Technology for Recordkeeping

Most businesses today use computers, tablets, and smartphones to maintain books and records rather than having bookkeepers make handwritten entries. Computer‐generated records save time—an important commodity for the small business owner—and generally are more accurate than handwritten entries.

The IRS accepts computer‐generated records if they are legible and provide all the necessary information. You are required to keep a description of the computerized portion of your accounting system. You must keep this documentation as long as you keep the records themselves. Your document should show:

• Applications being performed
• Procedures used in each application
• Controls used to ensure accurate and reliable processing
• Controls used to prevent the unauthorized addition, alteration, or deletion of retained records

Use recordkeeping software that facilitates recordkeeping both for tax purposes as well as for financial matters. Using software and cloud‐based solutions such as Intuit's Quickbooks Online, Online Simple Start, Quickbooks Pro, and QuickBooks Self‐Employed; Sage 50cloud and other Sage products; FreshBooks; GoDaddy; Sunrise; Xero; Wave; or Zoho Books enables you to forward data to your tax professional as well as transfer information into tax return preparation programs at tax time, saving you both time and money. Many accounting options integrate seamlessly with your sales activities, eliminating the need to input data more than once. For example, Shopify is integrated with QuickBooks and Xero, Avalara's sales tax product is integrated with QuickBooks, and Bigcommerce has also partnered with QuickBooks. There are also stand‐alone apps and apps accompanying accounting solutions to facilitate mobile accounting (including the ability to invoice and process payments on the go). For example, Botkeeper is an app that mines your bank account and credit card to automate your bookkeeping. Similar (not identical) options are Bench, NeatBooks, Pilot, and Scalefactor; prices vary considerably. As your business grows (and the number of users for your accounting solution exceeds your current licensing limit), you will likely move to more a sophisticated accounting product that can better accommodate your needs.

Your books alone do not fully substantiate deductions; you need supporting evidence. This evidence includes sales slips, invoices, canceled checks, paid bills, time sheets for part‐time help, duplicate deposit slips, brokerage statements on stock purchases and sales, and other documents that help to explain a particular entry in your books. Certain deductions—travel expenses and charitable contributions—require specific types of supporting evidence, as explained later in this chapter. The IRS considers your own memoranda or sketchy records to be inadequate when claiming deductions. However, you can upgrade these records by backing them up with a photo on your smartphone. For example, if you buy a business publication at the newsstand and cannot obtain a paper receipt, consider taking a photo (which is timestamped) to accompany your own memoranda. Keep these records and documentation in an orderly fashion. Use files or other storage facilities to retain receipts and other evidence.

Keep your files in a safe place. Data breaches can lead to identity theft and the need for data reconstruction, both of which are very costly problems. If you use desktop solutions, be sure to back up files regularly (online solutions do not require backup because data is automatically stored in the cloud). Consider using a service that enables you to automate your backup (e.g., every day at 2 a.m.). For paper files, store them in a fireproof safe or use a service, such as Neat, Receipts by Wave, and Shoeboxed, that will sort and store receipts for you. If you lose files with receipts because they were not stored safely, you may lose deductions and face penalties as well. If you “lose” records before or during an audit, you may be charged with a hefty negligence or accuracy‐related penalty. If, despite your best efforts, files and records that are not stored in the cloud are lost or destroyed by a casualty (such as a fire, storm, earthquake, or flood), you may be permitted to reconstruct records if you can prove those records existed before the casualty. Of course, reconstruction takes considerable time, and it is probably impossible to reconstruct all of your expenses. Therefore, take special care to safeguard your records.

Electronic Records

Storage of receipts and other records in paper form makes retrieval of wanted items difficult. This is especially so for large companies, but it can be problematic for smaller businesses as well. You can use an electronic storage system for preparing or keeping records. An electronic system includes an electronic imaging system and transfers to electronic storage media.

If an electronic imaging system is used, it must ensure accurate and complete transfer of the hard copy or the computerized books and records. It must include:

• Reasonable controls to ensure the integrity, accuracy, and reliability of the system
• Reasonable controls to prevent and detect the unauthorized creation of, addition to, alteration of, deletion of, or deterioration of records
• An inspection and quality assurance program evidenced by regular evaluations of the electronic storage system
• A retrieval system that includes an indexing system
• The ability to reproduce legible hard copies of electronically stored books and records

Once an electronic storage system has been tested to make sure that hard copies are being reproduced in compliance with the requirements above, the original hard copy books and records can be destroyed.

Travel Expenses

The tax law imposes special substantiation requirements for claiming travel expenses. If you fail to satisfy these requirements, your deduction for these business expenses may be disallowed. There are 2 types of records you need in order to claim deductions for your travel expenses:

• Written substantiation in a diary, log book, or other notation system containing certain specific information, and
• Documentary evidence (receipts, canceled checks, or bills) to prove the amount of the expense.

