If you own a business or are beginning one, you already know how important it is to keep track of your income and expenses. You must keep meticulous records of your costs in order to claim all of the tax deductions you are eligible for. You also want to ensure that you can defend the amounts recorded on your tax returns in case the IRS audits you.
Keep in mind that there is no one-size-fits-all approach to small business recordkeeping. When it comes to keeping records and demonstrating expenses are lawful for tax purposes, there are strict guidelines. Certain expenses, such as car, travel, meals, and home office costs, necessitate extra attention due to specific small business recordkeeping requirements or limitations.
Let’s take a look at the following two recent court decisions to illustrate some of the issues related to small business recordkeeping.
Small Business Recordkeeping Case 1: An activity must be engaged in for profit to qualify for a deduction
If a taxpayer can show that the primary goal of the activity is to make a profit, a business expense can be deducted. The expense must also be verified and be a legitimate company expense. In one case, a taxpayer claimed deductions that resulted in a loss, which she then exploited to avoid paying taxes on other income.
She engaged in a variety of things, including acting and selling jewelry in the entertainment sector. Her deductions were denied by the IRS since her activities were not for profit.
The taxpayer took her case to the United States Tax Court, where she was granted relief. During the years in question, the court determined that she was in the business of acting. But she was not able to show that all of the reported expenses were ordinary and necessary business expenses. Headshots, casting agency costs, courses to improve her acting skills, and part of the compensation for a personal assistant were all allowed deductions by the court. Other deductions were denied by the court because there was insufficient evidence “to firmly establish a connection” between the expenses and the business.
In addition, the court found that the taxpayer failed to show that she made a profit from her jewelry sales. She didn’t run it like a business, didn’t devote enough time to it, and didn’t seek out jewelry industry knowledge. As a result, all deductions relating to that action were ruled invalid. (Memo TC 2021-107)
Small Business Recordkeeping Case 2: A company must keep documents to back their claimed deductions
A taxpayer worked as a contract emergency room doctor at a medical center. He also started a company that provides emergency room physicians to hospitals around the world. He deducted expenses for his home office, travel, driving, continuing education, cost of products sold, and interest on Schedule C of his tax return. Most of the deductions were denied by the IRS.
The doctor presented evidence documenting his expenses in Tax Court, but he didn’t submit receipts or other evidence to show that the expenses were paid. He also didn’t account for the portion of his costs that could be attributed to personal activities.
The court denied the deductions, claiming that his evidence was insufficient and that he had failed to prove that the expenses were ordinary and necessary in his company. The court noted that even a deductible expense may be disallowed if there is insufficient substantiation. The doctor was also ineligible for home office deductions since he couldn’t show that it was his primary place of business. (Memo TC 2022-1)
A recordkeeping strategy
Using a methodical, proactive strategy will help you protect your deductions and make an audit much easier. In addition, you need to keep your records for an appropriate amount of time. Check out Landmark’s Records Retention Guide for information on the retention period for certain types of records. If you need help with small business recordkeeping, please contact us.
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