Organizing Income and Expenses for Tax Purposes Part 6

In a recent series of Legal Log entries, we have reviewed the types of information that is recorded concerning income and expenses for tax purposes. In this concluding installment, we focus on the elements required for actually keeping the records to prove income and expenses. These records are necessary, not only to manage the affairs of the business, but since federal and state tax laws require them. The purposes for keeping these records include:

1. Identifying the sources of money or property. This allows the business to identify receipts from non business or nontaxable sources.
2. Tracking deductible expenses. Prompt recording of expenses permits one to claim all appropriate business expenses and not overlook any deductible expenses.
3. Computing depreciation and capital gains and losses. Proper records of the costs, acquisition date, use and disposition of assets are necessary to compute the depreciation deduction (which is a recovery of the cost of acquiring the asset) and to compute any available capital gains or losses at the sale or disposition of the asset for tax purposes.
4. Computing earnings for self-employment taxes. Where the primary source of one’s personal tax return is from a business, either as a partnership or proprietor, or as a shareholder in an S corporation, and there is insufficient tax withholding, these business records permit the taxpayer to compute the self-employment tax liability for estimated tax and social security tax payments.
5. Providing documents to support information reported on federal and state income tax returns in case of a tax audit either by the Internal Revenue Service or by state tax authorities.

Accounting Methods
Accountants generally recognize two types of basic accounting methods. Certain special accounting methods that are necessary to accurately reflect business income and expenses may also be used. Combinations of the various methods will be accepted by the Internal Revenue Service under some circumstances if used consistently from year to year and clearly shows business income and expenses. At the end of each accounting period, various financial reports (income statements and the balance sheet) are prepared that shows the financial position of the business in terms of assets, liabilities and net worth.

Under the cash method of accounting, income is reported when it is actually received or constructively received and under the control of the recipient. Expenses are reported when they are actually paid. This method is now disfavored for tax purposes under the 1986 Internal Revenue Code. Under the accrual method of accounting, income is reported when earned, even though paid in a later tax year. By "earned," this refers to the completion of services performed, or products provided to a customer or client. Expenses are deducted when they are incurred, even if paid in a later tax year.

Bookkeeping
It is also necessary to select a system of bookkeeping entry as a part of the recordkeeping process. Accountants generally use either of these systems to record financial activity that occurs in a business. The Internal Revenue Service expects a system to be in place that permits the business to record and document all income and expense items contemporaneously, that is, as they occur.

Single entry bookkeeping is a system based on the annual statement of income and not on a balance sheet. It can be a simple system, and is very practical if one is starting a small business. With a daily summary of cash receipts, and a monthly summary of receipts and disbursements, the single entry system records the flow of income and expenses.

Double entry bookkeeping uses journals and ledgers and a method of classification known as accounts. Transactions are entered and summary totals are posted to ledger accounts to show income, expenses, assets liabilities and net worth. Income and expense accounts are closed at the end of each accounting period. Asset, liability, and net worth accounts are kept permanently. The accounting period is a segment of an accounting year. Each period is an equal segment of the accounting year, and may be monthly, quarterly, semiannually, or annual in length.

The double entry system is self-balancing. Since business transactions can be characterized as an exchange of one thing for another, the double - entry system reflects this exchange by recording each transaction as both a debit and a credit, each in different accounts. After the journal entries are posted to the ledger accounts, the total of the amounts entered as debits must equal the total of all amounts entered as credits. If these totals are not equal, then an error has been made which can be identified and corrected.

Description of Typical System
A typical small business recordkeeping system must use several elements, whether kept manually or on a computer. These elements include cyclical summaries of cash receipts, check disbursement journal, the annual summary, records of depreciable property, employee compensation records, and a business checkbook.

The summary of cash receipts is a record of cash sales, sales tax, receipts and deposits. A manual system includes a daily summary that documents the increase in cash for that day. Each daily summary is then entered on the monthly summary. The monthly summary of cash receipts provides the income activity of the business for the month. A monthly figure is obtained for net sales, sales tax, receipts and deposits. The monthly summaries are compiled for quarterly or annual statements. The use of computer software to enter each transaction electronically simplifies this procedure into the generation of a report from the entered data.

All disbursements of funds should be accounted for in the check disbursement journal. In a manual accounting system, categories of frequent or large expenses should be classified in separate columns. Except for limited and documented petty cash expenses, all disbursements should be made through the business checking account. In a computerized system, each entry is categorized as income or expense, and additional categories are selected similar to the manual system.

