What sets a stress-free business owner apart from a stressed-out one during tax time? Records.
Some may think that records are nothing more than pieces of papers, but when it comes to business taxes, records are everything.
Records are more than just papers. Especially in business, these records are so important because they save you from troubles at the end of the year. Even more so, they save you heaps when it comes to business taxes.
You must know that as a business owner, the IRS allows you to claim tax deductions for whatever legitimate expenses you may have had throughout the year. These tax deductions refer to reductions in your business taxes, and the expenses refer to your business’ current operating costs.
Based on the IRS rule, your legitimate business expenses must both be ordinary and necessary to be deductible. But how will you know if your expenses are ordinary and necessary?
- Ordinary Expense. If an expense is common and accepted in your trade or field of business, then it is considered an ordinary expense. As per the IRS rule, an expense can only be considered as ordinary if “the transaction which gives rise to it is of common or frequent occurrence in the type of business involved.”
- Necessary Expense. If an expense is appropriate for your profession or trade, then it is necessary. Remember that your expense does not necessarily have to be indispensable to be necessary, as per the IRS. For example, you had to spend some money to fix a broken window in your business office. That is considered a necessary expense. However, if you spend money to fix a broken window in your home, that is not a necessary expense.
When tax time comes, remember that you have to be able to prove these two things so that the IRS can honor your expenditures as necessary and ordinary:
- That your purpose for the expense is the bona fide business.
- That there is a clear and established relationship between your expense and your profession or business.
It is not enough that there is a business purpose behind your expense. You should be able to show that your money was spent on something that was related to your business. For instance, you are a dealer of cosmetic products. The IRS will certainly not question your membership in a cosmetic industry trade group, but it might question your membership in a travel club since it has nothing to do with your trade.
Keeping Records for Your Business Expenses
While it is good to know that you can have such deductible expenses, remember that you cannot avail of the privilege if you fail to keep good records. Just as how important it is for you to have deductible expenses, you must be able to prove that your expenses are legitimate enough to be considered deductible.
If you want to reduce your business tax bill and deduct your business expenses, you must be organized and meticulous enough to keep each and every record that can document your expenses. The IRS rule states that “business must maintain records sufficient to substantiate the amounts and purposes of deductions claimed.”
But just how do you particularly substantiate your expenses? Which specific details must you be able to present to the IRS to prove that your business expenses are legitimate?
Well, the details that you need to keep records of largely depend on the type of expense. When it comes to business, the rules of IRS on business tax deductions are divided into four categories– travel, entertainment, transportation, and gifts.
How to Prove Your Business Expenses
If you think recordkeeping is just about keeping receipts, then you might want to think again. When it comes to tax deductions, receipts are good proofs but the law does not consider them sufficient. Depending on the type of business expense that you want to be deductible, you should be able to provide the right and complete details to substantiate your claim for deductions.
Take a look at the following business expenses and the details that you need to keep records of under each type of expense, as per the IRS.
- Travel Expenses
- The cost of each separate expense for travel, lodging, and meals
- Other incidental expenses that may be totaled in reasonable categories, including (but not limited to) taxi fares, fees, and tips
- The dates when you left for the trip and returned from the trip, as well as the number of days spent solely on business
- The destination or area of your travel. Here, you should be able to provide the specific name of the city or town where you traveled.
- The particular business purpose for the expense, or the benefit gained from the business travel
- The cost of each separate expense for entertainment
- Other incidental expenses that may be totaled on a daily basis, such as taxi fares, telephone charges, etc.
- The date of entertainment
- The specific name and address or location of the place of entertainment. If the place of entertainment does not make apparent the type of entertainment, you also need to indicate the type of entertainment
- The particular business purpose for the expense, or the benefit gained from the entertainment
- The nature of the business activity or discussion. If the entertainment happened directly before or after a business discussion, you need to indicate the following:
- The date, place, nature, and duration of the business discussion, and
- The identities of the individuals who took part in both the business discussion and the entertainment activity
- Information about the recipients or participants in the entertainment activity and their relationship to you. Are they your employees? Clients? Business associates? Information about them may include their names, designations, or titles.
- It is also important to note that if the entertainment was a business meal, you should be able to prove that you or your employee was present during that particular entertainment activity.
- The cost of the gift
- The date when the gift was given
- A description of the gift
- The cost of each separate expense. If you used a car for transportation, you should be able to include additional details for your car expenses. These details include the cost of the car and any improvements applied to it, the date you started using it for business purposes, the mileage for every business use, and the total miles for the entire year.
