The IRS requires good recordkeeping for any deductions you claim on your tax return. No estimates or approximated values may be used – only actual records. If you’re in business for yourself, that means you need to make a record of your income and tax deductible business expenses. Without good records, if your tax return is audited, your deductions could be rejected and you could owe a lot more tax! But what exactly is good recordkeeping?
Good recordkeeping requires timely and accurate records that prove certain elements of your business expenses. Let’s unpack what that means.
What are timely and accurate records?
When you file a Schedule C, reporting your self-employed business income and expenses, you need a record of everything you counted. In short, if your return is examined, you’ll be asked for the backup evidence of every item that rolled into that total line. If you reported $8,500 of expenses and can only find a record of $7,000 of them – you’re going to have a problem. If you have to go back to your statements at that point and try to come up with support for your number, you’re likely going to struggle to make it through the audit. The IRS requires that you make a record of that information at the time you incurred the expense, or at least by the time you’ve filed for the deduction.
As a self-employed business owner, you are required by the IRS to keep a timely record of all the elements of a business expense. That means you need to capture the information roughly around when it happened. If you snap a photo of a receipt into a tracking app like BossTax, that’s a timely record of the business expense. If you forget to do that and snap a photo a few months later when you’re cleaning out your wallet, that’s still fine. You’ll have built up an electronic record that you can save as backup in case your return is audited later.
For an expense that’s straightforward, where you also have a receipt as proof, tracking isn’t that hard. If you stuff the receipt into an envelope as backup, as long as that receipt doesn’t get lost and is still legible, and everything adds up to your total filed, you are probably fine claiming that is your paper record of your business expenses. But if you lose your envelope or a receipt fades over the years after you file and becomes unreadable (for at least 3 years, and potentially up to 7 years after you filed!), you’re going to have a problem.
Okay so your stuffed paper envelope can take care of straightforward expenses. If you bought some business cards to hand out to clients, the receipt probably contains all the information you need. But what about expenses that aren’t as straightforward?
If you bought a coffee and donut, you probably need a note to explain why that was for business purposes. And if you have to jot down a cash receipt, or if you are trying to allocate part of a larger personal expense cost to a business purpose, failing to make the record in a timely way will likely result in a disqualification and cost you in back taxes and penalties.
A timely and accurate record is a listing of all of your business income and expenses, made around the time those events happened, with some note if needed to explain why it was a business expense. That doesn’t mean you have to become a professional accountant or use double-entry bookkeeping – but it does mean you should probably turn to a tracking app like BossTax and try to catch up with your tracking at least once a year and preferably even every few months.
Proving certain elements of a business expense
What pieces of information do you need to prove about a business expense? And what counts as proof?
Generally, the pieces of information you must be able to prove about a business expense are:
- the date
- a place or description,
- the “essential nature” of the expense, and
- the business purpose or business relationship
Most receipts include the first three pieces of information, so you’re almost done if you just keep a record of the receipt. You can snap a photo into the free BossTax app and those pieces of information will be read automatically and categorized into your business record.
Next, what is the “essential nature” of the expense? Let’s say you have lunch at a hotel restaurant with a customer so that you can discuss a prospective sale. The receipt says “The Boston Hotel”. But your expense wasn’t for a hotel stay, it was for a meal. In order to prove the essential nature of the expense, the document should also include some information that helps establish what you spent the amount on – like “The Dining Room” or “Chicken Caesar Salad”. If your receipt doesn’t come with that information, jot it down before you snap a picture and you’ll have a timely and accurate record.
Now you just need to add information about the business purpose of the expense, or the business relationship between the parties. In some cases, the business purpose is obvious from the context, and you don’t need to make an additional written record of the business purpose. For example, if you sell dental supplies, and drive a regular sales route to call on your dentist office clients, it’s sufficient to just record the trips – you don’t have to write down each time that the business purpose was a sales call or delivery. Or if you always order the same materials from a supplier for your business, you can record once what that supplier provides for your business.
But if it’s not obvious, you should make a timely note. For example, if you bought an espresso machine for your front lobby, you should make a note of that – otherwise you may have difficulty later establishing that it was indeed a deductible business expense. Or for that coffee and donut – make a note that it was for a client meeting or while you were traveling for work, to make sure that you can deduct that.
How long to retain records
How long do you have to keep all of these records? In general, you should save the records for 3 years after the date you file. Outside of that time period, you’re generally past the time when the IRS would examine your return, so you should be in the clear to clean out your file cabinet.
However, in some cases the IRS can examine your records going back up to 7 years. The time period for examining a tax return varies based on the specific circumstances of your return and the types of mistakes (or intentional changes/omissions) that might have been made. In some cases, states may go back even further.
You don’t need to keep a roomful of records though – making an electronic record allows you to create a cloud-based backup that’s easy to store for as long as you need it. BossTax allows you to export an Audit Archive that will keep your complete record of income and expenses, including photo image files, and will even save it for you so you have somewhere to go if you do get audited.
What if I didn’t keep good records for 2022?
We get it, we’re all busy and things slip! Deduct what you can based on the records you do have, and see our article, What to do if your records are incomplete.
