Establishing an Accounting System for Your Business
If you’re thinking about starting a business or are already in the thick of running one, make sure you keep a proper accounting of your income and expenses. If you don’t, you’ll have a lot more stress and headaches at tax time.
Besides helping you over the annual tax-filing hurdle and fulfilling quarterly requirements, accurate records allow you to track your company’s financial health and performance during the year. How are your profits running compared with last year? Can you afford to hire new employees? Analyzing your monthly or quarterly business financial statements (profit and loss statement, balance sheet, and so on) can help you answer these important questions.
Here’s another reason to keep good records: The IRS may audit you, and if that happens, you’ll be asked to substantiate particular items on your return. Small business owners who file IRS Form 1040 Schedule C, “Profit or Loss From Business,” with their tax returns are audited at a much higher rate than other taxpayers. Although that dubious honor may seem like an unfair burden to business owners, the IRS targets small businesses because more than a few small business owners break the tax rules, and many areas exist where small business owners can mess up.
If your small business is audited, well-prepared and organized financial records will help. Auditors are so used to “shoebox” accounting that being organized in and of itself helps establish you in the auditor’s eyes as a responsible business person.
The following sections cover the key tax-organizing things that small business owners need to keep in mind and get right.
Separating business from personal finances
One of the IRS’s biggest concerns is that, as a small business owner, you’ll try to minimize your company’s profits (and therefore taxes) by hiding business income and inflating business expenses. Uncle Sam thus looks suspiciously at business owners who use personal checking and personal credit card accounts for company transactions. You may be tempted to use your personal accounts this way because opening separate accounts is a hassle — not because you’re dishonest.
Take the time to open separate accounts (such as bank accounts and credit card accounts) for your business and your personal use. Doing so not only makes the tax authorities happy but also makes your accounting easier. And don’t make the mistake of thinking that paying for an expense through your business account proves to the IRS that it was a legitimate business expense. If the IRS finds that the expense was truly for personal purposes, it will likely dig deeper into your company’s financial records to see what other shenanigans are going on.
Documenting expenses and income in the event of an audit
It doesn’t matter whether you use file folders, software, or a good old-fashioned shoebox to collate receipts and other important financial information. What does matter is that you keep complete and accurate records of both expenses and income.
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Expenses: You’ll probably lose or misplace some of those little pieces of paper that you need to document your expenses. Thus, one advantage of charging expenses on a credit card or paying by check is that these transactions leave a trail, which makes it easier to total your expenses come tax time and prove your expenses if you’re audited.
Just be careful when you use a credit card because you may buy more things than you can really afford. Then you’re stuck with a lot of debt to pay off. Only charge on a credit card what you can pay off in full by the time your statement payment due date rolls around.
On the other hand (as many small business owners know), finding lenders when you need money is difficult. Signing up for a low-interest-rate credit card can be an easy and quick way for you to borrow money without groveling to bankers for a loan.
- Income: Likewise, leave a trail with your revenue. Depositing all your checks in one account helps you when tax time comes or if you’re ever audited. Be sure to use a dedicated account for your business; don’t be tempted to deposit business income into a personal account.
The later section “Keeping Good Tax Records for Your Small Business” provides full details on the process of stashing the right items.
Keeping current on income and payroll taxes
When you’re self-employed, you’re responsible for the accurate and timely filing of all your income taxes. Without an employer and a payroll department to handle the paperwork for withholding taxes on a regular schedule, you need to make estimated tax payments on a quarterly basis, or pay a fine.
If you have employees, you need to withhold taxes from each paycheck they receive, and you must make timely payments to the IRS and the appropriate state authorities. In addition to federal and state income taxes, you must withhold and send in Social Security and any other state or locally mandated payroll taxes, and you need to issue W-2s annually for each employee and 1099-MISCs for each independent contractor paid $600 or more. Got a headache yet?
For paying taxes on your own self-employment income, you can obtain Form 1040-ES, “Estimated Tax for Individuals.” This form comes complete with an estimated tax worksheet and four payment coupons to send in with your quarterly tax payments. It’s amazing how user-friendly government people can be when they want your money! The form itself has some quirks and challenges, but you’ll be happy to know that Book 1, Chapter 5 explains how to deal with them.
To discover all the amazing rules and regulations of withholding and submitting taxes from employees’ paychecks, ask the IRS for Form 941, “Employer’s Quarterly Federal Tax Return.” Once a year, you also need to complete Form 940, “Employer’s Annual Federal Unemployment (FUTA) Tax Return,” for unemployment insurance payments to the Feds.
