Recordkeeping for Individuals and Businesses

To calculate and prove taxable income, records are required, so many provisions in the tax code specify what records should contain and how long they should be kept. Businesses require records to show profit and loss, to prepare tax returns, to determine the financial status of the business, and to produce financial statements for investors and business owners. Business records are maintained in accounting systems that allow easy entry of transactions and to create the many financial reports that a business needs to operate and to pay taxes. There are 2 basic types of accounting reports: an income statement listing the income and expenses for a given time period and a balance sheet listing assets, liabilities, and owners equity, thus providing a snapshot of the business at a specific time.

The tax law does not stipulate a particular method to use for recordkeeping — only that the records be both complete and accurate. Good recordkeeping requires that the accounting system support the claimed income, expenses, and credits. Before records can be used to determine taxable income, the business must choose a tax year, accounting method, and whether to use single- or double-entry accounting. For most small businesses, single-entry accounting suffices. An accounting method should be selected that clearly reflects income and expenses. Separate records should be kept for each business.

Under the traditional paper system of accounting, a journal is a document listing individual transactions, while a ledger summarizes and totals the transactions. Depending on business size, there may be different journals and ledgers for different types of transactions. Most small businesses would have a business checking account, daily and monthly summaries of cash receipts, depreciation worksheets, and an employee compensation record. Accounting systems generally group accounts into categories, with a top category of revenue, expenses, and equity. Subaccounts are more detailed categories, such as repair and maintenance, interest, legal expenses, and advertising.

Years ago, businesses would use accounting books, where each transaction was recorded by writing in the book. Now most businesses use accounting software, so many accounting system details are handled automatically by the software. The business owner simply records the date, category, amount, and other details for each transaction. Recording transactions is simplified by using portable technology, such as tablets or smartphones, where transactions can easily be recorded or paper records imaged, then transferred to the main accounting system.

Owners of multiple businesses must maintain separate books and records for each business.

Supporting Documentation

Because the IRS depends on the taxpayer for most information determining taxable income, the IRS requires supporting documents for most transactions. Most deductions, for instance, require substantiation, such as receipts, canceled checks, credit card statements, or other documentation; otherwise, deductions may be disallowed. Paying an expense does not necessarily mean it can be deducted; the cost and that the expense was a business expense must also be demonstrable.

Supporting documents — the additional documents created by a transaction, such as sales slips, invoices, receipts, canceled checks, and petty cash slips for cash payments — should be kept to substantiate accounting entries. Most supporting documents should have, at a minimum, the payee's name, transaction amount and date.

Property used in conducting a business, such as computers or furniture, require additional information since these assets are usually depreciated over time. Some of the necessary information includes:

If a business has employees, then this information should be kept for each employee:

For accurate records, transactions should be recorded contemporaneously, at the time of the transaction or shortly thereafter. Smart phone apps can be used to record many transactions and can even transfer those records to cloud storage, preventing any loss of records. Small business owners should always have a business checking account separate from their personal account, for this is the simplest way of recording transactions for a given business, especially for the receipt of revenue. Credit cards for a specific business will also document many expenses automatically.

Electronic Records

Most businesses store their accounting information electronically, using off-the-shelf accounting software, such as QuickBooks. If a business uses a proprietary accounting system, documentation must be available for inspection by the IRS that provides information about the accounting system showing how the system handles entered data, the controls to ensure accurate and reliable processing, the measures to prevent unauthorized addition, alteration, or deletion of records, and a chart of accounts with detailed account descriptions. Revenue Procedure 98-25

Electronic storage records are subject to the same guidelines as paper records. Original paper records can be destroyed if they have been successfully stored electronically in compliance with IRS rules. The IRS may test the electronic storage system to see if its requirements are satisfied. Revenue Procedure 97-22

How Long Should Records Be Kept?

If the IRS audits an individual or business, it has the right to examine their books and records, but only within the time limit set by the statute of limitations. The statute of limitations is the later of:

Certain types of records should be kept longer. If a claim for a credit or refund is made, any relevant record pertaining to the credit or refund should be kept for at least 3 years after the amended tax return is filed. For a claim for worthless securities or a deduction for a bad debt, the record should be kept at least 7 years.

Records for property where tax basis is recorded should be held as long as the property is owned + 3 years after the due date of the return for the year when the property was sold. If the property is disposed of before it is fully depreciated, gain or loss must be reported, equal to the difference between the sale price and the tax basis. Gains may be taxed as capital gains or as a depreciation recapture, or a combination thereof.

