IRS Releases Publication 583 (1/2015), Starting a Business and Keeping Records

Introduction

Introduction

This publication provides basic federal tax information for people who are starting a business. It also provides information on keeping records and illustrates a recordkeeping system.

Throughout this publication we refer to other IRS publications and forms where you will find more information. In addition, you may want to contact other government agencies, such as the Small Business Administration (SBA). See How To Get Tax Help, later.

Future Developments

For the latest information about developments related to Publication 583, such as legislation enacted after it was published, go to http://www.irs.gov/pub583.

Comments and Suggestions

We welcome your comments about this publication and your suggestions for future editions.

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What New Business Owners Need To Know

As a new business owner, you need to know your federal tax responsibilities. Table 1 can help you learn what those responsibilities are. Ask yourself each question listed in the table, then see the related discussion to find the answer.

Table 1. What New Business Owners Need To Know About Federal Taxes

 (Note: This table is intended to help you, as a new business owner,

Determining Which Type of Business to Use

The most common forms of business are the sole proprietorship, partnership, and corporation. When beginning a business, you must decide which form of business to use. Legal and tax considerations enter into this decision. Only tax considerations are discussed in this publication.

TIP: Your form of business determines which income tax return form you have to file. See Table 2 to find out which form you have to file.

Sole proprietorships. A sole proprietorship is an unincorporated business that is owned by one individual. It is the simplest form of business organization to start and maintain. The business has no existence apart from you, the owner. Its liabilities are your personal liabilities. You undertake the risks of the business for all assets owned, whether or not used in the business. You include the income and expenses of the business on your personal tax return.

More information. For more information on sole proprietorships, see Publication 334, Tax Guide for Small Business. If you are a farmer, see Publication 225, Farmer's Tax Guide.

Partnerships. A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor, or skill, and expects to share in the profits and losses of the business.

A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it "passes through" any profits or losses to its partners. Each partner includes his or her share of the partnership's items on his or her tax return.

More information. For more information on partnerships, see Publication 541, Partnerships.

Business owned and operated by spouses. If you and your spouse jointly own and operate an unincorporated business and share in the profits and losses, you are partners in a partnership, whether or not you have a formal partnership agreement. Do not use Schedule C or C-EZ. Instead, file Form 1065, U.S. Return of Partnership Income. For more information, see Publication 541, Partnerships.

Exception--Community Income. If you and your spouse wholly own an unincorporated business as community property under the community property laws of a state, foreign country, or U.S. possession, you can treat the business either as a sole proprietorship or a partnership. The only states with community property laws are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.

Exception--Qualified joint venture. If you and your spouse each materially participate as the only members of a jointly owned and operated business, and you file a joint return for the tax year, you can make a joint election to be treated as a qualified joint venture instead of a partnership for the tax year. Making this election will allow you to avoid the complexity of Form 1065 but still give each spouse credit for social security earnings on which retirement benefits are based. For an explanation of "material participation," see the Instructions for Schedule C, line G.

To make this election, you must divide all items of income, gain, loss, deduction, and credit attributable to the business between you and your spouse in accordance with your respective interests in the venture. Each of you must file a separate Schedule C or C-EZ and a separate Schedule SE. For more information, see Qualified Joint Venture in the Instructions for Schedule SE.

Corporations. In forming a corporation, prospective shareholders exchange money, property, or both, for the corporation's capital stock. A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income. A corporation can also take special deductions.

C corporations. The profit of a C corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. However, shareholders cannot deduct any loss of the corporation. For more information on corporations, see Publication 542, Corporations.

S corporations. An eligible domestic corporation (or a domestic entity eligible to elect to be treated as a corporation) can avoid double taxation (once to the corporation and again to the shareholders) as long as it meets certain tests and elects to be treated as an S corporation. Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income. On their tax returns, the S corporation's shareholders include their share of the corporation's separately stated items of income, deduction, loss, and credit, and their share of nonseparately stated income or loss. For more information on S corporations and the tests that need to be met to be eligible to elect to be an S corporation, see the instructions for Form 2553, Election by a Small Business Corporation, and Form 1120S, U.S. Income Tax Return for an S Corporation.

Limited liability company. A limited liability company (LLC) is an entity formed under state law by filing articles of organization as an LLC. The members of an LLC are not personally liable for its debts. An LLC may be classified for federal income tax purposes as either a partnership, a corporation, or an entity disregarded as separate from its owner by applying the rules in Regulations section 301.7701-3.