If your business has a part-time or seasonal employee and the additional burden of filing Form 941 quarterly, the IRS has made the paperwork a tad easier. You may be able to file Form 944, “Employer’s Annual Federal Tax Return,” if your tax withholding on behalf of employees doesn’t exceed $1,000 for the year (which translates to about $4,000 in wages). If you qualify, you need to file only once each year. To see whether you qualify, call the IRS at 800-829-0115 or visit its website at www.irs.gov. If you do qualify, the IRS will send you something in writing.
Also check to see whether your state has its own annual or quarterly unemployment insurance reporting requirements. Look for your state’s Department of Labor or use the links on the U.S. Department of Labor website at www.dol.gov/whd/contacts/state_of.htm. And, unless you’re lucky enough to live in one of those rare states with no state income taxes, don’t forget to get your state’s estimated income tax package.
Falling behind in paying taxes ruins some small businesses. When you hire employees, for example, you’re particularly vulnerable to tax land mines. If you aren’t going to keep current on taxes for yourself and your employees, hire a payroll company or tax adviser who can help you jump through the necessary tax hoops. Payroll companies and tax advisers are there for a reason, so use them selectively. They take care of all the tax filings for you, and if they mess up, they pay the penalties. Check with a tax adviser you trust for the names of reputable payroll companies in your area. Generally, using a payroll service for form preparation and tax deposits is money well spent. The cost is much less than the potential penalties (and time) if you prepare them yourself.
Reducing your taxes by legally shifting income and expenses
Many small business owners elect to keep their business accounting on what’s called a cash basis. This choice doesn’t imply that all business customers literally pay in cash for goods and services or that the company owners pay for all expenses with cash. Cash-basis accounting simply means that, for tax purposes, you recognize and report income in the year you received it and expenses in the year you paid them.
By operating on a cash basis, you can exert more control over the amount of profit (revenue minus expenses) that your business reports for tax purposes from year to year. If your income fluctuates from year to year, you can lower your tax burden by doing some legal shifting of income and expenses.
Suppose that you recently started a business. And assume that you have little, but growing, revenue and somewhat high start-up expenses. Looking ahead to the next tax year, you can already tell that you’ll be making more money and will likely be in a much higher tax bracket. Thus, you can likely reduce your tax bill by paying more of your expenses in the next year. Of course, you don’t want to upset any of your company’s suppliers. But you can pay some of your bills after the start of the next tax year (January 1) rather than in late December of the preceding year (presuming that your business’s tax year is on a regular January 1st through December 31st calendar-year basis). Note: Credit card expenses are recognized as of the date you charge them, not when you pay the bill.
Likewise, you can exert some control over when your customers pay you. If you expect to make less money next year, don’t invoice customers in December of this year. Wait until January so you receive more of your income next year.
Be careful with this revenue-shifting game. You don’t want to run short of cash and miss a payroll! Similarly, if a customer mails you a check in December, IRS laws don’t allow you to hold the check until January and count the revenue then. For tax purposes, you’re supposed to recognize the payment as revenue when you receive it.
Note: One final point about who can and who can’t do this revenue and expense two-step. Sole proprietorships, partnerships (including limited liability companies, also known as LLCs), S corporations, and personal-service corporations generally can shift revenue and expenses. On the other hand, C corporations and partnerships that have C corporations as partners may not use the cash-accounting method if they have annual receipts of more than $5 million per year.
Keeping Good Tax Records for Your Small Business
Tax records pose a problem for many people because the IRS doesn’t require any particular form of record keeping. In fact, the IRS recommends, in general terms, that you keep records only to file a “complete and accurate” return. This section explores what records you should keep, where you should maintain them, and for how long.
Ensuring a complete and accurate tax return
In case you don’t feel like flipping through countless pages of government instructions on what constitutes a “complete and accurate” return, here are some common tax situations at a glance and the types of records normally required:
- Business expenses: The IRS is especially watchful in this area, so be sure to keep detailed proof of any expenses that you claim. This proof can consist of many items, such as receipts of income, expense account statements, and so on. Keep in mind that the IRS doesn’t always accept canceled checks as the only method of substantiation, so make sure you hang on to the bill or receipt for every expense you incur.
- Car expenses: If, for the business use of your car, you choose to deduct the actual expenses rather than the standard mileage rate (which is 53.5 cents per mile for tax year 2017), you need to show the cost of the car and when you started using it for business. You also must record your business miles, your total miles, and your expenses, such as insurance, gas, and maintenance. You need a combination of a log and written receipts, of course! Stationery and office supply stores carry inexpensive logbooks that you can buy for your vehicle usage and expense tracking. You can also find smartphone apps to serve the same purpose.
- Home expenses: If you own your home, you need to keep records of your mortgage and real estate tax payments, the purchase price and purchase expenses, and the cost of all the improvements and additions you make over time (save your receipts). Although you may not be selling your house this year, when you do, you’ll be thankful you have all your receipts in a neat little file. If you rent a portion of your house or run a business from it, you also need your utility bills, general repair bills, and housecleaning and lawn-mowing costs to calculate your net rental income or your home office expense.
