Tax Savvy for Small Businesses:

Recordkeeping & Accounting

“The income tax has made more liars out of the American people than golf has.”

—Will Rogers

Most ventures are started by enthusiastic people with ambition and drive. Whether they are hoping to build the next Fortune 500 company or simply to supplement their day job, it’s usually what the business will buy, sell, make or fix that interests them most. They aren’t intrigued by the paperwork. You are not alone if you hate paperwork, but the law mandates some basic recordkeeping.

The good news is that the IRS does not require business records to be kept in one uniform fashion. Any format is OK, as long as it is reliable and paints a true picture of income and expenses. Since no two enterprises are alike, no two recordkeeping systems are exactly alike. Never forget that the IRS (and state taxing agencies too) has the right to audit you and inspect your records.

This chapter outlines the minimum recordkeeping required and has tips on how to set up and maintain a good system. It also touches on basic accounting principles.

Recordkeeping in a Nutshell

1. The IRS doesn’t prescribe any particular format for keeping your business’s records, as long as they clearly reflect your income and expenses.

2. You can choose a manual or computerized recordkeeping system, but a computer saves time and is more accurate.

3. Small businesses are usually required to keep records and tax report on a calendar-year basis.

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A. Why You Need a Bookkeeping System

Some fledging entrepreneurs think that if there is money in their business checking account at the end of the month, they must be making a profit. But only if you keep accurate records will you really know if your business is making or losing money. A recordkeeping system is also crucial for preparing your annual federal and state income tax returns.

The first commandment of the tax code is thou shalt keep “records appropriate to your trade or business.” (IRC § 6001.) Most records don’t have to be kept in any particular form, but they must be accurate. (Reg. 31.6001-1(a).)

Records can also serve as an early warning system to let you know whether changes need to be made in your enterprise. Indeed, operating without good records is like flying in dense fog with no instruments. I can almost hear you saying, “I think I’ll skip this chapter; I hate bookkeeping. After all, if my business takes in enough money, all these paperwork matters will resolve themselves. If they don’t, I’ll hire someone to clean them up.” Think twice, please.

Take recordkeeping seriously. If you only get one thing out of this book, go away knowing that ignoring recordkeeping is inviting disaster. If the IRS ever audits and finds insufficient records or significant mistakes, it can force you out of business and wipe out your life savings as well.

Recordkeeping must become part of your everyday business routine, just like opening your doors each morning. Believe me, I am not an accountant, and I hate paperwork as much as any of you. I also hate shaving every morning, keeping fat out of my diet and carrying out the garbage in the rain, but these tasks never seem to go away. As we shall see, though, recordkeeping doesn’t need to be drudgery, and you don’t need to spend godawful amounts of time tracking every last penny.

Random Business Record Inspections

You may be audited after written notice, but there are no “IRS inspectors” roaming around spot-checking to see that records are being kept. In many states, however, employment or sales tax auditors do show up unannounced and demand to see records. So, just like the Boy Scouts, “be prepared.”

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B. How Long Records Should Be Kept

The IRS normally has three years to audit you and your business, starting from the date you file a tax return. So, three years is the absolute minimum period for record retention. However, for serious tax reporting misstatements, the IRS can go back six years—and for outright fraud, it can go back an unlimited period of time. Don’t overlook the fact that your state tax agencies can inspect your records, too. Some state agencies have statutes of limitations for auditing longer than the IRS’s.

Considering all the laws here, I advise my clients, as a rule, to keep their regular tax-related documents—receipts, invoices, bank statements—for six years.

There is an exception for asset records. Many entrepreneurs buy equipment, vehicles and sometimes real estate for their business. For assets like these, records should be kept longer than the normal six years. The reason is that depreciation deductions on assets are often taken over an extended period. If a tax agency audits, the issue of a depreciation deduction on the tax basis of a long-term asset is frequently questioned. Only by having the original acquisition documents can the starting tax basis be proven.

Example: In 1986, Calista bought a building for her insurance agency. She tax deducted all expenses of maintaining the building and took depreciation deductions. Calista sold her agency, including the real estate, in 1998. She filed her tax return reporting the sale of the business on 4/15/99. Calista should keep her 1986 documents on the purchase of the building until at least April 15, 2002 (three years from the date of the tax return), or better, for six years, to April 15, 2005.

