Taxpayers should claim every deduction to which they are legally entitled when they complete their tax returns every winter. As keeping up with the tax law changes can be almost a full-time job, many taxpayers rely on their tax professionals to notify them of what is and is not deductible. Sometimes, due to the timing of communications, things get lost. However, if taxpayers keep good records, isolate the way in which they pay their business expenses, and record their business income, they will not only get all their deductions, but will have written their own IRS Audit Survival Guide.
This article is designed to provide self-employed taxpayers a general structure for organizing their records. Future articles will provide examples and explanations of expenses of which self-employed taxpayers should be aware.
Tracking Business Expenses—Keep Those Receipts!
It is important to know which expenses are deductible for business purposes and/or personal purposes (such as real estate taxes—but not on the same property) and which are deductible only for business purposes, such as non-mortgage loan interest. The second part of tracking business expenses is knowing what type of documentation (receipts) the Internal Revenue Service believes supports a specific type of deduction. The first line of defense is always, practically speaking, receipts, receipts, receipts.
However, an IRS examiner may accept canceled checks or a debit card transaction as proof of a business expenditure, particularly if the taxpayer keeps the business account separate from the personal bank account. The taxpayer may have to point out to the IRS examiner that the account is used only for business, but that is a minor effort.
Keeping only the business transactions does require transferring funds to one’s personal bank account to pay the rent or mortgage and making sure neither account overdrafts. But it is a small inconvenience if it allows a taxpayer to sail through an examination with no change to the tax return. Credit cards used in the business should be treated the same as bank accounts, restricted to business use.
Smaller, easily faded receipts can be grouped by vendor and purpose, placed in date order, and then totaled. The adding machine tape should be stapled to them and should have written on it, in ink, the year, the dollars spent total and the expense category (or purpose).
Maintain a Separate Bank Account for the Business!
And keep those bank statements! The IRS also looks at the bank account for income verification and reviews deposit slips for cash back. If the deposits total more than the income reported on Schedule C, they will ask why. Well-documented deposit slips with, or detailed logs of, the source of all funds deposited work well. “Cash back” entries are added to the total deposits less loan proceeds, transfers, and cash infusions from one’s personal bank account to determine income. If everyting is well-documented or listed somewhere, the sailing should be good.
Keep a Long-Term File
Some business expenses span over more than one tax year (e.g., loans, mortgages, vehicles, office furniture). The acquisition, repayment for (if a loan is involved in the acquisition) and disposal of these items are relevant not only to the tax return prepared at the time purchased, but subsequent tax returns also.
Taxpayers should keep a separate “semi-permanent” file for vehicle, equipment and office furniture purchases, as well as loans on the business side of their finances and for home purchases and stock transactions on the personal side. This separate file should contain all the purchase agreements, bills of sales, UCC financing statements, all other loan documents, and all titles and registrations showing legal proof of ownership. Keeping a separate file for these items is an administratively effective way of having the information readily accessible for each of the years it may be needed.
Contracts with contractors often span more than one year and these also should be kept in a separate, always easily accessible, file at tax time. Home and mortgage papers, along with property tax records, and stock transactions should be kept in a personal file, again, always easily accessible at tax time.
Consider Scanning Documentation—Avoiding Faded Receipts
With today’s technology, taxpayers can scan their receipts and well-notated deposit slips—because they often fade and are also easy to lose or misplace. Scanning is wonderful! A flash drive with the entire year’s documentation can be safely stored in a safe deposit box or other place of a taxpayer’s choosing. With today’s technology, a taxpayer can organize its tax documentation easily by type: Expenses, Income, Long-Term Items.