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Learn what records Uncle Sam expects you to hold on to, and how this works for or against you.

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October 7, 2021

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Records are important, not only to back up tax deductions but also to qualify for those recent government funding programs or traditional loans. And, of course, records are an invaluable tool when preparing the financial statements so necessary in managing your business.

There’s a lot more to recordkeeping then meets the eye. The so-called “Cohan Rule” allows taxpayers to deduct business expenses even if they do not have the receipts to document them. But both the IRS and the Tax Court can legally reconstruct the expenses and income of any business without records, and it is up to the taxpayer to prove them wrong.

Requirements

A cancelled check and an invoice marked “paid” along with the serial number of the item purchased or a description of the work performed, is standard recordkeeping 101. While this recordkeeping strategy might be viable for big-ticket items, realistically, that’s not often the case for most of a nursery’s expenses, as the IRS well knows. There are many other acceptable ways to account for expenses.

Every business should be able to show that a payment was made (e.g., a cancelled check, credit card receipt) and the nature of the item purchased (an invoice with a description of the item or service). But the business must also show a bona fide business purpose for an expenditure and there must be a proximate relationship between the expenditure and the business. Unfortunately, neither the IRS nor the tax court will allow the use of the Cohan rule when it comes to travel and entertainment expenses – the area where it is usually needed the most.

Safeguarding

Another recordkeeping burden involves keeping your operation’s records safe. Failure to take steps to prevent a breach could prove costly. It could be a loss of customers, lawsuits by customers, suppliers or employees and, in many cases substantial fines. At least one state has passed legislation imposing fines for a breach of a customer’s information.

Exactly what steps should be taken to safeguard the operation’s data depend on a number of factors. Ensure the computers have antivirus and anti-malware in place. Use strong passwords and change them frequently. And make sure there is a firewall.

There are also some commonsense steps that can be taken immediately. Employees should be warned not leave a company laptop in a car or public place unattended. Upon purchasing new computers or systems, consider those with fingerprint or eye scanners. And limit access to information to those employees that really need it. Once they no longer need it — or leave the business — access should be denied.

IRS reconstruction

Any contractor or business owner with nonexistent or inadequate books and records is opening the door to having the IRS reconstruct the operation’s income. In one recent court case, the IRS’s reconstruction of income based on bank deposits was challenged by the taxpayer.

Although the Tax Court did not “see bad faith in the way the IRS conducted this bank-deposits income reconstruction,” if it turned out to have been inaccurate, the fault was with the taxpayer’s failures at recordkeeping. After all, as the court pointed out, the burden of proof was on the taxpayer to show the IRS was wrong, which he couldn’t without records.

Lost records

One of the biggest problems for anyone is reconstructing lost or destroyed records. While every nursery should have a backup of all records and supporting documentation, reconstructing absent records is possible, if difficult.

Every business owner is expected to take steps to reconstruct lost records, which can involve a little effort. Most financial institutions, for instance, keep records for a number of years. Usually, the first 18 months, and sometimes more, is free online.

In addition to requesting bank and credit card statements, invoices from vendors, etc., information and copies of previously filed returns can be obtained from the IRS.

It should be possible to alternatively document 80% of the operation’s expenses fairly easily (though time consuming). The other 20% could be extremely difficult although the IRS and courts will often accept less documentation than they would under other circumstances and may allow a significant portion of the 20%.

Holding period

The common belief that cancelled checks and other documents should be held for three years is wrong. It’s more complicated than that. With taxes, technically, it’s three years from the date the tax return is filed. But, if the IRS suspects income is underreported, they can go back six years. If they believe fraud is present, there is no limit.

For assets such as autos, equipment and other business property, all documentation should be kept for at least three years after the asset is disposed of. Even longer retention periods can apply to employment records. A good general rule of thumb might be to use a seven-year holding period.

The right system

One thing every business needs is accurate recordkeeping. As mentioned, records are a key to many aspects of the operation’s success — from assessing profit margins to ensuring it is in compliance with the tax rules.

Since the IRS does not require a business to keep records in any one manner, as long as the records produce an accurate accounting of income and expenses, a recordkeeping system that works best for the operation will do the trick. Today, there are two ways to keep those records, manual recordkeeping and computerized.

Manually kept records satisfy the tax law as long as they are accurate and can be understood or explained if questioned. That usually means business records are kept in preformatted record books (inexpensive, preformatted record books are readily available) or ledger sheets (also, widely available, ledger sheets are columnar pads of paper usually light green in color).

With both, each expense must be recorded, along with a brief description, the date incurred, the amount and to whom it was paid. On the profit side, similar records should show any income received by the business.

On the plus side, manual record keeping is inexpensive and easy to use. On the other hand, it is usually “single entry” with each transaction entered only once. In other words, there is no automatic check-and-balance system, and it is time consuming with expenses and income being tallied up by category or by month.

The importance of sourcing

Regardless of how the operation’s records are kept, the so-called “source” documents must be retained. There are the receipts, bank statements, purchase invoices and other records that back up the number entered into the recordkeeping system. While there is no requirement to keep receipts for any expense of less than $75, it is necessary to record all information about the expense.

That’s right, keeping electronic records doesn’t relieve a business of its responsibility to retain hardcopy records that are created or received in the ordinary course of business. Hardcopy records may be retained in microfiche or microfilm format. The IRS has also approved scanning to relieve the need to keep original documents.

Financial records

One of the most important records to keep is your operation’s financial records. Many owners concentrate on the required tax records but neglect the financial records because of a lack of time or being unaware to how to do it properly. Many, in fact, attempt to do it themselves figuring they will save money without an expensive professional. Unfortunately, problems can develop down the road as potential lenders as well as many government agencies often impose legal record requirements mandating the business maintain accurate and timely records.

Mark E. Battersby is the financial writer for Snow Magazine, a sister publication. He resides in Ardmore, Pa.