Maintaining good financial records is an important part of running a successful business. Not only will good records help you identify strengths and weaknesses in your business’ operations, but they will also help out tremendously if the IRS comes knocking on your door.
The IRS requires that business owners keep adequate books and records and that they be available when needed for the administration of any provision of the Internal Revenue Code (i.e., an audit). Here are some basic guidelines:
Copies of tax returns. You must keep records that support each item of income or deduction on a business return until the statute of limitations for that return expires. In general, the statute of limitations is three years after the date on which the return was filed. Because the IRS may go back as far as six years to audit a tax return when a substantial understatement of income is suspected, it may be prudent to keep records for at least six years. In cases of suspected tax fraud or if a return is never filed, the statute of limitations never expires.
Employment taxes. Chances are that if you have employees, you’ve accumulated a great deal of paperwork over the years. The IRS isn’t looking to give you a break either: you are required to keep all employment tax records for at least 4 years after the date the tax becomes due or is paid, whichever is later. These records include payroll tax returns and employee time documentation.
Business assets. Records relating to business assets should be kept until the statute of limitations expires for the year in which you dispose of the asset in a taxable disposition. Original acquisition documentation, (e.g. receipts, escrow statements) should be kept to compute any depreciation, amortization, or depletion deduction, and to later determine your cost basis for computing gain or loss when you sell or otherwise dispose of the asset. If your business has leased property that qualifies as a capital lease, you should retain the underlying lease agreement in case the IRS ever questions the nature of the lease.
For property received in a nontaxable exchange, additional documentation must be kept. With this type of transaction, your cost basis in the new property is the same as the cost basis of the property you disposed of, increased by the money you paid. You must keep the records on the old property, as well as on the new property, until the statute of limitations expires for the year in which you dispose of the new property in a taxable disposition.
Inventories. If your business maintains inventory, your recordkeeping requirements are even more arduous. The use of special inventory valuation methods (e.g. LIFO and UNICAP) may prolong the record retention period. For example, if you use the last-in, first-out (LIFO) method of accounting for inventory, you will need to maintain the records necessary to substantiate all costs since the first year you used LIFO.
Specific Computerized Systems Requirements
If your company has modified, or is considering modifying its computer, recordkeeping and/or imaging systems, it is essential that you take the IRS’s recently updated recordkeeping requirements into consideration.
If you use a computerized system, you must be able to produce sufficient legible records to support and verify amounts shown on your business tax return and determine your correct tax liability. To meet this qualification, the machine-sensible records must reconcile with your books and business tax return. These records must provide enough detail to identify the underlying source documents. You must also keep all machine-sensible records and a complete description of the computerized portion of your recordkeeping system.
Some additional advice: when your records are no longer needed for tax purposes, think twice before discarding them; they may still be needed for other nontax purposes. Besides the wealth of information good records provide for business planning purposes, insurance companies and/or creditors may have different record retention requirements than the IRS.