In addition, a separate petty cash account can be used, and is documented by keeping receipts of all petty cash expenses. The petty cash account is set at a fixed ceiling, and a check is periodically cashed as needed to replenish the account. When the account is replenished, the total cash balance left in the account plus the receipts that were kept should equal the account ceiling before the replenishing check is cashed. Such accounting of cash expenses can easily be tracked in a software system, and each receipt and disbursement of cash can easily be categorized when the item is imputed into the database.

The annual summary is a compilation of all business income and expense totals for the financial year. Monthly totals of disbursements by account classification are carried forward to the annual summary. Information from the annual summary is used to compute the annual financial statement. This is a report function that is easily generated in a software system.

A depreciation record is kept of information on property for which a depreciation deduction can be taken. It includes a description of each item, its total cost, (including installation, repair or improvement costs), the amount and date of any investment tax credit claimed, the salvage value of the property, the amount of any additional first year depreciation deduction claimed, the total amount available for depreciation, the estimated life and depreciation being used, the depreciation method being used, the amount of depreciation claimed in prior years, the depreciation balance still available, the current’s year’s depreciation amount, and the depreciation balance available after the current year. The more popular software programs include this capacity.

Employee compensation records are kept for each employee. This record should include all pay and deductions for each pay period, and the year to date, as well as the amount of tax withholding for each pay period. This record is also used to record gross pay, which is an expense that should then appear in the monthly summary, and the annual summary, and is used to compute employer payroll taxes. In the last few years, the most popular software systems have added on the ability to maintain databases for employee compensation records, including the production of employer tax returns on employee tax withholding, utilizing the correct withholding tables.

All payments totaling over $600 per year to each independent contractor must be reported to the Internal Revenue Service on a form 1099-MISC., similar to the W-2 form used to report employee earnings. It is suggested that a record similar to the employee compensation record be kept for payments to independent contractors.

All daily receipts should be deposited in the business checking account. All payments, except the controlled petty cash account, should be paid by checks drawn on the business checking account. All checks should show the business purpose for which the check is written. All deposit slips should be labeled as to the source of each item deposited, i.e., payments from business customers, personal loans to the business, proceeds from sales of property, etc. If the bank does not normally return deposit slips with the monthly bank statement, a copy of the deposit slip should be made. No check on the business account should be written to the order of the taxpayer or cash unless the taxpayer is making a draw from the business, or to pay a business expense in cash. In either case, this purpose should be clearly indicated on the check, and all receipts of cash expenses should be kept in the business records concerning the check. In a software system the check writing function permits the check to be categorized, and can even write the check, utilizing check forms created for the dot matrix or laser printer.

Computer Software Recordkeeping Systems
Several personal computer software products have come onto the retail marketplace that is designed for the individual and small business. Generally these software programs allow entry of all business expenditures and receipts, develop depreciation schedules of business property, track property depreciation, investment and credit accounts, designate an appropriate income or expense category for each expense or receipt of income, write business related checks, help reconcile checking account statements, maintain a petty cash expenditure ledger, and reflect account transfers. All expenses and receipts of income can be classified as specifically as necessary for accounting and tax purposes when entered into the database. These programs can be used to generate payroll checks for employees including computation of federal, state, and other withholding taxes. These programs can also be used to generate summaries and reports on a daily, weekly, monthly, quarterly or annual basis, covering cash receipts, check disbursements, record of depreciable property, employee compensation records, and a business checkbook register. In addition, other reports such as profit-loss statements, net worth, and budget versus actual comparisons can also be generated.

Further, these programs can generate files to transfer information into other software programs that generate each year’s federal (and state) income tax returns. Even if one organizes his or her business into a partnership or corporation, more sophisticated versions of these tax software packages will allow you to generate federal or state partnership or corporation tax returns.

The records and reports generated by these programs are acceptable to the Internal Revenue Service provided the records are kept contemporaneously and regularly. The supporting records may be stored electronically provided these electronic files are readily "translatable" into visual form, i.e., the computer files can be printed out. These software systems, when properly set up, allow the user to transfer summary data for a particular year from income and expense records to complete an IRS Form 1040, 1065 or 1120 with the various attachments and schedules from a business, and print out the tax return ready to be signed and mailed in a matter of minutes.

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