Reporting your solo business at tax time
If you are in business for yourself, you typically use the Schedule C to report your business income and expenses. The Schedule C is included in your personal income taxes, which are filed on the IRS Form 1040. You can use the Schedule C to report your income and expenses from any self-employed work you do, or work you do in a formal LLC partnership as long as the only other partner is your spouse and you file your taxes jointly. You do not have to file a separate business tax return, like the IRS Form 1120, unless you have formed a corporation or have partners in your business other than your spouse.
What type of work is covered?
You are a self-employed person if you perform any work outside of an employment arrangement, such as by being an independent contractor, rather than work for an employer. If you are employed, your employer issues you a W-2 form at the end of the year, reporting the wages they paid you. But if you are self-employed for tax purposes, you would either receive 1099 forms from each person or business who hired you to do work, or else you simply have to track for yourself the income you received from sales you made of goods or services. If you run your own selling business, like for Princess House or Pampered Chef, or Mary Kay or doTERRA, then you are self-employed and should receive a 1099 from that company. If you provide personal care services like hair and makeup styling, or yoga instruction, you are self-employed – and will probably not receive a 1099 from anyone, so it’s up to you to track and report your income on tax day.
To report your business income, you should fill out a separate Schedule C for each separate business you run. A business may have multiple clients or sources of income – so for example, if you are a housekeeper with 3 main clients, that’s one business rather than three. But if you are a housekeeper and a makeup stylist, that’s two separate businesses.
You will need to report the type of business you do on each Schedule C on Lines A and B. Line A asks for a short description of the business or professional activity that generated most of the income for that business. For example, you could say “Housekeeping”, or “Repair of Antique Cars”. The IRS uses a 6-digit code system to describe the activities, which is requested on Line B. You can look up the code that best fits your activities on the IRS site here. If you are in the sales business, you should use the code that matches the type of things you sell. Here are some commonly used codes:
- 611000 – Educational services (including schools, colleges, & universities)
- 524210 – Insurance agencies & brokerages
- 621610 – Home health care services
- 624410 – Childcare services
- 812910 – Pet care (except veterinary) services
- 541400 – Specialized design services (including interior, industrial, graphic, & fashion design)
- 541920 – Photographic services
- 458110 – Clothing & clothing accessories retailers
- 458310 – Jewelry retailers
- 455000 – General merchandise retailers
- 456190 – Other health & personal care retailers
- 485300 – Taxi, limousine, & ridesharing service
What income and business expenses should I track?
Business income is any money you receive for your work, which could be services you perform, goods you sell, or a mix of both. If you receive money as reimbursement for your travel to perform the work, or for expenses you incurred in doing your work, then these payments to you are also income. Whether you collect payments by check, cash, or through a service like Venmo or Paypal, you are responsible for adding up all of your income received during the year and reporting it accurately. The IRS will receive a copy of any 1099 form you receive, so make sure you don’t lose track of any of those forms and include them with your tax filing. And while the IRS won’t receive information on any cash payments you receive, or untracked payments through personal accounts like Venmo, you may have a problem if you are audited if you haven’t kept accurate track of all of those records. The IRS may request to look at those records in examining your tax return, and you could owe fines and interest on amounts that should have been included in your income.
Business expenses are any costs you spent to support your business. For example, if you bought Facebook ads to promote your sales, that expense would be reported as advertising cost on your Schedule C. If you traveled to meet with clients or to host a sales event, those costs would be reported as Travel costs. If you hired someone to deliver some packages for you, that cost would be reported as Contract Labor. All of these costs are reported in Part II of the Schedule C.
Sometimes business expenses can’t all be deducted in the year you spent them. Certain types of spending are considered investments, depending on their size and how long they will be used in your business. For example, if you buy a storage shed to store your business supplies and inventory, that cost would be considered an investment in your business. That cost must be divided over the useful life of the purchase and deducted in each year that you are using the storage shed for business purposes.
Other types of business expenses have restrictions or choices for your method of calculating the deduction. Two very common costs that fall into this category are use of your home office and use of a personal vehicle for business purposes. For more on how to handle and track these costs, see the article, How to deduct your home office [link] and Getting the most out of your personal vehicle deduction [link].
How do I track inventory and cost of goods sold?
Cost of goods sold are reported on Part III of the Schedule C. Costs of goods sold are the costs that went directly into the production of the good or service you sold or provided, rather than being a cost of the business. For example, if you sell goods for Amway, the cost of your purchase from Amway is a Cost of Goods Sold, while the cost of your store, insurance, and advertising are a cost of your business. If you sell essential oils for doTERRA and make a particular formulation for a client, the cost of your purchased oils are a cost of goods sold, while your cost of delivering the oil to your client and meeting with her is a cost of your business.
One important note – the cost of “freight in” or inbound shipping is a cost of goods sold. So if you bought a case of oils and paid $25 for the shipping, include that cost in your cost or purchases. But the cost of freight out – the cost of delivering goods to your customers – is not a cost of goods sold. These costs are separately deducted in Part II, under line 18 for Office expense as a cost of shipping.
Keeping up with tax tracking
Tracking your business income and expenses can feel overwhelming, and it’s easy to get behind. Sometimes you aren’t sure of what “counts” as a business expense, or you’re unsure if you kept complete enough records. But keeping track of how your business is performing is important both for accurate tax filings, and also to help you as a self-employed business owner track your progress and get more out of your work. A free tool like BossTax [link to download] can help make tracking – and catch-up – easier, and also offers options to get advice all year long or at tax time from a Tax Pro. With the right support, business profit tracking and tax filing can be a snap.