One of the key differences in the life of a business owner versus that of an employed person is that the business owner must keep financial records. Lots of financial records, all categorized, correct and up to date.
There are many important reasons for keeping these detailed records of your business' financial transactions. For one thing, this data keeps you, as the owner, constantly on top of how your business is doing financially. You'll be able to make business steering corrections in time to head off crashes.
Another important reason for keeping detailed financial records is that they are required as proof of what you claim on your tax returns! With good records, you can take tax deductions that will leave more money in your pocket. That reward makes recordkeeping well worth the effort.
Contents of this Recordkeeping section: |
- Why?
Because no documentation = no deductions!
If you don't keep records, you won't have the data to document business expenses and other business deductions -- those deductions that you subtract from your gross income to arrive at a lower taxable income so you can legitimately pay less tax.
Not having the records to support legitimate business-related deductions means you'll either pay way too much in taxes all the time -- or, if you're ever audited -- your attempted deductions may be disqualified and you'll face back taxes AND penalties.
It's tough enough to pay each year's taxes, plus next year's estimated tax as you go along. But having to also add payments for prior years' taxes plus penalties for underpayments makes life and business seriously difficult.
You want to avoid ever getting yourself in that situation. It kills your sense of humor and strains your family relationships and friendships, in addition to your bank accounts.
So -- although it IS a hassle -- keeping records is definitely something every business owner needs to do.
The good news is that once you get set up with a system to collect the data and get in the habit of doing it (and, better yet, getting some help with it), it just becomes a habit and you almost forget it's a hassle. Once you get used to it, it doesn't phase you anymore and you're ready -- even eager -- to familiarize yourself with more levels of financial tracking detail.
You start to see that by doing this, you may qualify for more opportunities to legally reduce your business and personal tax total -- that becomes a powerful incentive.
- What?
In general, you want to have some kind of legible, official-looking record to backup each business income or expense transaction. You assign each to whatever business category is most fitting. Then you add up the totals per category.
More Specifically What?
These totals by category are what eventually get entered into various blanks on your business tax forms.
More specifically, there are typically about 40 different expense categories most businesses should at least consider to see if these potential deductions apply to your own business situation. Some categories -- especially the ones where your business will have tiny totals -- might be able to be combined. But before you do so, check with your tax professional to be sure your combinations will fly with the IRS.
Here's an alphabetical list of potential expense categories from an accountant's tax organizer for small business clients:
- Accounting
- Advertising
- Answering service
- Bad debts from sales or service
- Bank charges
- Car and truck expenses
- Commissions
- Contract labor
- Delivery and freight
- Dues and subscriptions
- Employee benefit programs
- Insurance
- Mortgage interest (on business property)
- Other Interest
- Janitorial
- Legal and professional
- Office Expense
- Outside Services
- Parking and tolls
- Pension and profit sharing plans - contributions
- Pension and profit sharing plans - admin costs
- Postage
- Printing
- Rent - machinery, vehicles, equipment
- Rent - space
- Repairs
- Security
- Supplies
- Taxes - real estate
- Taxes - payroll
- Taxes - other
- Telephone
- Tools
- Travel
- Meals and entertainment
- Uniforms
- Utilities
- Wages
- Other expenses
- Cost of goods sold
- Inventory at beginning of year
- Purchases
- Cost of labor
- Materials and supplies
- Assets acquired -- such as computers, equipment, companies your business acquires and other assets.
You'll probably also want to categorize income, so you'll know much comes in from which revenue streams or which types of products or services you sell. What would be the income divisions you'd like to track?
Documentation the IRS expects to support deductions
What do you need to deduct auto expenses?
The auto expense deduction can sometimes be a gold mine of tax savings ... BUT only if you track and substantiate your claims strictly per IRS protocol.
IRS official words about documentation
The IRS has several helpful publications which explain the specific details of various typical business deduction categories and what they expect to see for each.
