Businesses must maintain tax records to substantiate amounts reported on their tax returns. Because of the hustle and bustle of business ownership, many business owners consider record keeping a low priority.
Bad Things Happen When Records Are Not Kept
However, if the IRS audits a business and the business owner has failed to maintain adequate records, the result can be catastrophic. Imagine spending $20,000 on marketing and failing to keep records of this expense. If the IRS disallows the deduction, and the taxpayer is in the 25% tax bracket, the IRS will send a bill for $5,000 plus significant penalties and interest. Imagine if the business owner had $200,000 in expenses and didn’t keep adequate records.
The IRS Requires Records to be Kept
Every taxpayer is required by IRC Section 6001 to maintain adequate tax records and to make those records available to the IRS upon request. When determining how long to keep tax records, we typically look at the relevant statute of limitations periods—the period of time a taxpayer can amend a tax return to claim a credit or refund or for the IRS to assess additional tax. The statute of limitations begins running from the tax return’s original due date (generally April 15th), or the date filed, if later.
The statute of limitations is generally 3 years. However, the limitations period is 6 years if the tax return understates gross income by more than 25%. There is no statute of limitations if a tax return was never filed or a fraudulent return was filed. There are special statutes of limitations for certain types of deductions (e.g., a 7 year statute of limitations applies to bad debts and worthless securities).
How Long Should Records be Kept?
A good rule of thumb is to add one year to the statute of limitations period. You often hear tax records should be kept for 7 years. This is based on the 6 year statute of limitations for returns that have a greater than 25% understatement of income, plus one year.
Certain tax records, however, should be kept much longer than described above and, in some cases, indefinitely. Records substantiating the purchase price of property that could eventually be sold, such as investment property and business assets, should be retained based on the record retention period for the year the property is sold.
Keep in mind that there may be nontax reasons to hold on to records beyond the time needed for tax purposes. This might include documents such as insurance policies, leases, real estate closing statements, employment records, and other legal documents.
The 7 year retention policy for tax purposes is a good rule of thumb (unless a special statute of limitations applies). The State of Michigan has a 4 year statute of limitations, in general. The 7 year retention policy will thus work well in the State of Michigan.
Records Can be Scanned into Computer Files
It’s also important to know that the IRS allows taxpayers to store certain tax documents electronically. The rules permit taxpayers to convert paper documents to electronic files (e.g., pdf or image files) and maintain only the electronic files. Then, the paper documents can be destroyed. Certain requirements must be met to take advantage of the electronic filing system, so contact us if you have any questions.
To see how this applies to you, give us a call at 248-538-5331.
Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.