More information. For more information on LLCs, see the instructions for Form 8832, Entity Classification Election.

Getting a Taxpayer Identification Number

You must have a taxpayer identification number so the IRS can process your returns. Two of the most common kinds of taxpayer identification numbers are the social security number (SSN) and the employer identification number (EIN).

Employer Identification Number (EIN)

EINs are assigned to sole proprietors, LLCs, corporations, and partnerships for tax filing and reporting purposes. See Form SS-4 and its instructions for more information and to see which businesses must get an EIN.

Applying for an EIN. You may apply for an EIN:

If you do not receive your EIN by the time a return is due, file your return anyway. Write "Applied for" and the date you applied for the number in the space for the EIN. Do not use your social security number as a substitute for an EIN on your tax returns.

More than one EIN. You should have only one EIN. If you have more than one EIN and are not sure which to use, contact the Internal Revenue Service Center where you file your return. Give the numbers you have, the name and address to which each was assigned, and the address of your main place of business. The IRS will tell you which number to use.

More information. For more information about EINs, see Publication 1635, Understanding Your EIN.

Payee's Identification Number

In the operation of a business, you will probably make certain payments you must report on information returns (discussed later under Information Returns). The forms used to report these payments must include the payee's identification number.

Employee. If you have employees, you must get an SSN from each of them. Record the name and SSN of each employee exactly as they are shown on the employee's social security card. If the employee's name is not correct as shown on the card, the employee should request a new card from the SSA. This may occur, for example, if the employee's name has changed due to marriage or divorce.

If your employee does not have an SSN, he or she should file Form SS-5, Application for a Social Security Card, with the SSA. This form is available at SSA offices or by calling 1-800-772-1213. It is also available from the SSA website at http://www.ssa.gov.

Other payee. If you make payments to someone who is not your employee and you must report the payments on an information return, get that person's SSN. If you make reportable payments to an organization, such as a corporation or partnership, you must get its EIN.

To get the payee's SSN or EIN, use Form W-9, Request for Taxpayer Identification Number and Certification. This form is available from IRS offices or by calling 1-800-829-3676. It is also available from the IRS website at IRS.gov.

CAUTION: If the payee does not provide you with an identification number, you may have to withhold part of the payments as backup withholding. For information on backup withholding, see the Form W-9 instructions and the General Instructions for Certain Information Returns.

Designating a Tax Year

You must figure your taxable income and file an income tax return based on an annual accounting period called a tax year. A tax year is usually 12 consecutive months. There are two kinds of tax years.

You must use a calendar tax year if:

First-time filer. If you have never filed an income tax return for your business, you can adopt either a calendar tax year or a fiscal tax year. Although, some partnerships and S corporations must use a particular tax year. See Publication 538 for more information. You adopt a tax year by filing your first income tax return using that tax year. You have not adopted a tax year if all you did was one or more of the following.

Choosing an Accounting Method

An accounting method is a set of rules used to determine when and how income and expenses are reported. You choose an accounting method for your business when you file your first income tax return. There are two basic accounting methods.

If an inventory is necessary to account for your income, you must generally use an accrual method of accounting for purchases and sales. Inventories include goods held for sale in the normal course of business. They also include raw materials and supplies that will physically become a part of merchandise intended for sale. Inventories are explained in Publication 538.

TIP: Certain small business taxpayers can use the cash method of accounting and can also account for inventoriable items as materials and supplies that are not incidental. For more information, see Publication 538.

You must use the same accounting method to figure your taxable income and to keep your books. Also, you must use an accounting method that clearly shows your income. In general, any accounting method that consistently uses accounting principles suitable for your trade or business clearly shows income. An accounting method clearly shows income only if it treats all items of gross income and expense the same from year to year.

More than one business. When you own more than one business, you can use a different accounting method for each business if the method you use for each clearly shows your income. You must keep a complete and separate set of books and records for each business.

Changing your method of accounting. Once you have set up your accounting method, you must generally get IRS approval before you can change to another method. A change in accounting method not only includes a change in your overall system of accounting, but also a change in the treatment of any material item. For examples of changes that require approval and information on how to get approval for the change, see Publication 538.

Business Taxes

The form of business you operate determines what taxes you must pay and how you pay them. The following are the four general kinds of business taxes.

Table 2. Which Forms Must I File?

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Income Tax

All businesses except partnerships must file an annual income tax return. Partnerships file an information return. Which form you use depends on how your business is organized. See Table 2 to find out which return you have to file.

