A discussion of the laws relating to business record keeping requirements and a case in point to help you see the value of keeping good records:
Deducting Business Expenses - The "Ordinary and Necessary" Test
The IRS allows businesses to claim tax deductions (reductions in their business taxes) for legitimate business expenses. These expenses are the current operating costs of running your business. To be deductible, the IRS says, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your field of business, trade, or profession. A necessary expense is one that is helpful and appropriate for your business, trade, or profession. An expense does not have to be indispensable to be considered necessary.
Generally, for an expenditure to be an ordinary and necessary business expense you must show a bona fide business purpose for the expenditure; there must be a clear relationship between the expenditure and your business. For example, if you sell bath products, your membership in a travel club would be questioned as bona fide, but your membership in a bath industry trade group would not be questioned.
To be "necessary" , an expense need be "appropriate and helpful" to the taxpayer's business. An expense to fix a leaky roof in your building would be necessary, but an expense to fix the roof in your home would not, unless you had a home office.
The requirement that an expense be "ordinary" connotes that "the transaction which gives rise to it must be of common or frequent occurrence in the type of business involved."
Maintaining Records for Business Expenses
But it's not enough to have deductible expenses; you must also keep good records to be able to show that those deductions are legitimate. In order to be able to deduct business expenses and reduce your business tax bill, the IRS says your business must "maintain records sufficient to substantiate the amounts and purposes of deductions claimed." Here are some more details on this general record keeping requirements:
- Property or use of property that is claimed for a business deduction may have both business and personal uses. This property, called "listed property," includes autos, cell phones, and computers. The documentation is more stringent for claiming deductions for business use of listed property and other property that has a business and a personal component. Although cell phones are no longer (as of 2011) listed property, you still must keep records showing personal use of cell phones.
- In addition to being ordinary and necessary, for records to be accepted by the IRS they must be contemporaneous; that is, they must be made "at or near the time" of the expenditure. For example, business mileage must be recorded as soon as the trip is completed, not days or weeks later.
- Business expense records must include+
- the amount spent
- the place where spent
- the business purpose
- who else was present and their business relationship to the individual
- the amount spent
- The IRS is also strict on the ability of a business to take deductions when records are lost. Unless the failure to produce records is due to loss beyond the control of the owner (by flood or fire, for example), the IRS says, "no deduction shall be allowed." If you don't have a plan to keep records safe in a disaster and a regular backup plan for records, you could lose many deductions.
Penalties for Negligence
In addition to IRS penalties for underpayment of taxes, additional penalties may be imposed for negligence. The IRS says, "The failures to keep adequate books and records or to substantiate items properly may constitute negligence."
A Case in Point
A handyman who formed an LLC was audited by the IRS, who disallowed many deductions because of poor record keeping. The Tax Court found in most cases for the IRS. Here are some details of this case, so you can see how poor records resulted in lost deductions:
- Casual labor.The owner kept first names of sub-contractors on planners, but no indication of amounts paid, hours worked, jobs (some work was done for owner's church, not for business)
- Meals and entertainment. Owner noted amounts paid on weekly planner, but did not include other required information as listed above.
- Car and truck expenses. Since a car or truck is likely to be used for both personal and business travel, detailed contemporaneous records must be kept to show percentages of use. Entries on weekly planners were not contemporaneous.
- Legal and Professional Fees The owner provided almost no records to back up payments. Copies of invoices from professionals should be tied to copies of checks.