Recordkeeping and Substantiation

All taxpayers are required to keep accurate, permanent books and records so as to be able to determine the various types of income, gains, losses, costs, expenses, and other amounts that affect their income tax liability for the year. These records must be retained for as long as they may be relevant for any tax purpose.

Generally, you will need to keep all records that support items on your tax return for at least four years, since the IRS may challenge your return for up to three years after its due date.

Deduction rules. In order to claim any deduction, a business owner, like any taxpayer, should be able to prove two things: what the expense was for, and that the expense was in fact paid or incurred. A receipt or invoice showing the description and cost of the item, plus a canceled check or credit card charge slip, are two types of documents that prove the amount and purpose of an expense.

In many cases, if you don't have records of a particular business expense but it's obvious that you must have incurred it, in an audit situation the IRS will estimate the amount of your expenses and allow you to deduct them. An example would be a retailer who has incomplete records of inventory purchases - the IRS will come up with a reasonable estimate of what the purchases should have been.

Certain expenses, which the IRS has found to be particularly susceptible to cheating, are subject to special documentation rules. The following expenses must generally be proven by adequate records or other evidence; if you have no records, the deduction will be completely disallowed:

• expenses for travel away from home (including meals and lodging while traveling)
• meals and entertainment expenses
• business gifts
• cars and other means of transportation
• cellular phones, computers, and other property of a kind that is generally used for entertainment or recreation

For these types of expenses, you must keep receipts for any expense over $75, and for all lodging expenses whatever the amount. You must also substantiate each individual expense as to: (1) amount, (2) time and place, and (3) business purpose.

For entertainment and gift expenses, you must also note the business relationship of the person(s) being entertained or receiving a gift. These things can be noted on the back of the receipt, or recorded in a formal expense log. For vehicle expenses, you'll also have to keep a mileage log.

Save Money There is no requirement that you keep a contemporaneous log or journal of your deductible expenditures. However, when you make a purchase or incur an expense, the sooner that you record the expense (and provide necessary documentary evidence), the more accurate your records are assumed to be by the IRS and the more valuable the records will be to prove the deduction. What's more, if you get into the habit of systematically recording your expenses and all the necessary supporting facts and records, you may discover that you have many more perfectly legitimate deductions than you thought!