The federal income tax is a pay-as-you-go tax. You must pay the tax as you earn or receive income during the year. An employee usually has income tax withheld from his or her pay. If you do not pay your tax through withholding, or do not pay enough tax that way, you might have to pay estimated tax. If you are not required to make estimated tax payments, you may pay any tax due when you file your return.

Reminder. If your business is an LLC, how you elected to have the LLC treated for tax purposes (either as a corporation, partnership, or as part of the LLC owner's tax return) will determine what taxes you must pay and what forms you should use to pay your taxes.

Estimated tax. Generally, you must pay taxes on income, including self-employment tax (discussed next), by making regular payments of estimated tax during the year.

Sole proprietors, partners, and S corporation shareholders. You generally have to make estimated tax payments if you expect to owe tax of $1,000 or more when you file your return. Use Form 1040-ES, Estimated Tax for Individuals, to figure and pay your estimated tax. For more information, see Publication 505, Tax Withholding and Estimated Tax.

Corporations. You generally have to make estimated tax payments for your corporation if you expect it to owe tax of $500 or more when you file its return. Use Form 1120-W, Estimated Tax for Corporations, to figure the estimated tax. You must deposit the payments as explained later under Depositing Taxes. For more information, see Publication 542.

Self-Employment Tax

Self-employment tax (SE tax) is a social security and Medicare tax primarily for individuals who work for themselves. Your payments of SE tax contribute to your coverage under the social security system. Social security coverage provides you with retirement benefits, disability benefits, survivor benefits, and hospital insurance (Medicare) benefits.

You must pay SE tax and file Schedule SE (Form 1040) if either of the following applies.

TIP: You can deduct a portion of your SE tax as an adjustment to income on your Form 1040.

The Social Security Administration (SSA) time limit for posting self-employment income. Generally, the SSA will give you credit only for self-employment income reported on a tax return filed within 3 years, 3 months, and 15 days after the tax year you earned the income. If you file your tax return or report a change in your self-employment income after this time limit, the SSA may change its records, but only to remove or reduce the amount. The SSA will not change its records to increase your self-employment income.

Employment Taxes

This section briefly discusses the employment taxes you must pay, the forms you must file to report them, and other forms that must be filed when you have employees.

Employment taxes include the following.

If you are not sure whether the people working for you are your employees, see Publication 15-A, Employer's Supplemental Tax Guide. That publication has information to help you determine whether an individual is an employee or an independent contractor. If you wrongly classify an employee as an independent contractor, you can be held liable for employment taxes for that worker plus a penalty. An independent contractor is someone who is self-employed. Generally, you do not have to withhold or pay any taxes on payments to an independent contractor.

Federal Income, Social Security, and Medicare Taxes

You generally must withhold federal income tax from your employee's wages. To figure how much federal income tax to withhold from each wage payment, use the employee's Form W-4 (discussed later under Hiring Employees) and the methods described in Publication 15.

Social security and Medicare taxes pay for benefits that workers and their families receive under the Federal Insurance Contributions Act (FICA). Social security tax pays for benefits under the old-age, survivors, and disability insurance part of FICA. Medicare tax pays for benefits under the hospital insurance part of FICA. You withhold part of these taxes from your employee's wages and you pay a part yourself. To find out how much social security and Medicare tax to withhold and to pay, see Publication 15.

Which form do I file? Report these taxes on Form 941, Employer's QUARTERLY Federal Tax Return, or Form 944, Employer's ANNUAL Federal Tax Return. (Farm employers use Form 943, Employer's Annual Federal Tax Return for Agricultural Employees.)

Federal Unemployment (FUTA) Tax

The federal unemployment tax is part of the federal and state program under the Federal Unemployment Tax Act (FUTA) that pays unemployment compensation to workers who lose their jobs. You report and pay FUTA tax separately from social security and Medicare taxes and withheld income tax. You pay FUTA tax only from your own funds. Employees do not pay this tax or have it withheld from their pay.

Which form do I file? Report federal unemployment tax on Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return. See Publication 15 to find out if you can use this form.

Hiring Employees

Have the employees you hire fill out Form I-9 and Form W-4.

Form I-9. You must verify that each new employee is legally eligible to work in the United States. Both you and the employee must complete the U.S. Citizenship and Immigration Services (USCIS) Form I-9, Employment Eligibility Verification. You can get the form from USCIS offices or from the USCIS website at http://www.uscis.gov. Call the USCIS at 1-800-375-5283 for more information about your responsibilities.

