Substantiation requirements

Your business is required to be able to substantiate (provide documentation about the facts regarding) any transaction on your books. You will want to maintain organized records, in addition to your books, which will let you quickly answer questions asked about any transaction.

This is most important for larger transactions or for transactions in a few high-risk parts of one’s tax return, but in principle, you need to be able to substantiate everything.

The IRS does not mandate that you have any particular style of recordkeeping, only that you do it in a consistent manner which lets you comply with your obligations. Internet companies customarily keep most of their records in one or more computer systems. It is important that you know what information is where, that you’re able to pull it at will, and that your records are available for the appropriate length of time. (In general, this is 3 years after the filing of the tax return for that year, but there are some exceptions. As a practical matter, internet businesses should store substantiating data indefinitely. Hard disk space is practically free; it’s certainly cheaper than setting up a process to routinely make the keep-or-delete decision about particular documents.)

Substantiating revenue items is fairly easy: keep copies of receipts and invoices. (These are described, in detail, in another chapter.) If you have particularly large transactions, you probably will want to be able to point to contracts or other documentation attesting to the details of what work was actually performed.

Your receipts/invoices will generally be centralized by nature in your system. If you happen to migrate systems, remember to save old receipts/invoices somewhere that won’t get wiped after the migration is over. Organizing them by year minimally; it is often useful to be able to order them within the year, as a common form of inquiry is “Your books show a revenue item for $12,000 on December 3rd, 2012. Substantiate it in an appropriate level of detail.”

Substantiating expense items is modestly trickier, as expenses are typically far more varied than revenue. Additionally, certain flavors of expenses have anomalously detailed recordkeeping requirements.

You will want to have a policy that any purchase of goods or services at your company requires a written receipt and/or invoice, and that all receipts/invoices are kept in a central place. Many companies use receipt-tracking or expense-tracking software. A lower-tech, but still compliant, way to do this is to establish a receipts@ email address for your company and require all employees, as a matter of policy, to have receipts either delivered there or to forward receipts there if they are issued one personally.

If a transaction doesn’t result in a receipt, you should treat that as an anomaly. Part of the discipline of having receipts is to force money moving out of the company to come with documentation justifying it; transactions which do not have receipts are suspicious by nature, and mayrepresent activity that your business wants to clamp down on, like embezzlement. Most of the time the reason is innocuous, but you should still immediately create a written record of the transaction and store it wherever you store receipts/invoices. (Note that backfilling written records from e.g. credit card statements is not acceptable; the IRS wants records to be maintained contemporaneously with the transaction or shortly thereafter, when the details are still fresh and when there is minimal possibility for fudging them for one’s tax advantage.)

Written records don’t have to be particularly elaborate for most transactions, particularly small-dollar ones; receipts aren’t generally that elaborate, either. You’ll want to cover who you paid (in an appropriate level of detail—”A man” is not appropriate, “the flower shop on 3rd street” probably is, at least for a small transaction), exactly how much was paid, the manner of payment (from an account, in cash, etc), what was purchased, and one’s rationale for not having a formal receipt/invoice.

Electronic records count as written records, particularly when you maintain them in an orderly fashion in the ordinary course of business. If it is your business’ ordinary practice to keep receipts in the receipts@ email inbox, for example, then a two-line email to receipts@ is a written record created in the ordinary course of business at your company, and it will generally be treated with routine deference.

You should keep statements (and similar documents) for all bank accounts, credit cards, etc indefinitely. Note that banks will sometimes retain statements on their own systems for less time than you’d like them to be retained—make a practice of saving the electronic copies in a place you control. Banks do go out of business occasionally; you don’t want to have to reconstruct an account statement from 5 years ago simply because you closed the account or the bank was bought in the interim.

Travel, transportation, entertainment, and gift expenses are sometimes abused by some taxpayers and, as a result, have specific recordkeeping requirements. You should be especially careful to keep written contemporaneous records for these transactions; the IRS describes what you need in Publication 463. A preview of coming attractions: you should keep a spreadsheet for each employee which shows any dates of travel, where they stayed (get receipts!), and what the business purpose for the travel was. You should, any time you do business entertaining (including meals), record the participants and the specific business purpose contemporaneously with information about the transaction; many small businesses simply write this on the back of the receipt.

As with most tax topics, the authorities try to be reasonable about the degree of ceremony required for small transactions, and it goes up as transactions get larger, more frequent, or more material in the total context of your business. It is unlikely that you need to write much more than “Dan Smith; candidate; discussed employment opportunity” if you buy someone $20 worth of lunch; if your end-of-year party costs your company $150,000, run that by your accountant and ask them what the appropriate level of substantiation is.