You'll find all of the publications we talk about here at the IRS website . To get them in PDF format, select the search drop down option for "Forms & Publications", enter the form number and click "GO". The HTML version is available by searching for the publication number in the "Entire Site" option.
We've found the best IRS info on documentation in these pubs:
- Publication 583, Starting a Business and Keeping Records
If you are preparing to launch your company, start with this pub first. It's the friendliest, but packed with vital info and real-life examples.
- Publication 535, Business Expenses
The bible for what you can and can't deduct for business.
- Publication 463, Travel, Entertainment, Gift & Car Expenses
These types of deductions are often disallowed in audits because people tend to overstate them and have little evidence to back them up. All it takes is making notes in your daily planner about where you traveled, total business miles involved and who you entertained where -- plus what was the business reason behind each expense.
- Publication 587, Business Use of Your Home
There has been a lot of confusion about home office expense deductions; this publication expresses the IRS position and gives examples.
- How?
How to keep your business records is a truly deep subject. Not like deep = profound, but instead, like deep = a deep pile of info!
Fortunately, this topic has become vastly simplified in recent years due to software that saves normal people -- like us -- from ever having to comprehend double-entry accounting! Double-entry accounting is laden with thorny mathematical mysteries and logic-defying nomenclature that makes sense only to trained accountants and bookkeepers.
Double-entry accounting is the basic system of bookkeeping. Each transaction is entered in two places. The two entries mathematically balance each other. If certain sums aren't equal, it shows there's an error somewhere that has to be found and fixed.
Small business accounting software now takes care of all that for us in the background, so transparently that we normal mortals don't have to worry about it. We see and use a friendly front end that's so clear, it's a no-brainer (almost, anyway).
It's said that Scott Cook, the founder of Intuit, the company that makes Quicken® and QuickBooks® software programs, was the first to have the concept that regular people should be spared from having to learn double-entry accounting just in order to do their bookkeeping. So hats off to Scott!
Simplify and automate
As business owners, all we are trying to do is be sure that we and our business keep adequate records to substantiate where the business' money comes from and goes to. The simpler and more automatic we can make this process, the better -- we have other important things to do with our time -- things like marketing, making sales, satisfying customers and sleeping.
Business accounting
Today, don't even think about doing your books in a hand-written ledger or creating a custom spreadsheet to track your accounting transactions.
And did you ever hear of the old shoebox method of business accounting? A technique used in the dark ages before inexpensive accounting software was developed. Throughout each year many small business owners stuffed all their receipts in a shoebox. Then, shortly before the annual tax deadline, they'd empty the shoebox on their living room floors and sort the receipts into stacks -- one stack for rent, another for utilities, etc. Then, to get totals for their tax forms, they'd add up each stack's receipts on their adding machine, or maybe even by hand -- gasp! Banish the shoebox method from your mind -- this is the 21st Century!
Business accounting software
Just get an accounting software program for small business and set it up on your computer. (Or, if you have a bunch of employees entering transactions, get a license for multiple computers.) Now many formerly laborious tasks can be accomplished in little time.
These programs come in options with different levels of features. But they should all print your checks, categorize transactions, automatically deal with recurring transactions, create your financial statements, set up budgets and do tons of other things, some specific to your industry or location, such as tracking billable hours or working at Point of Sale (POS). Unfortunately they can not yet pour you a fresh latte while they're updating your balance sheet, paying your vendors and reconciling your bank account, but they're probably working on adding that feature.
How it works
Business accounting software gives you a friendly, familiar looking front end on your computer screen to work with. For example, typically when you or an assistant writes a check, the input window looks like a real check, and when you view your bank transaction list, it looks like your check register.
Selecting which accounting software to purchase
If you are already working with an accountant and are ready to set up new books or switch brands, ask your tax pro what they recommend. Ideally you'd use a program their office is adequately familiar with and that their other clients haven't reported nasty problems with.
