Editor's Note: This article provides general information only, and readers should consult with a competent accountant or attorney familiar with the horse business before undertaking any action based on the material herein.
Everybody has one--an unorganized pile of receipts lurking in a shoebox, or in a desk drawer, or in a filing cabinet tucked away in a corner of the garage. The question is not whether the pile of papers should be organized. The general--if sometimes reluctant-- consensus is that financial records should be put in some sort of order. The real question is twofold: which records should be kept, and for how long?
Some people obsessively hang on to every scrap of paper forever, while others do not save anything. Neither extreme makes sense from a functional point of view, according to Chris A. Humphrey, a certified public accountant and a director of accounting and compliance services for Dean, Dorton & Ford PSC. A full-service accounting and business advisory firm in Lexington, Ky., Dean, Dorton & Ford has a number of equine business clients.
"There are several reasons for business owners to keep accurate records," Humphrey explains. "First, good records can help a business owner manage the day-to-day operation of the business. Without a record keeping system in place it is impossible to know how the business is doing."
Accurate records are essential to the preparation of profit and loss statements and balance sheets, for example. The former summarizes the income and expenses of a business during a certain period of time; the latter shows assets, liabilities, and the owner's equity in the business on a particular date. Profit and loss statements and balance sheets are valuable business management tools, and both are necessary documentation when applying for a business loan from a bank or other lending institution.
Nature of the Business
The nature of the business will dictate how the records are prepared and used. A high-volume retail tack store might need profit and loss statements and sales summaries prepared on a daily basis, while monthly records might be sufficient for a small riding lesson business. The trick, according to Humphrey, is to develop a record keeping system that provides necessary information in a manageable way, without being overwhelming. Form truly does follow function when it comes to business records.
Consider the paperwork generated by one simple credit card transaction, the purchase of a halter at the local tack store.
- At the time of the transaction, the seller should provide a written receipt for the halter, identifying the item and setting out the date, time, and purchase price. The receipt provides a record of the specific sale and will be necessary if the item must be returned to the tack store.
- Charging the purchase to a credit card will generate an independent record of the transaction, a charge slip that must be signed by the cardholder. The charge slip will identify the seller, the price, the date, and the time, but it probably will not identify the specific item purchased.
- Subsequent to the sale, the cardholder will receive a monthly billing statement from the credit card company. Such statements are itemized to a point, listing the vendor and the date and time of the charge. The actual items purchased generally are not identified individually, however, making it important for the cardholder to match receipts to the billing statement. Reviewing the billing statement also allows early detection of mistakes or fraudulent charges.
- If the cardholder pays the credit card bill by check, the canceled check will provide a record of the total payment, but not of the itemized purchases. If payment is made by an electronic funds transfer (EFT), the bank's online accounting software should provide a reference number for the transaction. Again, this record will reflect the transfer of money, but it will not identify the particular purchases listed on the credit card billing statement. Later credit card billing statements also will show receipt of the payment.
- Finally, the cardholder's monthly bank statement will reflect the credit card payment by check or by EFT.
Multiply the paperwork in this simple example by dozens, or perhaps hundreds, of transactions in a month, and the magnitude of business record keeping is evident. Reviewing and organizing business records on a regular basis rather than putting everything off until one marathon session at the close of the year can make the task seem less overwhelming. At a minimum, business owners should review their records and balance their business checkbooks and any other accounts on a monthly basis.
Everyone Pays Taxes
"Second," Humphrey says, "business records are the source of information used by the business owner or an accountant to prepare federal, state, and local income tax returns, and to substantiate that information if the business owner is audited. This usually will be the same information used for business management purposes and it must be accurate."
The Internal Revenue Service generally does not specify either a particular record keeping system or the types of records that should be kept, so long as the system used accurately shows business income and expenses. Travel, transportation, entertainment, gift expenses, and employment tax records have specific IRS record keeping requirements, however. These requirements and other questions relating to record keeping should be discussed with an accountant familiar with the horse business. The IRS does require that business tax records be available for inspection if there are questions about a tax return, and well-organized records can make an audit less painful.
Many accountants will prepare tax returns based on information summaries submitted by a business owner without seeing the actual documentation for income, expenses, and other items. This common practice does not mean that the accountant will share the blame if an audit turns up tax return entries that lack adequate supporting paperwork, however. That responsibility falls squarely on the shoulders of the business owner.
"Another reason for keeping good rec-ords is economic," Humphrey adds. "Accountants bill their clients by the hour, and the better organized a business owner's records are, the less time the accountant will have to spend preparing tax returns."
Navigating through a maze of paperwork with a tax return filing deadline looming is especially problematic for both business owners and accountants, and Humphrey advises clients to make record organization an ongoing task. It is much easier to spend a few hours a week putting records in order than to set the job aside until the end of the tax year, he says.