Form W-4. Each employee must fill out Form W-4, Employee's Withholding Allowance Certificate. You will use the filing status and withholding allowances shown on this form to figure the amount of income tax to withhold from your employee's wages. For more information, see Publication 15.

Employees claiming more than 10 withholding allowances. An employer of an employee who claims more than 10 withholding allowances for wages paid can use several methods of withholding. See section 16 of Publication 15.

Form W-2 Wage Reporting

After the calendar year is over, you must furnish copies of Form W-2, Wage and Tax Statement, to each employee to whom you paid wages during the year. You must also send copies to the Social Security Administration. See Information Returns, later, for more information on Form W-2.

Excise Taxes

This section describes the excise taxes you may have to pay and the forms you have to file if you do any of the following.

Form 720. The federal excise taxes reported on Form 720, Quarterly Federal Excise Tax Return, consist of several broad categories of taxes, including the following.

Form 730. If you are in the business of accepting wagers or conducting a wagering pool or lottery, you may be liable for the federal excise tax on wagering. Use Form 730, Monthly Tax Return for Wagers, to figure the tax on the wagers you receive.

Form 11-C. Use Form 11-C, Occupational Tax and Registration Return for Wagering, to register for any wagering activity and to pay the federal occupational tax on wagering.

Depositing Taxes

You generally have to deposit employment taxes, certain excise taxes, corporate income tax, and S corporation taxes before you file your return.

Generally, taxpayers are required to deposit taxes through the Electronic Federal Tax Payment System (EFTPS).

Any business that has a federal tax obligation and requests a new EIN will automatically be enrolled in EFTPS. Through the mail, the business will receive an EFTPS PIN package that contains instructions for activating its EFTPS enrollment.

Information Returns

If you make or receive payments in your business, you may have to report them to the IRS on information returns. The IRS compares the payments shown on the information returns with each person's income tax return to see if the payments were included in income. You must give a copy of each information return you are required to file to the recipient or payer. In addition to the forms described below, you may have to use other returns to report certain kinds of payments or transactions. For more details on information returns and when you have to file them, see the General Instructions for Certain Information Returns.

Form 1099-MISC. Use Form 1099-MISC, Miscellaneous Income, to report certain payments you make in your trade or business. These payments include the following items.

Form W-2. You must file Form W-2, Wage and Tax Statement, to report payments to your employees, such as wages, tips, and other compensation, withheld income, social security, and Medicare taxes. For more information on what to report on Form W-2, see the Instructions for Forms W-2 and W-3.

Form 8300. You must file Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business, if you receive more than $10,000 in cash in one transaction or two or more related business transactions. Cash includes U.S. and foreign coin and currency. It also includes certain monetary instruments such as cashier's and traveler's checks and money orders. For more information, see Publication 1544, Reporting Cash Payments of Over $10,000 (Received in a Trade or Business).

Penalties

The law provides penalties for not filing returns or paying taxes as required. Criminal penalties may be imposed for willful failure to file, tax evasion, or making a false statement.

Failure to file tax returns. If you do not file your tax return by the due date, you may have to pay a penalty. The penalty is based on the tax not paid by the due date. See your tax return instructions for more information about this penalty.

Failure to pay tax. If you do not pay your taxes by the due date, you will have to pay a penalty for each month, or part of a month, that your taxes are not paid. For more information, see your tax return instructions.

Failure to withhold, deposit, or pay taxes. If you do not withhold income, social security, or Medicare taxes from employees, or if you withhold taxes but do not deposit them or pay them to the IRS, you may be subject to a penalty of the unpaid tax, plus interest. You may also be subject to penalties if you deposit the taxes late. For more information, see Publication 15.

Failure to follow information reporting requirements. The following penalties apply if you are required to file information returns. For more information, see the General Instructions for Certain Information Returns.

In addition, there is no penalty for failure to include all the required information, or for including incorrect information, on a de minimis number of information returns if you correct the errors by August 1 of the year the returns are due. (To be considered de minimis, the number of returns cannot exceed the greater of 10 or 1/2 of 1% of the total number of returns you are required to file for the year.)

Failure to supply taxpayer identification number. If you do not include your taxpayer identification number (SSN or EIN) or the taxpayer identification number of another person where required on a return, statement, or other document, you may be subject to a penalty of $50 for each failure. You may also be subject to the $50 penalty if you do not give your taxpayer identification number to another person when it is required on a return, statement, or other document.

Deducting Business Expenses

You can deduct business expenses on your business or personal income tax return, depending on the form of your business. These are the current operating costs of running your business. To be deductible, 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.