If your tax pro's office suggests a brand they themselves use that is so specialized that they would have to the inputting for you, ask them to suggest something else. You want to use a commonly available brand that is user-friendly enough that any reasonably intelligent person -- such as you -- can use without special training.
There are many brands and programs out there, but for the typical small company we recommend these as the industry leaders in their platforms:
QuickBooks® for PCs
QuickBooks has become the de facto standard for small business accounting software for the PC. The big enchilada, so prevalent that other options are hardly seen or heard. So, if your small business uses the PC platform, get QuickBooks.
Your CPA's office probably does not use QuickBooks themselves -- they use sophisticated software specialized for accountants -- but they are familiar with it since so many of their clients use it. If you encounter a QuickBooks mystery you can't solve, they may be able to help you or refer you to help .
Your local Small Business Development Center (SBDC) may offer classes in using QuickBooks if you don't want to tackle it totally seat-of-the-pants.
It would be good to ask your tax pro which version of QuickBooks your company should select. QuickBooks offers specific versions for specific industries and other specific needs, but your accountant may prefer you choose a more generic version with less behind-the-scenes stuff built-in, so you could more easily tailor it yourself.
If you think your company is too big for QuickBooks
If your company is large or has more specialized or sophisticated needs than you see available in QuickBooks Pro or Premier, there are certainly many options. First examine QuickBooks' Enterprise Solutions, which are currently available for these industries: contracting, manufacturing, nonprofit, professional services, retail and wholesale. Ask your CPA if one of these would be a good fit for your company or if you should develop a Request for Proposal to send to other vendors who offer large-scale solutions.
Whatever you do, try hard to find existing software that offers modules to fit your special needs. Today there is so much proven accounting software available that you shouldn't need to even contemplate having a programmer custom-develop something for you from scratch. When you go the custom route, you are forever dependent on the programmer. If he or she becomes unavailable or their software company undergoes changes, your company may find it almost impossible -- or at least very time-consuming and expensive -- to add new features or get a glitch fixed.
MYOB Account Edge® for Apple® Macintosh
Intuit, the maker of QuickBooks ignored the Mac platform for many years, then they finally came out with a Mac update in 2004. But it appears they lost too much ground in the interim. In our testing, QuickBooks' Mac product had serious flaws: it corrupted our test files beyond repair and their tech support had no solution.
So Mac users, if you really want to use QuickBooks, we strongly recommend you step over to a PC to do so. Although you hate that thought, here is an advantage to it -- your accountant can take a copy of your PC file as-is and add accountant's journal entries to it, then return it to you updated.
If you want to do your business accounting on your Mac, the dominant, popular program is MYOB (Mind Your Own Business). It is as easy and friendly as you expect of Mac programs. However, be warned that your CPA will not be familiar with it, but she should be able to find her way around since MYOB will provide her office a free PC-version so she can add her accountant's notes to your file.
Setting up your software for the first time
Your software program will walk you step by step through the setup process for your company. But here are some general tips and things you need to have on hand and decisions you need to have made when you set this up.
- Beginning bank accounts balances to enter
What are all the bank accounts that the business has and what will be the opening balance you'll enter for each+
- Accounting method -- cash or accrual
In the cash method, a transaction is dated when money is actually paid or received. In the cash method, transactions are dated when the commitment to pay or be paid is made, although money won't change hands immediately. Check with your accountant to confirm which method your company should go with.
- What categories will be in your chart of accounts
This is just your list of different types of transactions you want to track, plus your different asset accounts, such as bank accounts, plus others.
Tips about accounting software
Whenever you issue checks, stick consistently with the same method. Either enter all your checks in accounts payable first, or never use accounts payable. Switching methods invites problems that you don't want to spend time dealing with.
Save backups off your hard drive often
Your accounting program automatically saves each entry as you make it, but it is super important for you to frequently save a current backup copy of your file OFF your computer and in a different location. You don't want to put it off just this time and be sorry when your hard drive suddenly goes looney and mysteriously loses all your accounting data.