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C. Timing Methods of Accounting: Cash and Accrual

Besides recordkeeping systems, there are also two accounting methods for recording the income and expenses called the “cash” and “accrual” methods. These are two sets of accounting rules for the timing of income and expenses.

The general proposition is that a venture’s income and expenses must ordinarily be tax-reported in the period in which they occur. Normally the period is a calendar year, but for a few businesses it may be a fiscal year.

Example: Monique bought $7,000 in supplies for her hairdressing salon in January 2001. But Monique hasn’t filed her 2000 income taxes yet—can she deduct the $7,000 expense on her 2000 tax return? No, because the expense was incurred in 2001. Monique cannot shift it to another year. This is true no matter which accounting method is applied.

Less clear-cut is the question: What if Monique had bought the supplies in 2000, but didn’t pay for them until 2001? In which year does Monique take the deduction? To answer, you need to know the difference between cash and accrual methods of accounting and which one Monique’s business is using.

1. Cash Method Accounting

The term “cash method” refers to recognizing for tax purposes an expense when it is paid or income when it is received—not how it is paid. So, don’t take the word “cash” here literally; it covers any kind of payment—checks, barter, credit cards, etc.—as well as the green stuff.

Most businesses selling services use the cash method of accounting for income and expenses. The cash method makes sense even to us non-accountants. You simply report income in the year you receive it and an expense in the year you pay it.

The cash method seems simple, but there are a few special tax rules to watch out for. One is a legal doctrine called “constructive receipt,” which requires counting some items as income before you actually receive them. This means you have income, for tax purposes, as soon as it is available or credited to your account—even if you don’t take it.

Example: Ray got a $3,000 check for consulting in early December 2001, but didn’t deposit it until January 2002. Because Ray could have cashed it in 2001—the banks were open and the check was good—2001 is the tax year in which Ray “constructively received” the $3,000.

The corollary of the constructive receipt rule is that you are not allowed a deduction in the current year for items paid for but not yet received.

Example: Ray got a special deal on Consulting Times, a monthly business publication. He paid $360 for a three-year subscription in July of 2001. He can tax-deduct only $60 in 2001 (¹/6 of the total); the balance must be prorated over the term of the subscription and deducted $120 (¹/3) in 2002, $120 (¹/3) in 2003 and $60 (¹/6) in 2004.

Watch the calendar. There is some flexibility allowed by the IRS for prepaying some expenses at the end of the year. The last week of every December, I review the income and expense figures of my law practice to see if I can shave some money off my tax bill. For instance, if I pay January’s office rent on December 27, I’ll get the deduction a year earlier. As long as I don’t prepay an expense more than 30 days in advance, I’m okay. Or, if I had an especially good year (meaning a big tax bill), I can stock up on office supplies or buy new equipment to write off under IRC § 179. And in some years I’ve found the converse is true—my late December accounting shows a disappointing year. Then I put off new purchases or paying creditors until January and hope for the best in the coming year.

2. Accrual Method Accounting

Most larger C corporations, manufacturers and businesses with inventories of goods must use the accrual method of accounting. The accrual method requires some getting used to for most folks.

With accrual accounting, income is treated as received when it is earned—regardless of when it is actually received. On the other side, an expense is recorded at the time the obligation arose—which is not necessarily when it is paid.

In accountant’s lingo, business expenses and income are considered accrued at the moment they become “fixed” under this method. Don’t fret, the example below shows that this is not rocket science.

Both income and expenses must meet what the tax code calls the “all events” test to become fixed. This means that everything required—all events—to secure a right to receive the income, or to cause a liability for the expense, must have happened. At that point in time it becomes fixed for accrual accounting purposes—whether or not any cash has changed hands.

Example: George’s Foundry, which uses the accrual method, receives a $4,500 deposit in 2001 for custom ironwork to be manufactured in 2002. The foundry won’t report $4,500 as income in 2001 because it hasn’t been earned yet. On the expense side, if the foundry incurs a $250 charge in 2001 for lawyer’s fees relating to the contract, it is accrued and tax deducted in 2001—even if not paid for until 2002.

Get help setting up accrual accounting. If your operation keeps inventories, manufactures goods or is a C corporation, consult a tax pro in setting up your accounting system. Find someone familiar with your industry, whether it is a gas station, a loan company or a medical practice. Most software programs accommodate accrual accounting.

Excerpted from “Tax Savvy for Small Business”, by Frederick W. Daily