What You Need to Know about Recordkeeping from a Tax Perspective

Tax records can be your best friend or your worst enemy. When your records are nicely organized in an easy to locate spot, maximizing your deductions becomes a breeze. On the other hand, disorganization of your records can be painful if you get audited by the IRS. No one wants to painstakingly dig through stacks of paper to find that one receipt from that one charitable contribution three years ago! So, as we near the end of the 2022 tax season, you may be wondering what to do with all the tax documents you have collected over the past several weeks and how to be better prepared for the next tax season. 

When trying to answer these questions, it is important to keep in mind that returns can be audited up to three years after the filing date. Also, the IRS can collect underpaid taxes up to six years after the filing date. Overall, good recordkeeping is imperative to easily prove what you reported on your returns.

Individual Recordkeeping

Below is a list of the most common records that should be kept for those who file an Individual return, i.e., a 1040. 

• Income received
  • W-2
  • 1099s
  • K1s (partnership income)
• Expenses
  
  • Medical expenses (unreimbursed)
  • Self-employment expenses (advertising, travel, and meals) 
  • Child/dependent care receipts
• Home improvement, sales, and refinances
  • Receipts for new appliances
  • Closing documents
• Specific uses of loan proceeds
  • Receipts for expenses
  • Spreadsheet
• Charitable contributions
  • Donation receipts
  • Spreadsheet of donation including the recipient, date, and amount
• Interest and taxes paid
  • Mortgage interest
  • Real estate taxes
• Records on nondeductible IRA contributions
  • Account statements

In addition to just keeping your records, it is important to have them organized in a manner that allows you easy access to the specific information you need. There is no right or wrong way to organize your documents, but the more convenient the method, the more likely you are to keep it up. A possible organizational method is to categorize your documents by month and then have separate folders for specifics like household documents and medical expenses. With so much of our lives online nowadays, recordkeeping can be done online or in hard copies, but choose one method and stick with it.

For reported income that is not captured on a W-2 or 1099, plus any expenses that you deduct. There are four basic questions that you should keep in mind when documenting these items: 

1. How much was spent/received?
2. What was it for?
3. Where did the money come from or go?
4. What was the reason for the expense/income? 

Business Recordkeeping

All businesses are required by law to keep records of gross income, deductions, and credits claimed on their income tax returns, but what else should businesses keep readily available?

Business owners have the freedom to choose whatever method of recordkeeping works best for them and their business. As long as you can easily see cash inflows and outflows, the IRS doesn’t care what system you use. Also, make sure that your personal and business expenses are separate. If your business account is not clearly separate, this could make your proof less reliable and cause you more headaches. 

Supporting documents that are imperative to keep until the period of limitation has run out are listed below:

• Business expense records
  • • Bank and credit card statements
    • Checks (including canceled ones) 
    • Receipts/invoices
• Employment tax records
• Loan documentation 

In addition to the supporting documentation, businesses should have a permanent set of books that includes income, disbursements, and the basis of depreciable assets. 

Let’s be honest—time gets away from everyone, and before we know it, we will be in the thick of the 2022 tax season. So start today with writing detailed notes about your receipts and deposits and stay on top of it. Use the following guidelines as appropriate for documenting the transaction: How much was spent/received? What was it for? Where did the money come from or go? What was the reason for the expense/income?  

Taking time to make notes in the present leaves less room to forget the small things later on. Each expense type has a varying amount of deduction associated with it, and by keeping track of the expense details, you ensure that you are taking the maximum deduction without mistakenly taking too much. Aside from all of the tax-specific benefits, good recordkeeping can help you understand the health and growth of your company.

Trust Recordkeeping

Trustees are responsible for maintaining the records of the associated trust accounts as long as the trustee is connected to the beneficiaries. In addition to the general clerical task of keeping up-to-date and organized records, a trustee should also make sure the trust assets are clearly defined from the trustee’s personal assets. 

Common documents that should be kept year over year include the following:

• 1099s issued to the trust (from brokerages, banks, etc.)
• Trust expenses
• Distributions to beneficiaries
• All K-1s issued to the trust, if applicable

Failure to Support Claims on Your Return/Audit Potential:

IRS audits are an extremely rare occurrence, with a 0.6% chance of occurring, as the majority of filed tax returns are received and processed without any scrutiny. However, don’t get complacent. Here are a few characteristics of a return that can make you more susceptible to an audit.

Digital currencies are not under the same level of control as regular currency by the US government. Therefore, the IRS tends to want to take a closer look at the return to make sure everything is accounted for and recorded properly. Other investment platforms typically provide you with a 1099-B for the year, but your crypto exchange may or may not. Thus, it is up to you to keep comprehensive records of your total number of coins, the date and price you bought at, the date and price you sold at, and your gain or loss for each transaction. This is especially important for transactions that occur between offline cold wallets and your account. 

The more you earn, the more likely you are to get audited. The understanding is that high-income earners tend to have more complex tax situations, which catches the attention of the IRS. In 2020, for those earning between $25,001 - $200,000, the chance of being audited was 0.4%. On the other hand, for those who reported an income between $1,000,0001 and $5,000,000, the chance of being audited increased to 2.5%. 

As the line between personal and business expenses/assets can become blurred, the IRS may want to dig deeper into your records to make sure you didn’t try to deduct more than is acceptable. 

The IRS has very strict guidelines for deducted expenses related to a home office; therefore, they are often intrigued whether or not the taxpayer is in compliance. 

Cash-based businesses have a higher potential for underreporting their income,  which catches the eye of the IRS to investigate the potential for tax crimes. 

Record Retention

In general, records that support income, deductions, or credits claimed on your tax returns should be kept until the opportunity for an audit has passed. The IRS can audit returns up to three years after the filing date or six years if the income was underreported. There are special occasions where you might be required to keep the tax return and its documents longer, which are laid out here. 

Although, at a minimum, your records should be kept until the period of limitation has expired, the recommended retention periods are listed below. 

• Bank deposit slips: seven years
• Bank statements: seven years
• Canceled or substitute checks: seven years
• Contracts: permanent
• Credit card receipts: seven years
• Employee records: the period of employment plus seven years
• Expense reports: seven years
• Financial statements: permanent
• Inventory records: seven years
• Paid invoices: seven years
• Tax returns (generally): seven years
• Depreciation schedules: the life of assets plus seven years
• Home purchase and improvement records: ownership period plus seven years
• Investment records: ownership period plus seven years
• Journal and general ledger: the life of business plus seven years
• Real estate records: ownership period plus seven years

Even though you may not need to keep your records for tax purposes, it is a good idea to double-check check they aren’t needed elsewhere. For example, insurance companies or creditors may have longer retention periods than the IRS does. 

Takeaway

If your recordkeeping system is up to date and organized, by the time next tax season comes around, you will be prepared to take advantage of any and every deduction you are eligible for. Not to mention the convenience of having all your documents at your fingertips to quickly and effortlessly send the necessary documents to the proper parties.

About the Author

Cassie Jackson is Operations Specialist on Team XY Tax Solutions. She can't get enough of working alongside her XYTS teammates towards a common goal and holistically approaching tax processes. When she's not tackling taxes, Cassie loves to get crafty and active, taking on home decorating projects and going hiking. And she has some great company—her two dogs Poof, a toy Aussie, and Remi, a mini Aussie.