Make changes early in your year
If you are going to start or change systems or set up a new company, try to do so at the beginning of your business year so you can avoid the hassle of duplicate bookkeeping. Most likely your business year will be in sync with the calendar year, starting with January 1.
There used to be more reasons for companies to choose a different start date for their year, but now most small firms can stick with the simplicity of January through December as their business year. Your accountant will advise you on this. If you have no reason to choose otherwise, go with the calendar year.
Maintain your accounting records
The frequency and number of transactions -- money coming in and money going out -- determines how often your company's accounting file needs to be updated and by what method.
Companies who have orders coming in every hour, such as from online sales, will want to get new data in as close to real time as possible, perhaps via automatic online entry.
But many small businesses that don't have a huge quantity of transactions going in or coming out will do just fine with bi-weekly updating. It would be nice to be able to say once a month is adequate, but with the different timing of bills, plus the importance of keeping on top of your cash flow situation, updating just once monthly could court danger.
Paper Receipts
The IRS still expects paper receipts as evidence to prove deductions. So it's important to get in the ongoing habit of saving receipts, invoices, planner notes and mileage diaries -- and filing them systematically. You want to be sure you'll have (and be able to find) the documentation that might be asked for some day, even years in the future.
Every year, more and more records and transactions of all sorts that used to be done on paper are now handled electronically. But at this point, the IRS rules for documentation have not officially changed to say we can forget about saving all those paper receipts.
To be on the safe side, continue saving paper records as you have been. But ask your accountant to be sure to let you know if the requirements for paper documentation change and how the new rules then play out in the first tested situations.
Meanwhile, for those online transactions that you never received or issued paper on, it's probably a good idea to print out and file the PDF's or email that described what money changed hands and why.
Or, if you don't want to print out all that and keep the paper, be SURE to keep all your electronic receipts together, organized in logical directories that will still make sense to you in seven years. Keep them easy to find on a permanent removable backup disc. Don't just keep this on your computer -- copy it onto a CD, DVD, ZIP or other device that you can keep permanently in a safe place -- preferably in another building away from your office. If a disaster strikes one location, your backup stored elsewhere is still safe.
- Who?
Who handles your recordkeeping responsibilities? Needless to say, there's no one answer to this question. Different sizes and types of companies need different technical solutions and staff or freelance help to get their recordkeeping done as simply as possible without undeserving their needs. Here we won't suggest, review or list all types of solutions to consider, but we will offer a few tips to consider as you make choices for your firm.
For soloists and small companies
Many solo business owners, such as consultants, may have infrequent sales, but each one brings in a hefty chunk of money. Plus, the smaller the business, the fewer expense payments need to be made. These owners are probably of the breed that went into business for themselves to be free of excessive red tape and prefer to keep things simple.
Do it yourself
Owners who keep their businesses small could actually fire up their accounting software a couple of times a month and deal with doing the updating and filing themselves.
Farm it in
Or -- as we recommend -- have a virtual assistant, freelance office assistant or bookkeeper come in for a few hours every two weeks or so to organize and process what needs to be paid, what has been paid, then print out checks, record deposits, reconcile bank accounts and file paper records.
If you want to delegate this function, it will be more helpful to have someone come IN to do the work in your office, instead of your having to gather the stuff and take it OUTSIDE so your provider can do it at her office. (If you have to gather the stuff together, drop it off, pick it up, then file everything, you've made the work convenient for someone else. Instead, the point should be that someone else handles it for YOUR convenience.)
Getting someone else to do this on a consistent basis frees your mind from getting embroiled in little details so you can keep your focus on income-producing work or enjoying more free time. Plus, this solution overcomes the procrastination that most of us feel coming on whenever we start to think about how we really need to get around to that pile of bookkeeping.
How does it get done?
OK, you've got your accounting software ready so each transaction can be input and categorized. And you've determined who will handle the task. Now, exactly what must be done?