There are a number of elements to substantiate for each business expense. In general, to substantiate each item you must show the amount, time, place, and business purpose for the travel expense or the business relationship with the person or persons you provide gifts to and, in some cases, a description of the item. The exact substantiation requirements depend on the type of business expense.

In all cases, you are strongly advised to use a written or electronic daily log or diary to record expenses. As you will see, you need written proof of your expenses (or an electronic log that can be turned into written proof), and this proof must be recorded “contemporaneously” with the expenses—generally meaning at the time you incur the expense or as soon as is practical thereafter to record it. Use a separate credit card for business expenses. The monthly statement from the credit card company is also useful in substantiating these expenses.

Charitable Contributions

Cash contributions of any amount must be substantiated by a written acknowledgment from the charity, a bank statement, or other permissible method (which depends on the amount of the donation). Presumably, a credit card statement showing the date of a contribution and the amount is also acceptable proof. Cash contributions of $250 or more require a written acknowledgment from the charity (the bank or credit card statement is not sufficient).

If a property donation is valued at over $5,000, you may also be required to obtain an appraisal by a certified appraiser and keep a record of this appraisal.

Depreciation

Depreciation allows you to recover the cost of property over the life of that property by deducting a portion of the cost each year. In order to claim your annual deductions, you must keep certain records:

• Costs and other information necessary to calculate your depreciation
• Capital improvements to depreciable assets
• Depreciation deductions already claimed
• Adjustments to basis as a result of depreciation deductions

This information not only is necessary for depreciation purposes but will also be needed to calculate gain or loss and any depreciation recapture on the sale or other disposition of a depreciable asset. For full details on claiming depreciation, see Chapter 14.

The same recordkeeping rules apply not only to depreciation but also to amortization and depletion deductions.

Basis

Basis is the cost of property or some other value assigned to property. Basis is used for several purposes: It is the amount on which depreciation deductions are based, as well as the amount used to determine gain or loss on the sale or other disposition of property. And it is a factor in figuring the qualified business income deduction (Chapter 21).

The basis of property can vary from its basis upon acquisition. Some items increase basis; others decrease it. Keep track of changes in basis. These can result from:

• Depreciation deductions or first‐year expensing
• Casualty deductions relating to the property
• Certain tax credits
• Capitalized costs, such as capital improvements. One court has said that proof of capital improvements to increase basis includes such items as written records, canceled checks, construction permits, and before‐and‐after pictures.

One of the most important records that must be kept for shareholders and partners is their basis in their entities, which is explained in Chapter 4.

Carryovers

A number of deductions may be limited in a current year, but you may be able to carry over any unused portion to other years. In order to take advantage of carryover opportunities, you must keep records of deductions you have already taken and the years in which they were taken. What is more, you must maintain relevant records for the carryover periods. The following list details the types of carryovers for which records should be maintained and limits on the carryover period, if any:

• At‐risk losses. Losses disallowed because of the application of the at‐risk rules (see Chapter 4) can be carried over indefinitely.
• Capital losses. There is no limit on the carryover period for individuals. There is a 5‐year limit on carryover losses for C corporations.
• Charitable contributions. Individuals who cannot fully use current charitable contributions because of adjusted gross income limits can carry over the unused deductions for a period of 5 years. C corporations that cannot fully use current charitable contributions because of the taxable income limit can carry over the unused deductions for a period of 5 years. If the deductions cannot be used within that 5‐year period (there is insufficient taxable income to offset the deduction in the carryover years), the deductions are lost forever.
• Farm losses. Farm losses barred because of a limitation (explained in Chapter 4) that has been suspended for 2018 through 2025 can still be carried forward and used starting in 2026.
• Home office deductions. Individuals who maintain an office in their home and whose actual home office deductions are limited in the current year by gross income earned in the home office can carry forward unused deductions indefinitely. The unused deductions can be used in a future year if there is gross income from the home office activity to offset it. (There is no carryover if the simplified method is used to figure the home office deduction as explained in Chapter 18.)
• Interest expense. Businesses with average annual gross receipts over $27 million for the 3 prior years are subject to the 30% interest limitation (explained in Chapter 13), although farming and real estate businesses may elect to be exempt. Any disallowed interest because of this limit can be carried forward and treated as business interest in the succeeding taxable year.
• Investment interest. Individuals (including partners, LLC members, and S corporation shareholders) may be limited in their current deduction for investment interest by the amount of their net investment income. Excess investment interest can be carried forward indefinitely. There is no limitation on corporations, so there is no carryover.
• Net operating losses. When operating losses cannot be used in full in the current year, they may be applied against income in certain other years. NOLs arising in 2021 cannot be carried back (other than a 2‐year carryback for farming businesses), but can be carried forward indefinitely. NOLs arising in 2018, 2019, and 2020 had a 5‐year carryback; unused amounts can be carried forward indefinitely. NOLs arising before 2018 had a 2‐year carryback and a 20‐year carryforward. Good recordkeeping is necessary to track these carrybacks and apply them in the correct order (see Chapter 4).
• Passive activity losses. Losses disallowed because of the application of the passive activity loss rules (suspended losses) can be carried forward indefinitely. The same rules apply to credits from passive activities.
• Tax credits. Business tax credits in excess of the general business credit are carried back one year and forward for up to 20 years. Partners and S corporation shareholders who have research credits passed through to them from their businesses have additional limitations that may require carryforwards, and the recordkeeping to claim the credits in future years.

