Here’s a simple six-step accounting system that will put thousands of dollars in tax savings in your pocket and keep the IRS out of your life forever.
1. Maintain a separate bank account for your business or self-employment activity.
Never use your personal bank account for business expenses. Having a separate bank account automatically creates the “shell” for the perfect documentation system.
If you don’t have a separate business bank account, now is the time to get one.
2. Maintain a separate credit card account for your business. Same deal as bank account – choose a credit card that you use exclusively for business expenses.
3. These two accounts (a bank account and a credit card account) should only be used for business. Never “mix” personal and business financial information.
The only income that goes into your business bank account is business income. The only expenses that are paid from the business bank account and the business credit card account
they are business expenses.
4. For each major category of income and expense, create a simple filing system each calendar year: a folder of files for each major category. Every time you write a check or use your credit card for a business expense, you assign that expense to the appropriate expense category and file the supporting documentation (receipt, invoice, canceled check, or whatever) in the appropriate file folder. .
5. Keep a separate file folder for all monthly bank statements and credit card statements.
6. Use a simple accounting software program like Quicken to record all deposits, checks, and credit card charges. Once a week or once a month, enter all transactions and assign each transaction to the appropriate income or expense category.
The importance of this categorization process cannot be stressed enough: it is the key to the whole system.
Using a software program is a great time saver. Once you’ve entered all of your individual income and expense transactions, and assuming you’ve assigned each transaction to the appropriate category and submitted documentation, you’ve completed all the work necessary to verify your income tax return.
One final comment: if you don’t have any computer skills, that’s fine. You can still use a good pencil and paper to classify your business expenses.
I have clients who don’t use anything more sophisticated than a spiral notebook. Each year they buy a new notebook and label each page with a particular income or expense category.
Each transaction is noted in the notebook on the corresponding page. At the end of the year, they add up the totals for each page, and voila, they give me an annual summary of all the major categories of income and expenses.
Get the picture? It doesn’t have to be fancy. It just has to be in writing, accurate, and supported by real paper documents.
Whether you use your computer or not, the bottom line is the same: every transaction has been assigned to the corresponding category, and every transaction has the corresponding paper trail: every receipt, invoice, canceled check, and credit card charge. it has been registered in the appropriate file folder. If the IRS questions any amount of income or expenses on your return, you’re good to go.