Setting up a record-keeping system
The tax year is a long time for keeping track of records that you need (and where you put them) when the filing season arrives. So here are some easy things you can do to make your tax-preparation burden a little lighter:
- Use an accordion file. You can buy one with slots already labeled by month, by category, or by letters of the alphabet, or you can make your own filing system with the extra labels. All this can be yours for less than $15.
- Set up a manila file folder system. Decide on the organizational method that best fits your needs, and get into the habit of saving all bills, receipts, and records that you think you may use someday for tax purposes or for things that affect your overall financial planning. This basic advice is good for any taxpayer, whether you file a simple tax return or a complicated one with far more supplemental schedules. Note that this plan, which should set you back about $5, is only minimal, but it’s much better than the shoebox approach to record keeping. (A scanning program for documents may also be of interest here.)
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Track tax information on your computer. A number of financial software packages enable you to keep track of your spending for tax purposes. Just don’t expect to reap the benefits without a fair amount of upfront and continuing work. You need to figure out how to use the software, and you must enter a great deal of data for the software to be useful to you. Don’t forget, though, that you still need your receipts to back up your claims; in an audit, the IRS may not accept your computer records without verifying them against your receipts.
If you’re interested in software, consider a business-oriented program, such as QuickBooks, for your small-business accounting. For really simple businesses, consider Quicken. You can merge data into QuickBooks at a later date if you desire. Whichever software you choose, keep in mind that the package tabulates only what you enter or download into it. So if you use the software to write your monthly checks but neglect to enter data for things you pay for with cash, for example, you won’t have the whole picture.
Deciding when to stash and when to trash
One of the most frequently asked questions is how long a taxpayer needs to keep tax records. The answer is easy — a minimum of three years. That’s because the statute of limitations for tax audits and assessments is three years. If the IRS doesn’t adjust or audit your 2017 tax return by April 15, 2021 (the three years start running on April 15, 2018), it missed its chance. (If you filed after April 15 because you obtained an extension, you must wait until three years after the extension due date rather than the April 15 tax date. The same is true when you file late — the three-year period doesn’t start until you actually file your return.)
Save all records for the assets that you continue to own. These records can include stocks and bonds, automobiles, your home (along with its improvements), and expensive personal property, such as jewelry, video cameras, or computers. Keep these records in a safe-deposit box in case you suffer a (deductible casualty) loss, such as a fire. You don’t want these records going up in smoke!
Some taxpayers take the practical step of videotaping their home and its contents, but if you do, make sure that you keep that record outside your home. You can save money on safe-deposit box fees by leaving your video with relatives who may enjoy watching it because they don’t see you often enough. (Of course, your relatives may also suffer a fire or an earthquake.)
In situations where the IRS suspects that income wasn’t reported, IRS agents can go back as far as six years. And if possible tax fraud is involved, forget all time restraints!
Watching out for state differences
Although the IRS requires that you keep your records for only three years, your state may have a longer statute of limitations with regard to state income tax audits. If you’re curious what your state’s rules are, check with your state’s income tax collecting authority. Also, some of your tax-related records may be important to keep for other reasons. For example, suppose that you throw out your receipts after three years. Then the fellow who built your garage four years ago sues you, asserting that you didn’t fully pay the bill. You may be out of luck in court if you don’t have the canceled check showing that you paid.
The moral: Hang on to records that may be important (such as home improvement receipts) for longer than three years — especially if a dispute is possible. Check with a legal advisor whenever you have a concern because statutes of limitations vary from state to state.
Replacing lost business records
If your business records have been lost or destroyed, you can often obtain duplicate bills from major vendors. You shouldn’t have a great deal of trouble getting copies of the original telephone, utility, rent, credit card, oil company, and other bills. Reconstructing a typical month of automobile use can help you make a reasonable determination of the business use of your car. If that month’s use approximates an average month’s business use of an auto, the IRS usually accepts such reconstructed records as adequate substantiation.
If you deposited all your business income in a checking or savings account, you can reconstruct that income from duplicate bank statements. Although banks usually don’t charge for copies of bank statements, they do charge for copies of canceled checks if you can’t obtain them online. These charges can be quite expensive, so do some legwork before ordering copies of all your checks. For example, obtain a copy of your lease and a statement from your landlord saying that all rent was paid on time before you request duplicate copies of rent checks.
By ordering copies of past returns with Form 4506, “Request for Copy of Transcript of Tax Form,” you can have a point of reference for determining whether you accounted for typical business expenses. Past returns reveal not only gross profit percentages or margins of profit but also the amounts of recurring expenses.
Developing and maintaining a business accounting system