- The date of the expense. For car expenses, the date when the car was used.
- Your business destination
- The business purpose for the expense
Now that you know the details that you need for each type of business expense, the next question you may have is where to keep such details. Usually, people think of receipts when the subject is recordkeeping when in fact, receipts are just one of the many records you can keep to back up your deductible expenses.
When is your evidence/proof adequate?
In IRS law, there is such a thing as adequate evidence. The law honors diaries, statements of expenses, logs, account books, trip sheets and other similar records as pieces of adequate documentary evidence. Documentary evidence cannot be considered adequate if it lacks the previously mentioned elements, such as the amount, place, date and all the other essential character of the expense. However, there are certain cases when the need for adequate evidence does not apply.
- When other than lodging, your expense is less than $75.
- When you have a transportation expense but there is no receipt readily available for it
- When you have lodging or meals while traveling away from home and you account the expense to your employer under an accountable plan, and you are provided a per diem that covers your meals and allowance
In preparing your documentary evidence, you should be able to take note of the following:
- No need to duplicate information. If your receipt already bears all the important information to prove the legitimacy of the expense, then you do not need to record the same information in your account book or other record books. You won’t have any problem with your records as long as your receipts and records complement each other in an organized manner.
- Keep timely records. To make your records more valuable, record the elements of your business expense near the time of the expense and support it with documentary evidence. Records have greater value when they are prepared at the time of the expense than later when there is a tendency for you to not accurately recall the expenses anymore.
- Prove your business expense. When it comes to proving the business purpose behind the expense, the degree of proof depends on the case. In the event that the purpose of your expense is not clear given the surrounding circumstances, then you have to make a written explanation that clearly states your purpose.
- No need to disclose confidential information. In providing documentary evidence for your business expenses, you do not necessarily have to disclose confidential information relating to your deductible expenses in your diary or account book. Just make sure that you record the information elsewhere, either at the time of the expense or near the time of the expense.
What if You Have Incomplete Records?
If your records aren’t complete to prove your expense, then you must be able to prove the element of your expense through the following:
- A written or oral statement you personally made. This statement should contain all the specific details about the element.
- Other supporting evidence sufficient.
What if Your Records have Been Destroyed?
There are instances when records get destroyed for reasons that are beyond your control, like fire, flood and other phenomena. In such cases, you cannot possibly produce a receipt. However, since the IRS implements strict policies when it comes to presenting records to prove the legitimacy of business expenses, you need to reconstruct your records or expenses.
Separating and Combining Expenses
In recordkeeping, there are cases when you need to separate your expenses or combine your expenses.
- Separating expenses. Generally, each separate payment must be considered a separate expense. An example would be an entertainment expense for a client you treated to a dinner and then a theatrical show. In that case, the cost of the theater passes and the dinner expense must be taken as two separate expenses and must, therefore, be recorded separately.
- Combining expenses. In your record, you can make just one entry for reasonable categories such as telephone calls, taxi fares, and other incidental travel costs, but your meals should be in a separate category. Tips for services related to the meal can be combined with the meal expense.
How Long Should You Keep Your Records?
There is no specific timeframe indicated in the law when you should keep your records. However, if you think that your receipts and records might be needed to administer any of the provisions of the Internal Revenue Code, it is best to keep them for as long as possible. Usually, it is safe to keep your records for a span of 3 years from the time you file your income tax return on which you claimed your deductions.
How about the Records Provided by your Employees for Reimbursement?
For records reimbursed for expenses, the rule is different. Once the employees have already handed the records and documentation to their employers and have already been reimbursed, there is generally no need for them to keep copies of the records. Just to be sure, however, it is sometimes better to keep such records because there are instances when employees need to prove their expenses, such as in the following conditions:
- If you claim deductions for expenses that exceed your reimbursements.
- If your expenses are reimbursed under a non-accountable plan.
- If your employer does not utilize sufficient accounting procedures to verify the expense accounts.
- If you are related to your employer as per the Per Diem and Car Allowances section of IRS Publication 463, chapter 6.
Generally, recordkeeping is not as laborious as it sounds. It’s simply all about giving the IRS what they want so you can save yourself from all the troubles that may arise in the future. You may not know when you will need your records again, so just to be on the safe side, keep them indefinitely. They don’t take up much space in your room anyway.