  Depreciation and carryovers are not the only tax items that may run beyond the current tax year. If you are on the cash basis and prepay certain expenses, you may not be allowed a current deduction for your outlays. You may be required to deduct the expenses ratably over the period of time to which they relate. Some examples of commonly prepaid expenses that may have to be deducted ratably include:

  • Insurance premiums. If your insurance premiums cover a period of more than 12 months, you may be required to deduct them over the term covered by the policy.
  • Prepaid interest. If you pay points or other amounts treated as prepaid interest to obtain financing to acquire real estate for your business, you deduct the prepaid interest ratably over the term of the loan. If you dispose of the property or refinance the loan before the end of the term, you can then deduct any unused portion of the prepaid interest in that final year.
  • Rents. If you prepay rents for a period of more than 12 months, you may be required to deduct the rents over the term of the lease.
  • Subscriptions. If you pay for subscriptions running more than 12 months, you generally have to deduct the cost over the term of the subscriptions. For example, if you pay in full the cost of a 3‐year subscription to a business journal, you generally must deduct the cost over the same 3‐year period.

You need to keep a running record of Section 1231 losses—losses on the sale of certain business assets. This is because of a special recapture rule that applies to net ordinary losses from Section 1231 property. A net Section 1231 gain is treated as ordinary income to the extent it does not exceed nonrecaptured net Section 1231 losses taken in prior years. Nonrecaptured losses are the total of net Section 1231 losses for the 5 most recent years that have not yet been applied (recaptured) against any net Section 1231 gains in those same years. In order to determine this recapture, you must retain information on Section 1231 gains and losses. Section 1231 losses are explained in more detail in Chapter 6.

If you own a pass‐through entity that has negative qualified business income (QBI) for the year, you must also keep track of this information (the QBI deduction is explained in Chapter 21). While it does not impact your business income, it affects your QBI deduction going forward. The negative QBI is carried forward and treated as negative QBI from a separate business for purposes of determining the QBI component in the next taxable year (i.e., it is an offset to positive QBI in the next taxable year).

Tax Returns

Keep copies of tax returns to help you prepare future returns, as well as to help you if your return is questioned by the IRS. While you can obtain old returns from the IRS, this entails unnecessary time and expense. Although you may only need information on an old return for 3 additional years (or 6 years if you omit more than 25% of your gross income from your return), it is a good idea to keep old tax returns indefinitely. If the IRS claims you never filed a return, it has an unlimited number of years in which to audit you. But if you have your old return along with proof that you filed it (for example, a certified receipt or an acknowledgment of e‐filing from the IRS), the IRS has only 3 years, in most cases, to start an audit.

Keep a record of the basis of property used in your business for as long as you own the property, plus the statute of limitations on filing the return for the year in which property is sold or otherwise disposed of.

Employer Records

If you have employees, special recordkeeping rules apply. For tax purposes, you are required to keep records on employment taxes for at least 4 years after the due date of the return or after the tax is paid, whichever is later. Keep copies of all returns you have filed and the dates and amount of tax deposits you have made. Your records should also show your employer identification number (EIN). Every business type (sole proprietorship, partnership, and corporation) must have one if wages are paid (see Chapter 26).

You may also need to retain certain employee records for purposes other than taxes. For example, OSHA requires an employer to keep certain employee medical records for at least the duration of employment plus 30 years.

Income Tax Withholding

You must keep records of each employee's name, address, and Social Security number, the amount of each wage payment, the amount of each payment subject to income tax withholding, and the amount of income tax withheld. You must also keep copies of all employees' withholding certificates (Form W‐4).

Other Employment Taxes

Similar records must be kept for each employee for Social Security and Medicare taxes, as well as for federal unemployment taxes (FUTA).

Other Tax Records

Certain documents should be retained indefinitely. These include IRS letters and private rulings you've obtained. For corporations, retain all corporation resolutions related to taxes and other matters. And, of course, retain all accounting records, annual financial statements, and audit reports forever.

How to Dispose of Tax Records

Gone are the days when you could simply toss your old files in the garbage. Today, because of the potential for identity theft affecting both individuals and businesses, proper disposal is essential. For tax records containing Social Security numbers, bank accounts (the business's or employees' accounts if paychecks use direct deposit) or credit card information, be sure to follow federal and state laws regarding disposal. Shredding documents on paper or CDs and DVDs is a good way to prevent unwanted eyes from viewing confidential information. Be sure to wipe tax and other confidential information off computers, tablets, and smartphones being disposed of. Physically destroy thumb drives containing tax records by smashing them or submerging them in water.