The following are brief explanations of some expenses that are of interest to people starting a business. There are many other expenses that you may be able to deduct. See your form instructions and Publication 535, Business Expenses.

Business Start-Up Costs

Business start-up costs are the expenses you incur before you actually begin business operations. Your business start-up costs will depend on the type of business you are starting. They may include costs for advertising, travel, surveys, and training. These costs are generally capital expenses.

You usually recover costs for a particular asset (such as machinery or office equipment) through depreciation (discussed next). You can elect to deduct up to $5,000 of business start-up costs and $5,000 of organizational costs paid or incurred after October 22, 2004. The $5,000 deduction is reduced by the amount your total start-up or organizational costs exceed $50,000. Any remaining cost must be amortized.

For more information about amortizing start-up and organizational costs, see chapter 7 in Publication 535.

Depreciation

If property you acquire to use in your business has a useful life that extends substantially beyond the year it is placed in service, you generally cannot deduct the entire cost as a business expense in the year you acquire it. You must spread the cost over more than one tax year and deduct part of it each year. This method of deducting the cost of business property is called depreciation.

Business property you must depreciate includes the following items.

TIP: Depreciation must be taken in the year it is allowable. Allowable depreciation not taken in a prior year cannot be taken in the current year. If you do not deduct the correct depreciation, you may be able to make a correction by filing Form 1040X, Amended U.S. Individual Income Tax Return, or by changing your accounting method. For more information on how to correct depreciation deductions, see chapter 1 in Publication 946.

Business Use of Your Home

To deduct expenses related to the business use of part of your home, you must meet specific requirements. Even then, your deduction may be limited. You may be able to use the simplified method to figure your expenses for business use of your home. For more information, see Schedule C (Form 1040) and its instructions.

To qualify to claim expenses for business use of your home, you must meet both the following tests.

You do not meet the requirements of the exclusive use test if you use the area in question both for business and for personal purposes.

Exceptions to exclusive use. You do not have to meet the exclusive use test if either of the following applies.

Principal place of business. Your home office will qualify as your principal place of business for deducting expenses for its use if you meet the following requirements.

Which form do I file? If you file Schedule C (Form 1040), use Form 8829, Expenses for Business Use of Your Home, to figure your deduction. If you file Schedule F (Form 1040) or you are a partner, you can use the worksheet in Publication 587.

More information. For more information about business use of your home, see Publication 587.

Car and Truck Expenses

If you use your car or truck in your business, you can deduct the costs of operating and maintaining it. You generally can deduct either your actual expenses or the standard mileage rate.

Actual expenses. If you deduct actual expenses, you can deduct the cost of the following items:

 Depreciation   Lease payments   Registration

Example. You are the sole proprietor of a flower shop. You drove your van 20,000 miles during the year. 16,000 miles were for delivering flowers to customers and 4,000 miles were for personal use. You can claim only 80% (16,000 ÷ 20,000) of the cost of operating your van as a business expense.

Standard mileage rate. Instead of figuring actual expenses, you may be able to use the standard mileage rate to figure the deductible costs of operating your car, van, pickup, or panel truck for business purposes. You can use the standard mileage rate for a vehicle you own or lease. The standard mileage rate is a specified amount of money you can deduct for each business mile you drive. It is announced annually by the IRS. To figure your deduction, multiply your business miles by the standard mileage rate for the year.

CAUTION: Generally, if you use the standard mileage rate, you cannot deduct your actual expenses. However, you may be able to deduct business-related parking fees, tolls, interest on your car loan, and certain state and local taxes.

Choosing the standard mileage rate. If you want to use the standard mileage rate for a car you own, you must choose to use it in the first year the car is available for use in your business. In later years, you can choose to use either the standard mileage rate or actual expenses.

If you use the standard mileage rate for a car you lease, you must choose to use it for the entire lease period (including renewals).

Additional information. For more information about the rules for claiming car and truck expenses, see Recordkeeping

This part explains why you must keep records, what kinds of records you must keep, and how to keep them. It also explains how long you must keep your records for federal tax purposes. A sample recordkeeping system is illustrated at the end of this part.

Why Keep Records?

Everyone in business must keep records. Good records will help you do the following.

Monitor the progress of your business. You need good records to monitor the progress of your business. Records can show whether your business is improving, which items are selling, or what changes you need to make. Good records can increase the likelihood of business success.

