Record keeping is an important part of running a small business. Not only will keeping good records help you understand your business results, but good records also help small businesses minimize taxes and avoid costly audits.
Except in a few cases, the IRS does not require special kinds of records. Whether you use QuickBooks, some other accounting software, or keep manual records understanding the records you need to retain is important.
Here are the key records that small businesses need for tax compliance:
Identify sources of your income. Business records should identify income from all sources. This information is important to separate business from non-business receipts and taxable from nontaxable income.
Keep track of deductible expenses. Taxpayers must prove they are entitled to deductions if the IRS challenges them. So, small businesses need to record expenses when they occur so they will be accurate and properly documented. In many cases, the IRS requires contemporaneous records, meaning that the record of the expense must be created at the time it was incurred to take a deduction.
Keep track of your basis in property. The cost of property, improvements made, and depreciation or other write-offs taken all factor into the basis of a small business’s property. The basis of an asset is used to figure the gain or loss on the sale, exchange or other disposition of property. The basis of property also is used to calculate depreciation, amortization, depletion and casualty losses.
Support items on tax returns. Taxpayers must keep business records available at all times for inspection by the IRS. If the IRS examines any of a business’s tax returns, the taxpayer may be asked to explain the items reported. A complete set of records will speed up the examination, and accurate records can head off an IRS challenge to particular items.
How Long to Keep Records
How long an owner should keep documents depends on several factors, including the type of expense and the event recorded in the document. The IRS suggests taxpayers keep records for three years, in general. The three-year rule is based on the fact that a taxpayer should keep records that support an item of income, deduction or credit shown on a tax return until the period of limitations for that tax return runs out. The period of limitations is the period of time in which a taxpayer can amend a tax return to claim a credit or refund, or the IRS can assess additional tax. However, three years may not be long enough for small businesses.
IRS Advice on Record Retention
- Keep records for 3 years if you report all income and you file all required returns.
- Keep records for 3 years from the date you filed your original return or 2 years from the date you paid the tax, whichever is later if you file a claim for credit or refund after you file your return.
- Keep records for 7 years if you file a claim for a loss from worthless securities or a bad debt deduction.
- Keep records for 6 years if you do not report the total income that you should report, and it is more than 25% of the gross income shown on your return.
- Keep records indefinitely if you do not file a return.
- Keep employment tax records for at least 4 years after the date that the tax becomes due or is paid, whichever is later.
Please note that if the IRS believes a taxpayer intentionally failed to report income, there is no time limit on audit or the IRS coming after a taxpayer.
Records Connected to Property
The best practice is to keep property records until the period of limitations expires for the year in which you dispose of the property. You must keep these records to figure any depreciation, amortization, or depletion deduction and to figure the gain or loss when you sell or otherwise dispose of the property.
If you received property in a nontaxable exchange, your basis in that new property is the same as the basis of the property you gave up, increased by any money you paid. You must keep the records on the old property, as well as on the new property until the period of limitations expires for the year in which you dispose of the new property.
Burden of Proof
Burden of Proof is a legal term that refers to the duty placed on one side or the other in a legal dispute to prove or disprove a disputed fact. In tax law, the burden of proof usually is on the taxpayer to prove the accuracy of the tax return. The IRS has the burden of proof when it seeks to impose penalties or charge the taxpayer with a criminal instead of a civil violation.
What this means for the small business owner is that they must be able to prove expenses to deduct them, by producing detailed records.
Business owners should keep all records of employment taxes for at least 4 years after filing the 4th quarter for the year. These should be available for IRS review. Records should include:
- Employer identification number.
- Amounts and dates of all wage, annuity, and pension payments.
- Amounts of tips reported.
- The fair market value of in-kind wages paid.
- Names, addresses, social security numbers, and occupations of employees and recipients.
- Any employee copies of Form W-2 that were returned as undelivered.
- Dates of employment.
- Periods for which employees and recipients were paid sick leave and the amount and weekly rate of payments the employer or third-party payers made to them.
- Copies of employees’ and recipients’ income tax withholding certificates (Forms W-4, W-4P, W-4S, and W-4V).
- Dates and amounts of tax deposits made.
- Copies of returns filed.
- Records of allocated tips.
- Records of fringe benefits provided, including substantiation.
Paper v. Electronic Records Safekeeping
Businesses that keep paper records should keep them in a secure location, preferably under lock and key, such as a desk drawer or a safe. Businesses that keep records electronically on a computer should always have an electronic back-up, ideally stored in the cloud or off-site from the business.
These suggestions are based on the general rules for record keeping for federal tax purposes. More specific rules may apply depending on the type of business a taxpayer is in. Clear, detailed and consistent records are a small business’s best defense in an audit.