Recordkeeping for Individuals and Businesses
To calculate and prove taxable income, records are required, so there are numerous provisions in the tax code as to what records should contain and how long they should be kept. Businesses also 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. A separate set of 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 the size of the business, 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 would consist of more detailed categories, such as repair and maintenance, interest, legal expenses, and advertising.
Years ago, businesses would use actual accounting books, where each transaction was recorded by actually writing in the book. Nowadays, most businesses use accounting software, so many of the details of the accounting system 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 either be recorded or paper records imaged and transferred to the main accounting system.
Because the IRS depends on the taxpayer for most of the information that determines 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. The payment of an expense does not necessarily mean that the taxpayer is entitled to the deduction; that the taxpayer actually incurred 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 the following:
- when the property was acquired
- purchase price
- how the property was used in the business
- cost of any improvements
- deductions taken for depreciation or casualty losses
- if the property was sold or otherwise disposed of, then the following are required:
- the date of disposition
- the sale price and any related expenses to the sale
If a business has employees, then the following information should be kept for each employee:
- total pay for the period
- number of hours worked
- deductions withheld from the employee's pay.
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, thereby preventing any loss of records. Small business owners should always have a business checking account that is 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.
Most businesses store their accounting information electronically, using off-the-shelf accounting software, such as QuickBooks. If a business uses a proprietary accounting system, then documentation should 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 decide to 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 the books and records maintained by the taxpayer, but the amount of time accorded to the IRS is limited by the statute of limitations. In most cases, the statute of limitations is the later of 3 years either after the due date of the return or 2 years after the tax is paid. 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. 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. Some items, such as IRS private letter ruling, should be kept indefinitely.
Certain types of records should be kept longer. If a claim for a credit or refund is made, then any relevant record pertaining to the credit or refund should be kept for at least 3 years after the amended tax return is filed. If there was a claim for worthless securities or a deduction for a bad debt, then the record should be kept at least 7 years.
Generally, the IRS can require documentation for 6 years for any unreported income that was greater than 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. However, if you can prove that you did file a return, and the IRS cannot audit the return if its tax year is outside of 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.
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 Specific Types of Expenses
Besides the basic informational requirements for most transactions, a business purpose should also be recorded for all travel or entertainment expenses, including the business relationship, names and other contact information of the associated people and a description of the expense.
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.
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 do not have to be retained if the taxpayer is using the standard mileage rate 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, then 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, then the IRS may allow a reconstruction of the information, but only if it can be substantiated to some degree.
In some cases, the courts have developed case law for what has become known as 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 the taxpayer had a reasonable basis for not having accurate records. However, a particular court may not allow the use of the Cohan rule, so the taxpayer would be wise to maintain accurate records.
Carryovers and Prepaid Expenses
There are some limitations to deductions in the current tax year, many of which are limited by the income earned for that year. If the entire deduction cannot be claimed, then 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 in some cases, the carryover period is indefinite. Therefore, records must be maintained for the entire carryover period and for the time thereafter required of other records.
Prepaid expenses that apply to future tax years cannot usually be deducted in the current tax year, but 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 known as §1231 property, can be deducted from ordinary income. If there are any gains from §1231 property in future years, then those gains 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.