Get an in-box
A crucial tool is probably one of the most basic, unsophisticated pieces of equipment in your office -- the in-box! You need an in-box that can be exclusively used for financial stuff.
Whenever you receive a new bill, new payment, new deposit receipt, new bank statement, or any new piece of finance-related info, just drop it in the financial in-box.
Then, whenever you, your virtual assistant, your staffer -- whoever you determined will be your record keeper -- steps over to deal with the financial stuff, the first thing you do is sort out the in-box contents into piles. A pile for new bills, a pile for deposits, and so forth so that each item can be dealt with as a group with like items.
Your diligent record keeper works through the piles systematically. Each completed or to-be-done transaction gets recorded into your accounting software program, categorized by type and action taken. Most everything will be either an income item or expense item of some type. You select the appropriate categories via dropdown menus.
Then you ask the software to print your deposit slips, your checks, the reconciliation of your bank statement -- whatever paper you need for further action or filing. Now you just sign the checks and mail whatever needs mailing.
In the process of inputting each transaction, your company financial statements were automatically updated, so you can look at any of them via the software to see where you stand. How's your Profit & Loss (P&L) picture looking this month? How does that compare to where you were this time last year? How close are you running to the budget you projected? How much total cash does your Balance Sheet show the company has on hand right now?
Ask the software any question about your business' current financial situation you can think of -- it can probably show you the answer in an instant.
How do you wrap it up at year end for your taxes?
Unlike the old 'shoebox method of accounting, since you've kept your data up to date throughout the year with your accounting software, there's no big year-end hassle. You've already got all your answers! You can set up an early meeting with your accountant. His office will be able to finish your returns before their annual March/April frazzle period sets in.
Take a careful look through the expanded version of your Profit and Loss Statement that your software offers. It will show the detailed list of each transaction, so you can be sure everything is in what you feel is the right category. Then review your categorization with your accountant to see if he or she thinks you should classify anything differently.
Your recordkeeping is done! And since your filing of papers was dealt with each time after the accounting data was updated, you've got the paper documentation in place. Go celebrate!
- How long?
From IRS Publication 583, here's a clear and handy list of how long you must keep records.
| If you... |
Then the period is... |
| Owe additional tax and situations (2), (3), and (4), below, do not apply to you |
3 years |
| Do not report income that you should report and it is more than 25% of the gross income shown on the return |
6 years |
| File a fraudulent return |
Not limited |
| Do not file a return |
Not limited |
| File a claim for credit or refund after you filed your return |
Later of 3 years or 2 years after tax was paid |
| File a claim for a loss from worthless securities or a bad debt deduction |
7 years |
The easy way
Now you don't want to be bothered with re-sorting your saved records every year -- you have other things to do. So here's a way to make it easier...
As you can see, seven years is the max time length listed for any category of receipt. (Except for tax evasion -- so if you are planning to be dishonest, you'd better rent a giant storage locker since you'll need to save all records forever!)
So why not just forget about the three-year and six-year categories -- just group them with the seven-year saves. Now after the end of each year, as soon as you figure you have all the bank statements, receipts and what-not from the prior year, pull out last year's accounting receipts from your file drawers. Or better yet, have your record keeper do it for you.
Leave the material you need to keep at hand, like information about your phone plans, credit card agreements, contracts, etc. Also keep software and equipment registrations and warranties, but attach a copy of your purchase receipt. We keep annual receipts in separate folders from evergreen info so we don't have to sift through each file folder at year end to confirm what gets pulled and what stays.
Box up what you need to save compactly
On the outside of this package, write CAN BE TOSSED 01/01/yyyy! Here you put the first of the year seven years hence. For example, if you are saving records from 2004, you write in 01/01/2011, which is 7 full years after the end of 2004.
Now file that away in your storeroom or attic -- wherever you keep what you don't need to get at often. As you put that away, you look for the package from seven years ago -- the one that has this year's date on it. You shred it! Or burn it! It will feel cathartic to have that seven-year-old baggage officially out of your life!
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