A first step in avoiding costly hassles with the IRS is identifying potential problem areas. As a recent government report confirmed, one frequent source of audit conflict between the IRS and small businesses is the documentation of travel and entertainment expenses.
Maintaining records is critical. If the IRS should select your return for audit, you need to be prepared. Good recordkeeping is your first line of defense against audit adjustments and penalties. While your records must be accurate, the IRS generally does not require any particular form of recordkeeping.
You should keep receipts, sales slips, invoices and bank statements that refer to any item on your return. Once your return has been prepared, it is imperative that you have records supporting the claimed income and deductions. Furthermore, travel and entertainment expenses must be documented with additional elements.
Special record-keeping requirements
Travel – If you use your car in business, whether you base your deductions on actual expenses or you use an IRS standard mileage rate, there are a number of records that you must keep. They include contemporaneous records of business miles and total miles, records showing when you started using your car in business and its basis and records of actual expenses if you do not use the standard mileage rate.
Meals and entertainment – As a general rule, you can deduct meals and entertainment expenses only if they are ordinary and necessary and either directly-related to or associated with your trade or business. In addition, the deduction for either type of expense generally is limited to 50 percent of the cost. To be considered directly connected to or associated with business, the meal or entertainment event must meet three conditions:
- It must have been scheduled with more than a general expectation of deriving future income or a specific business benefit from the event.
- A business meeting, negotiation, or transaction must actually occur during the meal or entertainment, or immediately preceding or following it.
- The main character of the event, considering the facts and circumstances, is the active conduct of your trade or business.
Even if a meal or entertainment expense qualifies as a business expense, none of the cost is deductible unless strict and detailed substantiation and recordkeeping requirements are met to the letter. Adequate records must include documentary evidence, such as receipts or invoices, and contemporaneous detail of the amount, time, place and business purpose of the expense.
Another question that arises with respect to recordkeeping is how long you need to keep the records. The short answer is you need to keep them for as long as the IRS can potentially challenge you on the item to which a particular record relates.
If you have any questions about the general recordkeeping matters touched upon here or have specific questions related to travel and entertainment, please give us a call.