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In last week’s blog post we covered how to keep your documentation contemporaneous and consistent to stay compliant with the IRS and make tax time a lot easier! This week let’s cover what kind of documentation you need to keep and for how long.
COMPREHENSIVE – WHAT TO KEEP AND HOW LONG TO KEEP IT
Understanding the different types of business records necessary for tax compliance is important. In general, these records can be classified into the following four categories:
- Documents that Substantiate Income—All income is taxable unless it isn’t.
- Documents that Substantiate Deductions— Paying an expense from a business account doesn’t magically convert it to a business expense. Deductions are allowed for “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” Remember, even when an expense is considered ordinary and necessary, certain business deductions (e.g., travel expenses, meals, and mileage) are subject to special rules.
You must have proof of the deduction and how it ties to your business. You should document the following information for your deductions:
- The amount of the deduction
- The date of the deduction
- The business purpose of the deduction (aka keeping receipts isn’t sufficient!)
The best practice is using separate accounts, credit cards, and records for business and personal expenditures. But having individual business and personal accounts is only the first step; you must use them properly. When maintained and operated appropriately, business-only accounts simplify record-keeping, tax reporting, and information retrieval in the event of an audit.
Keep the following documents for three years after the return is filed:
- Lender Forms 1098 to substantiate interest paid on mortgaged real property.
- Credit card statements showing end-of-year interest paid on business-use-only credit cards.
- Loan or other statements showing business interest paid on loans for tangible personal property or lines of credit from creditors or vendors.
- Receipts showing the payment amount, the date of the payment, and the business purpose of the payment for all business expenses.
- Mileage logs showing the date of the trip, the mileage, and the business purpose of the trip for each vehicle used in the business. Mileage logs should include business use trips and other personal use to determine the business use percentage for the vehicle.
- Documents Related to Assets and Liabilities— You should keep loan documents to help prove deposits from loan proceeds. Loan proceeds should not be deposited on the same deposit ticket as sales revenue. Loan documents, amortization schedules, and end-of-year payment statements should also be kept for three years to substantiate the amount of business interest paid for a given tax year unless the loan is related to the purchase of a specific asset.
Documents (including loan documents) that substantiate the basis of an asset should be kept for at least three years after the asset is sold or otherwise disposed of.
Important: Overstating the basis of an asset has the same effect as under-reporting gross income. Substantial understatement of income (by 25% or more) extends the statute of limitations for potential examination from three to six years.
- Documents That Substantiate Ownership Interests—These documents should be kept for at least three years after a given shareholder or partner’s interest is terminated. The records should clearly show what was given in exchange for the partnership interest or shares (money, property, etc.) and the shareholder or partner’s basis, as well as the fair market value of the property contributed. The documents should also clearly state what was received regarding shares or percentage interest in exchange for the contribution.
- Because partnership distributions do not have to be strictly pro rata, partnership documents should include an operating agreement or another document that spells out the partner’s distributive percentage if it differs from their ownership percentage.
- Partnership ownership documents should also include records that substantiate whether the partner is a limited (usually investment only) partner or a general partner (i.e., a working partner subject to self-employment tax on distributions). It is also essential that any documents that report changes to distributive share, ownership percentage, etc., be kept in addition to the original documents.
These documents should be kept for three years after the filing date of the returns to which they apply. It is often the case that the partner or shareholder’s basis is different from the business’ basis in certain assets.
Final Note: Compliant record keeping is critical for small business owners—For the help and expertise you need, contact a certified tax planner today! And to receive even more information on this and get tax strategy worksheets you can take to your CPA look into our DeTax University program. We want to help you find as many ways to save money on taxes as you legally can!