Now that your taxes are done, what do you need to keep and for how long?
by Kris Houghton, Meyers Brothers Kalicka, P.C.
With tax time behind many of you for your 2005 income, you may be wondering if you can clean out some old staff files. This article will explain the importance of retaining the proper documentation to support your recent income tax filing. Retention period
According to IRS regulations, books or records must be available for review or inspection by revenue officers for so long as they may be material in the administration of the Code. Whether records are material depends on the item for which the record is kept and the time period available for the Service to assess additional tax. Expense records, for example, must be kept throughout the entire limitations period, generally ending the later of three years after the filing date of the return to which the deduction applies or two years from the tax payment date. For returns filed early, the limitations period is counted from the due date of the return. These same rules generally follow for records of income and credits, although longer periods apply if the taxpayer agrees to an extension. When a taxpayer files a claim for refund, abatement, or credit, the retention period to at least four years after the date the claim is filed.
There are exceptions. Examples include a six-year limitations period for assessment when there has been a substantial omission of income. Alternatively, a seven-year period for filing a claim for credit or refund relating to bad debts or losses on securities. Employers required to withhold income tax on wages, including sick pay, must retain the associated records for four years after the tax due date. Even mutual agreements between the Service and the taxpayer (not atypical for larger business entities) extend the limitations period. Finally, there is no limitations period if either fraud or failure to file a return is established.
Basis. Records establishing asset basis may be needed for substantially longer periods. While the rules outlined above generally apply, records involving business assets against which depreciation, amortization, or depletion deductions are claimed must be retained for six years. In these situations, a taxpayer must be able to substantiate business-use percentages. Failure to do so can result in depreciation recapture.
Audits. Taxpayers contesting an audit assessment through litigation may begin the action in any of three courts: district court, Tax Court, or the Court of Federal Claims. In all three settings, the burden of proving that the Service's assessment is incorrect is generally placed on the taxpayer. Furthermore, in refund suits, the taxpayer also must prove that any tax liability has been satisfied.
Specific examples of records to be retained for certain deductions are discussed below:
Employee travel expenses
Generally, the burden for retaining records of reimbursed employee expenses on the taxpayer claiming the deductions. When an employer claims the employee expense as a deduction, this burden lies with the employer. However, reimbursed expenses that are a form of additional compensation shift the record-retention burden to the employee who reports compensation income accompanied by an offsetting deduction.
When this type of expense involves travel or transportation costs, an employer claiming the deduction must require employees to provide an “adequate” accounting of such expenditures. In these situations, sufficient internal controls must be maintained by the employer to allow verification by a person other than the reporting employee.
Per diem allowances given instead of a dollar-for-dollar reimbursement can lighten the employee's recordkeeping responsibilities. While the employee is well advised to maintain records after providing substantiation to the employer, only the employer is required to maintain records.
A 50% deduction for the cost of business-related meals. To be deductible (1) either the taxpayer or an employee of the taxpayer must be present at the meal, and (2) the meal must not be lavish.
Record retention rules similar to those discussed above apply for deducting these types of expenses. Specifically, a taxpayer claiming a deduction for the cost of business meals generally must retain records substantiating the following information:
- The cost or amount of each separate meal expense.
- The business reason for the meal.
- The date.
- The place where the meal was eaten, i.e., the name and address or location.
- Which meal was involved, e.g., breakfast, lunch, or dinner.
- Information concerning the person or persons for whom the meal expense was taken, including occupation and business relationship. * Documentation as to the presence of either the taxpayer or an employee of the taxpayer.
A taxpayer must establish these items:
- The amount of each separate expenditure.
- The extent of business or investment use.
- The date or time of the use.
- The business purpose.
When an automobile's use reflects a combination of both business and personal driving, only the cost of business use is deductible. To calculate this component, a business-use ratio (business use/total use) is applied to the acquisition or lease cost of the asset. This ratio also must be applied to related operating costs. In this instance, records must be kept substantiating not only related expenditures, but also business use of the automobile. These records include, but are not limited to, such items as account books, diaries, expense sheets, trip sheets, expense reports, corroborating statements written at or near the time of use, and other documentary evidence (e.g., cancelled checks and receipts).
Taxpayers deducting gifts as a business expense must establish the time, business purpose, and amount of the gift. While the promotion of good will generally is an adequate description of the business purpose of the gift, a description of the relationship to the taxpayer must include information sufficient to establish a business link to the taxpayer including, but not limited to, both the name and title (or other designation) of the recipient. Also, an annual $25-per-donee deduction limitation may affect business-gift substantiation requirements. If the taxpayer does not appear to be attempting to deduct gifts-in excess of $25 made to any one donee during a tax year, the Service accepts a general listing of the donees as sufficient substantiation.
Given the specificity of property items, a tax expense deduction requires documentation detailing the particular nature of associated property. Additionally, payments for state, county, and city sales taxes, as well as any other sales tax imposed by a taxing authority, may be substantiated by receipts issued by the vendor of the item. State and local income tax payments may be verified by copies of state or local income tax returns and cancelled checks or receipts establishing payment.
Cash contributions. Receipts, cancelled checks, or some other reliable written documentation is required to substantiate cash contributions. This evidence should substantiate that the contribution was made and its amount. Contributions in excess of $250 must be substantiated by a written contemporaneous acknowledgement by the donee.
Property contributions. Additional records may need to be maintained for property contributions. For all property contributions, a receipt should be retained that contains the name of the donee, a description of the property, and the date and location of the donation. Taxpayers should retain all of these items, except for the receipt, for incidental contributions such as clothing dropped off in a bin where no receipt is obtained. Taxpayers should maintain written records to support the FMV of the property. These records should indicate how the FMV was determined. Written records of a property's basis should be retained for ordinary-income property. Property contributions of $250 or more require a written contemporaneous acknowledgement as required by Section 170(f)(8).
If a taxpayer deducts more than $500 for a property contribution, additional records should be maintained. The manner of acquisition, e.g., by gift or purchase, along with the property's acquisition date should be retained. For property held less than 12 months preceding the contribution date, a written record of the property's basis should be maintained. For property contributions valued at more than $5,000, appraisals should be obtained. A copy of the appraisal should be retained and a copy should be attached to the tax return filed for the year of the deduction.
With the increased emphasis on verifying reported tax liabilities, recordkeeping is becoming an expensive and monumental task. Documentary evidence of expenditures, supplemented by contemporaneously compiled records, diaries, and logs, provide the best defense against additional assessments. Adequate care in the production and retention of substantiating evidence is key to defending against an adverse redetermination of tax liability.