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 how long you should keep your records.
How Long to Keep Records
The statutes of limitations tell you the time period during which the IRS can audit your returns. If your returns are examined, you need tax records that prove your deductions. This means you need to keep your records for longer than you might think.
Assets such as your car, desk, computer, and office building are relevant to your tax return during their depreciable class lives. If you are depreciating the assets, the depreciation shows up in those returns. If you used Section 179 to expense the assets, then you have potential recapture during the depreciable class life.
Example You buy a $1,500 desk and depreciate it over the seven-year MACRS life (this takes eight years). In year eight, you still have to prove the depreciation. That means you need the original purchase record in year eight. You also need the purchase record in year eleven to meet the three-year statute of limitations on this year eight deduction. If you used Section 179 expensing on this desk, your records requirement is identical to the example. You have recapture exposure during the eight years, and you need to hold onto your proof of purchase for three years beyond that, or 11 years in total.
Make this easy. For any asset that has a life of more than one year, keep the purchase records in a permanent file. With a separate permanent file of asset purchases, you don’t have to think or worry about class lives or limitation periods.
The five-drawer method
To use the five-drawer method, you need to keep your permanent files in another place (such as a different set of file drawers). Next, you must report your income and file and pay your taxes on time or with extensions, to limit your audit exposure to three years from the date you filed your return. If you fit this profile, the five-drawer system can simplify your records retention. It works like this:
Drawer 1: Accumulation of current year tax return information
Drawer 2: Last year (tax return filed this year, say on April 15)
Drawer 3: Two years ago
Drawer 4: Three years ago
Drawer 5: Four years ago
At the beginning of each year, the contents of drawer 5 go to the dump and all drawers move down one notch.
If you have employees, you must keep all employment tax records for at least four years after the date the tax becomes due or is paid, whichever is later. Again, simplify. If you have employees, use a six-drawer method. Toss the sixth drawer when your four-year statute expires.
Next time, we’ll talk about accounting software and payroll.