Prepare your financial statements. You need good records to prepare accurate financial statements. These include income (profit and loss) statements and balance sheets. These statements can help you in dealing with your bank or creditors and help you manage your business.

Keep track of deductible expenses. You may forget expenses when you prepare your tax return unless you record them when they occur.

Prepare your tax returns. You need good records to prepare your tax returns. These records must support the income, expenses, and credits you report. Generally, these are the same records you use to monitor your business and prepare your financial statements.

Support items reported on tax returns. You must keep your business records available at all times for inspection by the IRS. If the IRS examines any of your tax returns, you may be asked to explain the items reported. A complete set of records will speed up the examination.

Kinds of Records To Keep

Except in a few cases, the law does not require any specific kind of records. You can choose any recordkeeping system suited to your business that clearly shows your income and expenses.

The business you are in affects the type of records you need to keep for federal tax purposes. You should set up your recordkeeping system using an accounting method that clearly shows your income for your tax year. See Choosing an Accounting Method, earlier. If you are in more than one business, you should keep a complete and separate set of records for each business. A corporation should keep minutes of board of directors' meetings.

Your recordkeeping system should include a summary of your business transactions. This summary is ordinarily made in your books (for example, accounting journals and ledgers). Your books must show your gross income, as well as your deductions and credits. For most small businesses, the business checkbook (discussed later) is the main source for entries in the business books. In addition, you must keep supporting documents, explained later.

Electronic records. All requirements that apply to hard copy books and records also apply to electronic storage systems that maintain tax books and records. When you replace hard copy books and records, you must maintain the electronic storage systems for as long as they are material to the administration of tax law. An electronic storage system is any system for preparing or keeping your records either by electronic imaging or by transfer to an electronic storage media. The electronic storage system must index, store, preserve, retrieve, and reproduce the electronically stored books and records in legible format. All electronic storage systems must provide a complete and accurate record of your data that is accessible to the IRS. Electronic storage systems are also subject to the same controls and retention guidelines as those imposed on your original hard copy books and records.

The original hard copy books and records may be destroyed provided that the electronic storage system has been tested to establish that the hard copy books and records are being reproduced in compliance with IRS requirements for an electronic storage system and procedures are established to ensure continued compliance with all applicable rules and regulations. You still have the responsibility of retaining any other books and records that are required to be retained.

The IRS may test your electronic storage system, including the equipment used, indexing methodology, software and retrieval capabilities. This test is not considered an examination and the results must be shared with you. If your electronic storage system meets the requirements mentioned earlier, you will be in compliance. If not, you may be subject to penalties for non-compliance, unless you continue to maintain your original hard copy books and records in a manner that allows you and the IRS to determine your correct tax.

For details on electronic storage system requirements, see Revenue Procedure 97-22, available at http://www.irs.gov/Tax-Exempt-Bonds/Revenue-Procedures.

Supporting Documents

Purchases, sales, payroll, and other transactions you have in your business generate supporting documents. Supporting documents include sales slips, paid bills, invoices, receipts, deposit slips, and canceled checks. These documents contain information you need to record in your books.

It is important to keep these documents because they support the entries in your books and on your tax return. Keep them in an orderly fashion and in a safe place. For instance, organize them by year and type of income or expense.

Gross receipts. Gross receipts are the income you receive from your business. You should keep supporting documents that show the amounts and sources of your gross receipts. Documents that show gross receipts include the following.

Expenses. Expenses are the costs you incur (other than the cost of inventory) to carry on your business. Your supporting documents should show the amount paid and that the amount was for a business expense. Documents for expenses include the following.

Travel, transportation, entertainment, and gift expenses. Specific recordkeeping rules apply to these expenses. For more information, see Publication 15.

Assets. Assets are the property, such as machinery and furniture you own and use in your business. You must keep records to verify certain information about your business assets. You need records to figure the annual depreciation and the gain or loss when you sell the assets. Your records should show the following information.

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Recording Business Transactions

A good recordkeeping system includes a summary of your business transactions. (Your business transactions are shown on the supporting documents just discussed.) Business transactions are ordinarily summarized in books called journals and ledgers. You can buy them at your local stationery or office supply store.

A journal is a book where you record each business transaction shown on your supporting documents. You may have to keep separate journals for transactions that occur frequently.

A ledger is a book that contains the totals from all of your journals. It is organized into different accounts.

Whether you keep journals and ledgers and how you keep them depends on the type of business you are in. For example, a recordkeeping system for a small business might include the following items.