Humphrey also suggests that business owners and accountants stay in contact with each other throughout the year, rather than waiting until tax time.
"We like to be proactive for our clients and address situations before they become problems," Humphrey says.
Keep What, and For How Long?
The IRS provides some guidance about which business records should be kept, and for how long, in Publication 583 (1/2007), Starting a Business and Keeping Records. This publication is available at www.irs.gov.
For tax purposes, a business owner should keep records that show gross receipts, purchases, other business expenses, taxes paid and refunds received, assets, and employee wage and tax information. There might be nontax reasons to keep other documents, however, and business owners should consult with an accountant and an attorney for assistance in implementing a comprehensive plan for keeping--and destroying--records.
The following are a few tips on these items.
Gross receipts represent business income from any and all sources. Business records that show income include bank deposit slips for the business account, copies of receipts given to customers, invoices, credit card charge slips, and, for independent contractors, IRS Form 1099-Misc. (It should go without saying that business owners should maintain separate bank accounts, credit cards, and other records for the business apart from their personal accounts and records. Mixing business and personal funds is an invitation to an unfavorable experience with an IRS audit.)
Purchases of inventory are items a business owner buys at wholesale and resells to customers at a retail price. Inventory is not an issue for most horse businesses, but many equine-related businesses, such as tack and feed stores, maintain an inventory of merchandise. Documents showing inventory purchases include canceled checks, credit card sales slips, and invoices from vendors.
Business expenses are expenditures that arise in the ordinary course of doing business. Most of these expenses can be subtracted from gross receipts to arrive at taxable income, and they can be substantiated with canceled checks, credit card sales slips, invoices, and records of petty cash payments. (Many businesses keep a small amount of petty cash on hand to make small payments without having to write a check. Such payments should be documented with a written record.)
Assets are property--including horses--used in a business. The IRS recommends the following information be maintained for each asset: date and circumstances of acquisition of the asset; the purchase price; the cost of any improvements made to the property; tax deductions taken during the year of acquisition (called Section 179 deductions) and subsequent depreciation deductions; deductions taken for casualty losses from fire, storm, and theft; use of the asset; and disposition of the asset if sold, including the selling price and any expenses associated with the sale.
Determining how long business rec-ords must be kept is problematic, despite seemingly straightforward IRS guidelines. In general, business records should be retained for as long as they might be useful to the IRS in resolving any questions about a tax return. The period of limitations for record retention is the time during which the taxpayer can amend a return to claim a credit or refund, or during which the IRS can impose an additional tax.
The basic limitation period is three years after the tax return in question was filed, with the period running from the date of filing. If the return was filed before the actual due date, the limitation period does not start to run until the due date.
Humphrey, who says he prefers to "err on the side of caution," recommends that business owners keep records for at least a year beyond the IRS limitation period.
If a taxpayer underreports his or her gross income by more than 25% of the gross income actually reportable, the limitation period is extended from three to six years. If a taxpayer files a fraudulent tax return, or if he or she fails to file a return at all, there is no limit on the time during which the IRS can require documentation of information.
Some business records should be kept indefinitely. These include filed tax returns; documents relating to real property, such as deeds, mortgages, and mortgages with releases showing that liens have been satisfied; corporate minutes and other documents; insurance policies and related documents; and estate- planning documents.
A Paperless Society
Dean, Dorton & Ford, like many accounting firms, is moving toward a paperless workplace, where client files are maintained electronically rather than on paper. Their accountants also recommend that most clients use commercially available accounting software to maintain their business records.
"The technology is so advanced, and electronic document storage is so much easier now, that there is no excuse for not keeping good business records," Humphrey says.
The IRS allows taxpayers to use computerized accounting systems and electronic storage for data provided the systems meet criteria for reliability and information retrieval. For example, a taxpayer using computerized accounting software must be able to use the program to produce legible documentation to "support and verify" information used to determine tax liability and the entries made on a tax return.
In theory, at least, a taxpayer should be able to destroy paper records after the records have been archived electronically. Detailed requirements for computerized accounting systems and electronic data storage can be found in Revenue Procedures 98-25 and 97-22, respectively, available from the IRS.
Hardly anyone enjoys sifting through stacks of business records, especially when the alternatives can be so attractive: going to a horse race or show, riding, or just sitting on the porch and watching horses graze. The benefits of a well-organized system for maintaining records far outweigh the hassle, however, and a good goal for everyone this year is to finally tame that mountain of unorganized paperwork.
About the Author
Milt Toby is an author and attorney who has been writing about horses and legal issues affecting the equine industry for more than 40 years. Former Chair of the Kentucky Bar Association's Equine Law Section, Milt has written eight nonfiction books, including national award winners Dancer’s Image and Noor. He teaches Equine Commercial Law in the University of Louisville's Equine Industry Program.
POLL: It's Derby Week!