Publication 583
Starting a Business and Keeping Records
(Revised: 5/2002)

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 Instructions for Forms 1099, 1098, 5498, and W-2G.

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.

• Payments of $600 or more for services performed for your business by people not treated as your employees, such as subcontractors, attorneys, accountants, or directors.
• Rent payments of $600 or more, other than rents paid to real estate agents.
• Prizes and awards of $600 or more that are not for services, such as winnings on TV or radio shows.
• Royalty payments of $10 or more.
• Payments to certain crew members by operators of fishing boats.

You also use Form 1099-MISC to report your sales of $5,000 or more of consumer goods to a person for resale anywhere other than in a permanent retail establishment.

Form W-2.   You must file Form W-2 to report payments to your employees, such as wages, tips, and other compensation, withheld income, social security, and Medicare taxes, and advance earned income credit payments. 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 certain 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

To be sure that all taxpayers pay their fair share of taxes, 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 Forms 1099, 1098, 5498, and W-2G.

• Failure to file information returns. A penalty applies if you do not file information returns by the due date, if you do not include all required information, or if you report incorrect information.
• Failure to furnish correct payee statements. A penalty applies if you do not furnish a required statement to a payee by the required date, if you do not include all required information, or if you report incorrect information.

Waiver of penalty.   These penalties will not apply if you can show that the failures were due to reasonable cause and not willful neglect.

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 ½ 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.

Business Expenses

You can deduct business expenses on your income tax return. 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 capital expenses.

You usually recover costs for a particular asset (such as machinery or office equipment) through depreciation (discussed next). Other qualifying start-up costs can be recovered through amortization. This means you deduct them in equal amounts over a period of 60 months or more. If you do not choose to amortize these start-up costs, you generally cannot recover them until you sell or otherwise go out of business.

For more information on business start-up costs, see chapter 9 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.

• Office furniture.
• Buildings.
• Machinery and equipment.

You can choose to deduct a limited amount of the cost of certain depreciable property in the year you place it in service for use in your business. This deduction is known as the section 179 deduction. You can also take a special depreciation allowance of 30% of the cost of qualified property for the year the property is placed in service. For more information about depreciation, the section 179 deduction, and a definition of qualified property, see Publication 946, How To Depreciate Property.

Business Use of Your Home

You may be able to deduct the expenses for the part of your home you use for business. The business use of your home must meet specific requirements before you can deduct any of these expenses. Even then, your deduction may be limited.

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

1. Your use of the business part of your home must be:
   1. Exclusive (however, see Exceptions to exclusive use, later),
   2. Regular, and
   3. For your trade or business, and
2. The business part of your home must be one of the following:
   1. Your principal place of business,
   2. A place where you meet or deal with clients or customers in the normal course of your trade or business, or
   3. A separate structure (not attached to your home) you use in connection with your trade or business.

Exceptions to exclusive use.   You do not have to meet the exclusive use test if you use part of your home:

1. For the storage of inventory or product samples, or
2. As a day-care facility.

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

• You use it exclusively and regularly for the administrative or management activities of your trade or business.
• You have no other fixed location where you conduct substantial administrative or management activities of your trade or business.

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, Business Use of Your Home (Including Use by Day-Care Providers).

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:

If you use your vehicle for both business and personal purposes, you must divide your expenses between business and personal use. You can divide your expenses based on the miles driven for each purpose.

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.

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 the standard mileage rate or actual expenses.

If you want to use the standard mileage rate for a car you lease, you must choose to use it for the entire lease period. For leases that began on or before December 31, 1997, the standard mileage rate must be used for the entire part of the lease period (including renewals) after that date.

Additional information.   For more information about the rules for claiming car and truck expenses, see Publication 463, Travel, Entertainment, Gift, and Car Expenses.

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.

• An income statement shows the income and expenses of the business for a given period of time.
• A balance sheet shows the assets, liabilities, and your equity in the business on a given date.

Identify source of receipts.   You will receive money or property from many sources. Your records can identify the source of your receipts. You need this information to separate business from nonbusiness receipts and taxable from nontaxable income.

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 return. 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 special kind of records. You can choose any recordkeeping system suited to your business that clearly shows your income.