TIP: The system you use to record business transactions will be more effective if you follow good recordkeeping practices. For example, record expenses when they occur, and identify the source of recorded receipts. Generally, it is best to record transactions on a daily basis.

Business checkbook. One of the first things you should do when you start a business is open a business checking account. You should keep your business account separate from your personal checking account.

The business checkbook is your basic source of information for recording your business expenses. You should deposit all daily receipts in your business checking account. You should check your account for errors by reconciling it. See Reconciling the checking account, later.

Consider using a checkbook that allows enough space to identify the source of deposits as business income, personal funds, or loans. You should also note on the deposit slip the source of the deposit and keep copies of all slips.

You should make all payments by check to document business expenses. Write checks payable to yourself only when making withdrawals from your business for personal use. Avoid writing checks payable to cash. If you must write a check for cash to pay a business expense, include the receipt for the cash payment in your records. If you cannot get a receipt for a cash payment, you should make an adequate explanation in your records at the time of payment.

TIP: Use the business account for business purposes only. Indicate the source of deposits and the type of expense in the checkbook.

Reconciling the checking account. When you receive your bank statement, make sure the statement, your checkbook, and your books agree. The statement balance may not agree with the balance in your checkbook and books if the statement:

Before you reconcile your monthly bank statement, check your own figures. Begin with the balance shown in your checkbook at the end of the previous month. To this balance, add the total cash deposited during the month and subtract the total cash disbursements.

After checking your figures, the result should agree with your checkbook balance at the end of the month. If the result does not agree, you may have made an error in recording a check or deposit. You can find the error by doing the following.

When your checkbook balance agrees with the balance figured from the journal entries, you may begin reconciling your checkbook with the bank statement. Many banks print a reconciliation worksheet on the back of the statement.

To reconcile your account, follow these steps.

Bookkeeping System

You must decide whether to use a single-entry or a double-entry bookkeeping system. The single-entry system of bookkeeping is the simplest to maintain, but it may not be suitable for everyone. You may find the double-entry system better because it has built-in checks and balances to assure accuracy and control.

Single-entry. A single-entry system is based on the income statement (profit or loss statement). It can be a simple and practical system if you are starting a small business. The system records the flow of income and expenses through the use of:

In the double-entry system, each account has a left side for debits and a right side for credits. It is self-balancing because you record every transaction as a debit entry in one account and as a credit entry in another.

Under this system, the total debits must equal the total credits after you post the journal entries to the ledger accounts. If the amounts do not balance, you have made an error and you must find and correct it.

An example of a journal entry exhibiting a payment of rent in October is shown next.

General Journal

  Date       Description of Entry      Debit      Credit

If you use a computerized system, you must be able to produce sufficient legible records to support and verify entries made on your return and determine your correct tax liability. To meet this qualification, the machine-sensible records must reconcile with your books and 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. This documentation must be sufficiently detailed to show all of the following items.

How Long To Keep Records

You must keep your records as long as they may be needed for the administration of any provision of the Internal Revenue Code. Generally, this means you must keep records that support an item of income or deduction on a return until the period of limitations for that return runs out.

The period of limitations is the period of time in which you can amend your return to claim a credit or refund, or the IRS can assess additional tax. Table 3 contains the periods of limitations that apply to income tax returns. Unless otherwise stated, the years refer to the period after the return was filed. Returns filed before the due date are treated as filed on the due date.

Table 3. Period of Limitations

 ----------------------------------------------------------------------

Employment taxes. If you have employees, you must keep all employment tax records for at least 4 years after the date the tax becomes due or is paid, whichever is later. For more information about recordkeeping for employment taxes, see Publication 15.

Assets. Keep records relating to property until the period of limitations expires for the year in which you dispose of the property in a taxable disposition. You must keep these records to figure any depreciation, amortization, or depletion deduction, and to figure your basis for computing gain or loss when you sell or otherwise dispose of the property.

Generally, if you received property in a nontaxable exchange, your basis in that property is the same as the basis of the property you gave up, increased by any money you paid. You must keep the records on the old property, as well as on the new property, until the period of limitations expires for the year in which you dispose of the new property in a taxable disposition.

Records for nontax purposes. When your records are no longer needed for tax purposes, do not discard them until you check to see if you have to keep them longer for other purposes. For example, your insurance company or creditors may require you to keep them longer than the IRS does.

Recordkeeping System Example

This example illustrates a single-entry system used by Henry Brown, who is the sole proprietor of a small automobile body shop. Henry uses part-time help, has no inventory of items held for sale, and uses the cash method of accounting.