Records for Employees

Records for any employees must be maintained for the later of 4 years either after the due date of the return or after the tax is paid. Keep records of all filed returns and tax deposit amounts and dates. Keep records for each employee:

Other agencies may have longer holding requirements for employee records, including the Equal Employment Opportunity Commission, Occupational Safety and Health Administration, and other federal agencies. States and municipalities also have their own recordkeeping requirements.

Extended Time Limits for Tax Violations and Important Information

The IRS can require documentation for 6 years for any unreported income exceeding 25% of the gross income for that year's return. However, there is no statute of limitations if either a fraudulent return was filed or no return was filed. If you can prove you did file a return, the IRS cannot audit the return if the tax year is beyond the statute of limitations.

A 20% negligence penalty may be imposed for underpayment of tax resulting from failure to keep adequate books or to substantiate deductions properly.

IRS letters, private letter rulings, accounting records, annual financial statements, audit reports, and corporation resolutions  should be kept indefinitely.

Because accounting information, including supporting documents, are being recorded and stored electronically, there should be no problem with storing the records indefinitely. Indeed, older records may be needed for other reasons. Lenders or potential investors in the business may want to inspect a longer history of the business. Deleting older records may have unforeseen legal or other consequences. The IRS may claim that a fraudulent return was filed or that the correct amount of employment taxes was not paid. So it would behoove any business owner to keep all business records indefinitely.

Additional Transaction Information for Some Types of Expenses

Certain expense require specific or additional documentation.

Besides the basic informational requirements for most transactions, a business purpose must be recorded for travel or entertainment expenses, including the business relationship, names and other contact information of the associated people, and a description of the expense. These expenses must be contemporaneously recorded and supported by documentary evidence, such as receipts or credit card statements.

For gifts, the cost, date given, description, and the business reason for giving the gift should be recorded, including the name of the donee, occupation, and business relationship.

Vehicle expenses should show the odometer reading for the start and end of the trip, destination, trip purpose, and the names of visited people. An odometer reading should be recorded at the start of every year to substantiate business use percentage.

Generally, supporting documents do not need to be maintained for a travel or entertainment expense if it is less than $75 or if a receipt was not available, such as for a taxi. However, lodging requires documentation regardless of cost. Vehicle expense receipts are not needed if the standard mileage rate is used for deducting vehicle costs.

Charitable contributions have special recordkeeping requirements. Cash contributions must be substantiated by a written acknowledgment from the charity, especially if the amount exceeds $250. If the value of donated property exceeds $5000, the claimed value should be supported by a certified appraiser for the property.

Records for property that is depreciated, amortized, or depleted must be maintained for the applicable tax years and for the required years thereafter. Additional information that should be recorded include the cost, other direct buying expenses, capital improvements, deductions already claimed, and adjustments to the tax basis of the property. This information is then used for cost recovery deductions, first-year expensing, casually deductions, capitalized costs, some tax credits, the gain on property disposition, and to calculate any recaptured depreciation.

The Cohan Rule

If records are destroyed, the IRS may allow a reconstruction of the information, but only if it can be substantiated to some degree.

Some courts have developed case law for what is called the Cohan rule, after the songwriter George M Cohan, that allows the approximation of unsubstantiated expenses if there is sufficient evidence to support the amount, and if there was a reasonable basis for not having accurate records. However, courts have discretion on whether to apply the Cohan rule, so accurate records should be maintained.

Carryovers and Prepaid Expenses

Deductions may be limited for the current tax year by the income earned for that year or by law. If the entire deduction cannot be claimed, the unclaimed portion can be carried over to future tax years. The length of this carryover period is determined by the reason for the carryover, but sometimes the carryover period is indefinite. Therefore, records must be maintained for the entire carryover period and for the time thereafter required of other records, usually 3 years after the carryover period ends.

Prepaid expenses that apply to future tax years must be deducted in the applicable year, so the recordkeeping holding requirement is extended by the prepaid period. So if you pay for a 3-year subscription, then the record for that subscription must be held for at least 6 years.

Some business credits, such as the disabled access credit, employee Social Security credit, and the work opportunity credit, also have carryover provisions, where some unused credits can be carried forward for up to 20 years.

Losses on some types of business property, collectively called §1231 property, can be deducted from ordinary income.
Gains from §1231 property in future years will be taxed as ordinary income to the extent that losses were deducted in the previous 5 years on the same type of property. Thus, appropriate records must be maintained for §1231 property with non-recaptured losses.

There are specific carryover periods for certain transactions. Losses or credits that can be carried forward indefinitely:

Other carryover periods:

Properly Disposing Tax Records

Because tax records have significant amounts of information about individuals, state and federal laws require their proper disposal to prevent identity theft and to protect privacy. All paper records should be shredded. All electronic records should be fully destroyed, either by destroying the memory units holding the information or by erasing their memory completely, beyond any possibility of retrieval.