Your best effort to organize your books always falls by the wayside because something more urgent (or more enjoyable) comes along.  As a self-employed, unincorporated, or home business owner, can your business survive a tax audit? Is your record keeping system setup to increase the likelihood of a smooth flowing audit (it will happen eventually)? If you do your own bookkeeping, do you know if you are following good practices? Do you know what common bookkeeping errors to avoid?

If you’re serious about minimizing your business taxes, the first things to do are to clean up your books and get them up to date.  The first place you can save money related to taxes is by not being charged by your tax preparer to sort through a year’s worth of disorganized invoices, bank statements and receipts. Below are five things you can do to avoid paying extra for your tax preparer’s time, and/or to minimize the expense of an audit should this be your unlucky year.

1. Separate Your Business and Personal Finances
Find areas where you’re mixing business and personal finances, something you should always avoid. The temptation to mix your finances is huge, especially given the trend toward more sole proprietorships. The vast majority of businesses are sole proprietorships launched with credit cards, home equity lines of credit, and other personal financial resources. But this is all the more reason to be very disciplined about keeping things separate, as these kinds of companies are among the most commonly targeted for an IRS audit.

When you commingle funds, the true performance of your business quickly becomes hard to pin down. It’s a challenge to establish hard numbers for expenditures and revenues. Your and tax filing becomes more complex (and expensive due to added hours required).

The benefits of keeping clean books include potential tax advantages in the deductions you won’t miss. Keeping clean books can also keep you under the IRS radar, thus avoiding “distracting” audits. Additionally, it just makes good business sense at a strategic level because well-organized books provide clarity about the true performance of your business so you’re better equipped to make important decisions, impress lenders and investors, attract partners, and potentially sell the business for top dollar.

There are many circumstances where you’ll be confronted with choices to make about mixing personal and business finances. For example, you might have to use personal credit to purchase assets, or you might have to move money from a personal account to a business account to cover a shortfall. Perhaps you’ll need some extra cash personally and will want to take that cash out of the business. The key is making sure that you do this in a completely organized and well-documented way to minimize any negative impact.

2. Reconcile Your Bank (and Credit Card) Statements
Reconcile all of your business bank statements through the end of December. Since the review of bank statements is part of any IRS audit, you want to make sure that you don’t miss any transactions that are relevant for the tax year.  

The business checking account in your books contains a record of the transactions (checks written, receipts from customers, etc.) that involve all of the checking account activity. The bank also creates a record of the company’s checking account activity when it processes the company’s checks, deposits, service charges, and other items. Soon after each month ends the bank provides you with a bank statement. This statement lists the activity in the bank account during that month as well as the ending balance. Verify that the amounts on the bank statement are consistent with the amounts in the company’s books and vice versa. This process of confirming the amounts is referred to as reconciling the bank statement. The benefit of reconciling the bank statement is that you need to know that the amount of money reported in your books is the same as the amount shown in the bank’s records.

Because most companies write hundreds of checks each month and make many deposits, reconciling the amounts on the company’s books with the amounts on the bank statement can be time consuming. The process is complicated because some items appear in the company’s checking account in one month, but appear on the bank statement in a different month. For example, checks written near the end of September are deducted immediately on the company’s books, but those checks will most likely not clear the bank account until early October. Sometimes the bank decreases the company’s bank account without informing the company of the amount. For example, a bank service charge might be deducted on the bank statement on September 30th, but the company will not learn of that amount until it receives the bank statement in early September. From these two examples, you can see why there will likely be a difference in the balance on the bank statement vs. the balance in the company’s books. It is also possible (perhaps likely) that neither balance is the true balance. Both balances may need adjustment in order to report the true amount of cash on hand.

After you adjust the balance per bank to be the true balance and after you adjust the balance per books to also be the same true balance, you have reconciled the bank statement. Now do the same for your business credit card statements.

3. Automobile Expenses
Automobile expenses can be a major expense for a small business. You should maintain a log to keep track of where and when business travel occurred, who was seen, and what was the business purpose of the trip. While some individuals only track business use, I recommend keeping the log for all auto expenses, since those who itemize their deductions can also deduct transportation as a medical expense, and as a charitable contribution deduction if active in a charity. The business tax returns will want to know when you placed the vehicle in service, and the amount of the business, commuting and personal miles for each vehicle for the year. And if you are audited, your business travel log will be scrutinized and compared to the business appointments shown in your calendar and other journals you should be keeping. Just keeping a mileage log without notes and explanations will not be acceptable.

4. Non-Employee Compensation
You should review your records on the independent contractors you have paid to see if the government must be notified of their non-employee compensation. Employees receive a W-2 form to identify their income and withholding tax. Similarly, independent contractors who make $600 or more receive form 1099-MISC from you, with the federal and state governments receiving a copy. Contractors who are corporations are exempt from receiving this form, but individuals, partnerships and limited liability companies must receive them. If you wait until year-end to obtain the contractor’s social security number or employer identification number you might not be successful in obtaining that required information. Have your contactors fill out form W-9 to give you the needed information.

5. Check for Inconsistencies, Reasonableness, and Discrepancies
Having your bank statements reconciled and having your financial information up to date, will give you an appropriate starting point to check for general accuracies, or inaccuracies, in your books.

Before sending your information to your tax preparer, perform some type of reasonableness test on your income statement.  If you see something that doesn’t look right there is a good chance that it isn’t.  Make sure to investigate all items that do not meet these tests and ensure that there is a good explanation for each of them.  A common error is to have the same items reported in December and in January.  One method to analyze the books and find errors is to review income statements and other financials on a month to month basis, where inconsistencies are more easily identified.

Finally, run a balance sheet for the last day of the year and compare this against the balance sheet you provided to your tax accountant for your tax return last year. If any account balances have changed from amounts entered on your prior year return, make sure to identify what has changed.  Doing this yourself will save you money since your accountant will charge you to do it as part of your tax preparation.  To minimize tax issues, try to identify discrepancies and bring them to the attention of your tax preparer.

So schedule time on your calendar now to work on these items and decide now what your deadline is to get your books and records ready for tax season. If this process is painful for you, remember that it’s easier to file your business records and update your and bookkeeping system on at least a monthly basis. If you stick to a regular schedule then next year at this time you’ll be ready for tax season.  Then again, your best efforts to organize your books may still fall by the wayside because something more urgent (or more enjoyable) comes along.  If that’s you, contact me as I can take all this pain away, and your books will be clean, accurate, up to date and ready for your tax preparer to spend the least amount of time(and money) on your returns.

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