These sample records should not be viewed as a recommendation of how to keep your records. They are intended only to show how one business keeps its records.

1. Daily Summary of Cash Receipts

This summary is a record of cash sales for the day. It accounts for cash at the end of the day over the amount in the Change and Petty Cash Fund at the beginning of the day.

Henry takes the cash sales entry from his cash register tape. If he had no cash register, he would simply total his cash sale slips and any other cash received that day.

He carries the total receipts shown in this summary for January 3 ($267.80), including cash sales ($263.60) and sales tax ($4.20), to the Monthly Summary of Cash Receipts.

Petty cash fund. Henry uses a petty cash fund to make small payments without having to write checks for small amounts. Each time he makes a payment from this fund, he makes out a petty cash slip and attaches it to his receipt as proof of payment. He sets up a fixed amount ($50) in his petty cash fund. The total of the unspent petty cash and the amounts on the petty cash slips should equal the fixed amount of the fund. When the totals on the petty cash slips approach the fixed amount, he brings the cash in the fund back to the fixed amount by writing a check to "Petty Cash" for the total of the outstanding slips. (See the Check Disbursements Journal entry for check number 92.) This restores the fund to its fixed amount of $50. He then summarizes the slips and enters them in the proper columns in the monthly check disbursements journal.

2. Monthly Summary of Cash Receipts

This shows the income activity for the month. Henry carries the total monthly net sales shown in this summary for January ($4,865.05) to his Annual Summary.

To figure total monthly net sales, Henry reduces the total monthly receipts by the sales tax imposed on his customers and turned over to the state. He cannot take a deduction for sales tax turned over to the state because he only collected the tax. He does not include the tax in his income.

3. Check Disbursements Journal

Henry enters checks drawn on the business checking account in the Check Disbursements Journal each day. All checks are prenumbered and each check number is listed and accounted for in the column provided in the journal.

Frequent expenses have their own headings across the sheet. He enters in a separate column expenses that require comparatively numerous or large payments each month, such as materials, gross payroll, and rent. Under the General Accounts column, he enters small expenses that normally have only one or two monthly payments, such as licenses and postage.

Henry does not pay personal or nonbusiness expenses by checks drawn on the business account. If he did, he would record them in the journal, even though he could not deduct them as business expenses.

Henry carries the January total of expenses for materials ($1,083.50) to the Annual Summary. Similarly, he enters the monthly total of expenses for telephone, truck/auto, etc., in the appropriate columns of that summary.

4. Employee Compensation Record

This record shows the following information.

5. Annual Summary

This annual summary of monthly cash receipts and expense totals provides the final amounts to enter on Henry's tax return. He figures the cash receipts total from the total of monthly cash receipts shown in the Monthly Summary of Cash Receipts. He figures the expense totals from the totals of monthly expense items shown in the Check Disbursements Journal. As in the journal, he keeps each major expense in a separate column.

Henry carries the cash receipts total shown in the annual summary ($47,440.95) to Part I of Schedule C (not illustrated). He carries the total for materials ($10,001.00) to Part II of Schedule C.

CAUTION: A business that keeps materials and supplies on hand generally must complete the inventory lines in Part III of Schedule C. However, there are no inventories of materials and supplies in this example. Henry buys parts and supplies on a per-job basis; he does not keep them on hand.

Henry enters annual totals for interest, rent, taxes, and wages on the appropriate lines in Part II of Schedule C. The total for taxes and licenses includes the employer's share of social security and Medicare taxes, and the business license fee. He enters the total of other annual business expenses on the "Other expenses" line of Schedule C.

6. Depreciation Worksheet

This worksheet shows the information used in figuring the depreciation allowed on assets used in Henry's business. Henry figures the depreciation using the modified accelerated cost recovery system (MACRS). He purchased and placed in service several used assets that do not qualify for the section 179 deduction. Depreciation and the section 179 deduction are discussed in Publication 946. Henry uses the information in the worksheet to complete Form 4562, Depreciation and Amortization (not illustrated).

7. Bank Reconciliation

Henry reconciles his checkbook with his bank statement and prepares a bank reconciliation for January as follows.

Daily Cash Receipts

1. Daily Summary of Cash Receipts

 Date    January 3, 20 __

 Year   20__   Month  January

 Year   20__   Month   January

 Name   John E. Marks      [ ] Full Time  Soc. Sec. No. 567-00-8901

             Cash         Materials/   Gross      FICA     Bank

                                             Section 179

 Date       January 31, 20__

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