year period.
You need to keep a running record of Section 1231 losses—losses on the sale of certain business assets. This is because of a special recapture rule that applies to net ordinary losses from Section 1231 property. A net Section 1231 gain is treated as ordinary income to the extent it does not exceed nonrecaptured net Section 1231 losses taken in prior years. Nonrecaptured losses are the total of net Section 1231 losses for the 5 most recent years that have not yet been applied (recaptured) against any net Section 1231 gains in those same years. In order to determine this recapture, you must retain information on Section 1231 gains and losses. Section 1231 losses are explained in more detail in Chapter 6.
Finally, you need to keep track of tax credits that are not completely used in the current year. Tax credits that are part of the general business credit (such as the work opportunity credit, employer Social Security credit, and the disabled access credit) are subject to a carryback and carryforward period depending on the year in which the excess credits result. For credits arising in years beginning after December 31, 1997 (except for 2010), the excess credits are carried back one year and forward for up to 20 years. For credits of small businesses (average annual gross receipts under $50 million) arising in 2010 only, the carryback period was 5 years; the carryforward period remained 20 years. No election can be made to forgo this carryback period.
How Long You Should Maintain Records
Your books and records must be available at all times for inspection by the IRS. You should keep these books and records at least until the time when the IRS's ability to question your deductions runs out. This time is called the statute of limitations. In general, the statute of limitations is either 3 years after the due date of your return or 2 years after the date the tax was paid—whichever is later. Some records must be kept even longer. You need to keep records to support the basis in property owned by the business. You also need to keep records for depreciation and carryovers, as discussed earlier.
Tax Returns
Keep copies of tax returns to help you prepare future returns, as well as to help you if your return is questioned by the IRS. While you can obtain old returns from the IRS, this entails unnecessary time and expense. Although you may only need information on an old return for 3 additional years (or 6 years if you omit more than 25% of your gross income from your return), it is a good idea to keep old tax returns indefinitely. If the IRS claims you never filed a return it has an unlimited number of years in which to audit you. But if you have your old return along with proof that you filed it (for example, a certified receipt or an acknowledgment of efiling from the IRS), the IRS only has 3 years, in most cases, to start an audit.
Keep a record of the basis of property used in your business for as long as you own the property, plus the statute of limitations on filing the return for the year in which property is sold or otherwise disposed of. For example, if in 2016 you buy equipment that you will sell in 2017, keep records on the basis of the property at least until 2021 (3 years from the due date of the return for the year in which the property was sold).
Employer Records
If you have employees, special recordkeeping rules apply. For tax purposes, you are required to keep records on employment taxes for at least 4 years after the due date of the return or after the tax is paid, whichever is later. Keep copies of all returns you have filed and the dates and amount of tax deposits you have made. Your records should also show your employer identification number (EIN). Every business type of, sole (sole proprietorship, partnership, and corporation) must have one if wages are paid (see Chapter 1).
Income Tax Withholding
You must keep records of each employee's name, address, and Social Security number, the amount of each wage payment, the amount of each payment subject to income tax withholding, and the amount of income tax withheld. You must also keep copies of all employees’ withholding allowance certificates (Form W-4). Similarly, you must keep any earned income credit advance payment certificates (Form W-5) filed with you by low-income wage earners who want to receive an advance on their earned income credit.
Other Employment Taxes
Similar records must be kept for each employee for Social Security and Medicare taxes, as well as for federal unemployment taxes (FUTA).
Other Tax Records
Certain documents should be retained indefinitely. These include IRS letters and private rulings you've obtained. For corporations, retain all corporation resolutions related to taxes and other matters. And, of course, retain all accounting records, annual financial statements, and audit reports forever.
How to Dispose of Tax Records
Gone are the days when you could simply toss your old files in the garbage. Today, because of the potential for identity theft affecting both individuals and businesses, proper disposal is essential. Shredding documents on paper or CDs and DVDs is a good way to prevent unwanted eyes from viewing confidential information. Use special technology to wipe tax and other confidential information off computers being disposed of.