Series 2: Here is our Second Message in a series designed to help you handle the basics of sound business record keeping. Our prior message addressed Checking Accounts .
You may hate the ‘records keeping’ part of the tax system, but it’s critical to your tax health. It’s also important the health of your business. Good records help you monitor and improve your business. Do not depend on the IRS for mercy when it comes to your tax records. You will never find the word “mercy” in the same sentence with the IRS. It does not exist in the code or the regulations. I have yet to meet a “merciful” IRS agent. Where there is no mercy, you have no choice but to play defense and keep your records correctly.
Here we will address logs and receipts.
To deduct your vehicle expenses, you need proof of business use. This is true regardless of the form your business takes.
Thus, if you operate as a corporation, you (the employee) must submit proof of your business use to the corporation. We recommend that you keep your vehicle mileage in your appointment book so it reflects your business activities for each day. Check out our Auto Mileage Form on the Resources Page. Further, the appointment-book recordings facilitate use of a sampling method, such as the three-month log of business miles to prove business use for the year.
If you own rental properties, you should track for at least three consecutive months the time spent on the rentals, to prove material participation and, if applicable, real estate professional status.
If you claim a deduction for an office in the home, you should track time spent working in the home office. Your use of the home office must meet the “regular use” test. If you use your home office a little more than 10 hours a week on a consistent basis, you meet the requirements for regular use as set out in the Green Case.
Record Required Elements of Travel and Entertainment
Regardless of business form, you need to prove, for each day of travel, where you were and why you were there. For entertainment, you need to record:
- why, and
- how much.
You can meet all these requirements by adding a short note to the receipt with the name of the person you entertained, and why you entertained this person.
The “why” should relate to the immediate or future business benefit you hope to achieve with the entertainment. Try to keep the “why” explanation to seven words or less. We made up this seven-word guideline and have used it successfully for the past 15 years because it makes for a clear explanation of the entertainment activity. Further, you have additional corroborative evidence in your files and e-mails.
The receipt contains the remaining documentation for:
- what (e.g., food, drinks, golf);
- when (date);
- where (name and address of the place); and
- how much.
If you operate as a corporation, you need to turn the documentation in to the corporation, and the corporation needs to either pay for the entertainment and travel expenses directly (say, with a corporate credit card) or reimburse you for the amounts spent. Make certain the corporation pays. You do not want to claim deductions for these expenses as employee business expenses.
For all expenses, from the purchase of your desk to pens for your office, keep these two points in mind:
- You need to prove what you bought; and
- You need to prove that you paid for what you bought.
Step 1: What you bought. Generally, the receipt or invoice will prove both the description of what you bought and how this purchase relates to your business. With entertainment at a restaurant, the receipt that proves what you bought is the receipt that shows the details of what you had to eat and drink.
Step 2: What you paid. Tax law considers the charge to a credit card as payment, regardless of when the card gets paid. Thus, you can prove payment by credit card with either the credit card receipt that shows the total charge or the credit card statement. The canceled check proves payment by check. The bank statement proves payment by electronic transfer.
As a general rule, don’t pay in cash. These are the first questions an auditor will ask about a cash payment:
- Where did the cash come from?
- How good is the trail of cash to the payment?
- Was an ATM withdrawal evident before the cash payment?
- Did the taxpayer really spend the cash or just make up this deduction?
You face no such questions for payments by check or credit card.
For most small businesses, a petty cash system is a disaster and we discourage our clients from using one. If you have such as system and it works well for you, be pleased to know that you are the exception rather than the rule. We strongly recommend using the reimbursement method to all of our clients in Pittsburgh and nationwide.
Under the reimbursement method, if you or an employee spends money on behalf of the business, you simply have the business write a check to reimburse the expense based on documentary evidence such as a receipt for the expenditure, and an expense report for the auto mileage, if applicable. The reimbursement method is direct, clear, and less subject to mistakes than the petty cash system.
Next time, we’ll discuss How Long to Keep Records.