Tax and financial advice from the Silicon Valley expert.

What records are required to preserve your tax deductions?

As we begin a new year, many people are puzzling over what records they should keep and what they can throw away.

Unlike other areas of our legal system, taxpayers have the burden of proof to substantiate they are entitled to the deductions that they claim on their income tax returns. In other words, we are “guilty until proven innocent” or are required to satisfy the IRS (or other tax authorities) that we entitled to the deductions that we claim.

Basically, we are required to document the Payment and the Purpose for the items that we deduct. This means you shouldn’t throw away your documents immediately after your income tax returns are prepared and filed!

The payment (including who was paid, the amount, and date of payment) can be documented using a cancelled check or a credit card statement. These days, banks no longer return cancelled checks, and in many cases we don’t even receive paper bank statements. You will need to have access to these documents when you are examined by the tax authorities, which may be three or four years after filing your income tax returns. (More in the event of fraud or a substantial understatement of tax liability!) Since you probably won’t have access to them online more than a year or so after the statements are issued, I recommend that you get paper statements, including copies of the cancelled checks. If you have to pay a fee to get them, pay it. You can then scan these documents to save them on your computer, but keep a current backup in case your hard disk crashes!

The purpose can be documented using invoices and receipts. In most cases, a cancelled check or credit card statement isn’t enough to substantiate the purpose. In some cases, there isn’t enough information on the receipt to document a deductible purpose. In that case, it is a good idea to keep a copy of promotional material explaining the expenditure. (I am helping with an audit where an agent is proposing to disallow deductions for a business coach despite a letter of explanation from the coach and having invoices to document the expenses!)

Some items require longer record keeping. For example, the purchase documents for securities should be kept until the statute of limitations has expired after they are sold! You should keep quarterly or annual mutual fund statements showing the reinvestment of dividends. The IRS is trying to reduce this burden by requiring the mutual fund companies and stock brokerage companies to provide cost information when securities are sold. Sometimes, these companies just don’t have the information, such as when securities are transferred between companies.

Taxpayers who have interests in pass through entities like partnerships, limited liability companies and S corporations should keep documents showing amounts paid for their investments in these companies and the Schedules K-1 for all years so that a history of reinvested earnings less deductions and distributions can be substantiated. The IRS is routinely asking for this information to determine whether a taxpayer has sufficient investment in the entity to claim a tax loss.

Records should be kept for the purchase of major assets, like a residence, jewelry, furniture and appliances. Records for major improvements should be kept. These records can be helpful not only for tax documentation but for documenting losses for insurance claims.

Most of us just escaped the requirement to establish the “carryover basis” of inherited assets. If possible, we should be prepared in the event it is reenacted. (This means your executor or trustee will need to know when your acquired your assets and how much you paid for them. Good luck to them with that!)

Businesses should keep a file of purchase receipts for depreciable assets. The records are important for both income tax and property tax documentation.

The tax authorities are accepting technology updates, so “paperless” computer records (scanned copies) are being accepted. There is software available to help organize these records. Again, be sure to keep a backup, including offsite backups in case of a disaster.

Remember that receipts for charitable contributions should include a statement that no goods or services were received in exchange for the gift, or what the value of goods or services received was.

Your income tax returns are considered permanent records. You are supposed to keep them throughout your lifetime. Your executor or trustee can dispose of them after your death. (Seven years after death is a “safe” time for disposing of them, unless there is an audit or tax ligitgation still in process.)

Keeping good records can help preserve deductions and save tax dollars. It can also keep your stress level down and help you sleep better at night knowing you can substantiate your deductions.

When having your tax returns prepared, a good question to ask your tax return preparer is what records you should have to support what is reported on the return.

The IRS has two excellent publications on this subject available at their web site,
Publication 552, Recordkeeping for Individuals and Publication 583, Starting a Business and Keeping Records

Tax and financial advice from the Silicon Valley expert.