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 Accounting Method, earlier. If you are in more than one business, you should keep a complete and separate set of records for each business.

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 next.

Supporting Documents

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

• Cash register tapes.
• Bank deposit slips.
• Receipt books.
• Invoices.
• Credit card charge slips.
• Forms 1099-MISC.

Purchases.   Purchases are the items you buy and resell to customers. If you are a manufacturer or producer, this includes the cost of all raw materials or parts purchased for manufacture into finished products. Your supporting documents should show the amount paid and that the amount was for purchases. Documents for purchases include the following.

• Canceled checks.
• Cash register tape receipts.
• Credit card sales slips.
• Invoices.

These records will help you determine the value of your inventory at the end of the year. See Publication 538 for information on methods for valuing inventory.

Expenses.   Expenses are the costs you incur (other than purchases) 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.

• Canceled checks.
• Cash register tapes.
• Account statements.
• Credit card sales slips.
• Invoices.
• Petty cash slips for small cash payments.

A petty cash fund allows you to make small payments without having to write checks for small amounts. Each time you make a payment from this fund, you should make out a petty cash slip and attach it to your receipt as proof of payment.

Travel, transportation, entertainment, and gift expenses.   Special recordkeeping rules apply to these expenses. For more information, see Publication 463.

Employment taxes.   There are specific employment tax records you must keep. See Publication 15.

Assets.   Assets are the property, such as machinery and furniture, that 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.

• When and how you acquired the asset.
• Purchase price.
• Cost of any improvements.
• Section 179 deduction taken.
• Deductions taken for depreciation.
• Deductions taken for casualty losses, such as losses resulting from fires or storms.
• How you used the asset.
• When and how you disposed of the asset.
• Selling price.
• Expenses of sale.

Documents that may show this information include the following.

• Purchase and sales invoices.
• Real estate closing statements.
• Canceled checks.

What if I don't have a canceled check?   If you do not have a canceled check, you may be able to prove payment with certain financial account statements prepared by financial institutions. These include account statements prepared for the financial institution by a third party. These account statements must be highly legible. The following is a list of acceptable account statements.

Proof of payment of an amount, by itself, does not establish that you are entitled to a tax deduction. You should also keep other documents, such as credit card sales slips and invoices, discussed previously.

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.

• Business checkbook.
• Daily summary of cash receipts.
• Monthly summary of cash receipts.
• Check disbursements journal.
• Depreciation worksheet.
• Employee compensation record.

The business checkbook is explained next. The other items are illustrated later under Sample Record System.

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.

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:

• Includes bank charges you did not enter in your books and subtract from your checkbook balance, or
• Does not include deposits made after the statement date or checks that did not clear your account before the statement date.

By reconciling your checking account, you will:

• Verify how much money you have in the account,
• Make sure that your checkbook and books reflect all bank charges and the correct balance in the checking account, and
• Correct any errors in your bank statement, checkbook, and books.

You should reconcile your checking account each month.
 

Before you start to 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.

1. Adding the amounts on your check stubs and comparing that total with the total in the amount of check column in your check disbursements journal. If the totals do not agree, check the individual amounts to see if an error was made in your check stub record or in the related entry in your check disbursements journal.
2. Adding the deposit amounts in your checkbook. Compare that total with the monthly total in your cash receipt book, if you have one. If the totals do not agree, check the individual amounts to find any errors.

If your checkbook and journal entries still disagree, then refigure the running balance in your checkbook to make sure additions and subtractions are correct.

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.

1. Compare the deposits listed on the bank statement with the deposits shown in your checkbook. Note all differences in the dollar amounts.
2. Compare each canceled check, including both check number and dollar amount, with the entry in your checkbook. Note all differences in the dollar amounts. Mark the check number in the checkbook as having cleared the bank. After accounting for all checks returned by the bank, those not marked in your checkbook are your outstanding checks.
3. Prepare a bank reconciliation. One is illustrated later under Sample Record System.
4. Update your checkbook and journals for items shown on the reconciliation as not recorded (such as service charges) or recorded incorrectly.

At this point, the adjusted bank statement balance should equal your adjusted checkbook balance. If you still have differences, check the previous steps to find the errors.

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