Record Keeping for Self-Employed and Sole Proprietors

What record keeping does the IRS expect from a sole proprietorship?

A self-employed person must keep books or records sufficient to show gross income, deductions and credits, and the law generally sets no required format (26 U.S.C. 6001; 26 CFR 1.6001-1; Publication 583). A workable set has two parts: a summary of transactions (journals and ledgers, or accounting software) and the documents behind each entry.

Keep an invoice or deposit record for every payment you receive, whether or not a Form 1099 arrives; Publication 583 asks for documents showing the amounts and sources of your gross receipts.

A case is not simple when personal and business money share an account, when a year or more of receipts is unsorted, when a preparer quotes extra to sort a shoebox, or when the IRS has asked for records. See "Different for you?" at the end.

Gather first: statements for every account and card that touched the business, payment-platform reports, every Form 1099 received, invoices sent, the receipts and bills you have, any mileage or trip notes, and last year's return.

What is the simplest record keeping system for a sole proprietor?

Pay business costs from one business account, keep each month's receipts in one folder, and reconcile the statement once a month. This follows Publication 583, which advises a new business to open a business checking account kept separate from personal funds, to record expenses when they occur, and to reconcile the account each month. It calls single-entry bookkeeping (income and expenses tracked through daily and monthly summaries) the simplest to maintain and a practical start for a small business, though not suitable for everyone (Publication 583). Someone with more than one business should keep a complete, separate set of records for each.

For opening the account, see a business bank account for a sole proprietor. For choosing software, see a bookkeeping app for Schedule C.

Can I rely only on the bank feed, or do I still need receipts?

Relying only on bank transactions leaves gaps. A feed shows that money moved, and Publication 583 says proof of payment, by itself, does not establish a deduction. It tells you to keep documents such as credit card sales slips and invoices to show you also incurred the cost (Publication 583). The IRS says taxpayers generally meet their burden of proof with the information and receipts, where needed, for their expenses (IRS: Burden of proof).

A feed line gives a vendor, a date and an amount. It does not show what was bought or whether it was for the business: a card charge at a general store could be supplies or a personal purchase. For travel, gifts and car use, the elements below must also be recorded.

So match each feed line to its support: sales records or invoices for deposits, receipts or invoices for purchases, and account or loan records for transfers and borrowing. Add a purpose where the vendor name does not explain it. "Categorized" is a label in the software; "supported" means a receipt or note stands behind it. A feed is also not a reconciliation; see bank feeds are not reconciliation.

Whatever holds your books is itself a record. The IRS says examiners will request the accounting software backup file in the majority of cases where a taxpayer keeps books in it (IRS: electronic accounting software records). What a valid receipt shows is in IRS receipt requirements.

What should I write down for each expense?

Capture the same few things for every expense: how much, when, what (and where), who, and why. Most come from the receipt; the "why" is usually yours to add.

Costs that are partly personal, such as a phone or internet bill, also need the business share written down; see mixed-use expenses and the business percentage.

Record each item at or near the time. Publication 463 says a record kept then has more value than a statement prepared later, when recall is poor, and that a weekly log counts as timely. It also says you need not copy what a receipt already shows, as long as your records and receipts complement each other in an orderly way. For travel, gift and car expenses it says a written statement of business purpose is generally needed, but not when the purpose is clear from the circumstances (Publication 463).

Which expenses need extra records: car, travel, gifts and meals?

Travel away from home, gifts and car use need more than a receipt. The Code allows no deduction for travel, gifts or listed property such as a car unless you prove, by adequate records or by sufficient evidence corroborating your own statement, the amount, the time and place (or date and description), the business purpose and the recipient's business relationship (26 U.S.C. 274(d)). Publication 463 adds that amounts you approximate or estimate cannot be deducted (Publication 463).

Sources: Publication 463 (chapters 2 and 5), 26 U.S.C. 274 and 26 CFR 1.274-5(j)(2): a mileage rate replaces the record of actual cost, never the record of business miles, time and purpose. To choose between the two, see standard mileage rate or actual car expenses. Meals during a business trip go with the travel record.

If you claim car expenses, the return asks about the car. Schedule C, Part IV (used when Form 4562 is not required for the business) asks for the date the vehicle was placed in service for business, the business, commuting and other miles, and whether you have evidence to support the deduction and whether it is written (Schedule C; instructions). Publication 463 allows one entry for a round trip and, in some cases, a record kept for part of the year; the full log rules are in mileage log requirements.

How do I handle cash purchases and small items?

Pay from the business account or card where you can, because the statement then records the payment. When you pay cash, get a receipt. Publication 583 says that if you cannot get a receipt for a cash payment, you should make an adequate explanation in your records at the time of payment. It also says to avoid checks payable to cash, to attach a petty cash slip to the receipt for small cash payments, and, if you must write a check for cash to pay a business expense, to keep the receipt for that payment (Publication 583).

For travel, gift and car expenses, a receipt is not required for an expense under $75, except lodging, or for a transportation charge when a receipt is not readily available. The amount, date, place and purpose still go in your log (26 CFR 1.274-5; Publication 463). That dollar line comes from those rules, so do not treat it as a general rule for every expense. Keep the receipt for a small item when you can; when none exists, write a one-line entry with the date, amount, vendor and purpose at the time of payment.

Cash you receive is a separate question: see cash business sales records.

Can I keep receipts as photos or scans instead of paper?

Yes, if the electronic system meets the IRS requirements; a pile of photos in a phone is not automatically enough (Publication 583). What qualifies, and when the paper can be thrown away, is in scanned receipts instead of paper.

What do I hand my bookkeeper each month and at year end?

Hand over the same small set each month, then a few extra items at year end. The goal is that your bookkeeper can match every statement line to a document or a note without asking you.

Sources: Publication 583 and Schedule C instructions. Schedule C asks whether you made any payment that requires Forms 1099.

If a contractor gives you no tax ID, you may have to withhold from reportable payments, and you may owe any amount you should have withheld (26 U.S.C. 3406; Instructions for the Requester of Form W-9). See collecting tax IDs from contractors. If you sell goods, also send stock records and what is needed to value year-end inventory; see inventory or supplies for small sellers.

Why send a monthly batch instead of 100 photos at year end?

A year-end pile of unlabeled photos must be sorted, dated and matched to statement lines before bookkeeping starts, and each expense's purpose then depends on memory. A monthly batch keeps the matching small and the notes close to the time. Photograph each receipt whole and flat when you get it, drop it into that month's folder, and add the one-line purpose then.

For who categorizes and who chases receipts, see what your bookkeeper needs from you. To compare doing it yourself with hiring help, see doing your own books or hiring a bookkeeper.

How long do I keep everything?

Generally until the period of limitations for the return runs out, which is usually 3 years after you file (a return filed early counts as filed on the due date). Longer periods apply in listed cases, such as income left off the return that is more than 25% of the gross income shown (for a business, counted before the cost of sales), no return filed or a fraudulent return, and records about property last until the period ends for the year you dispose of it (IRS: How long should I keep records; Publication 583; 26 U.S.C. 6501(e)). Keep copies of filed returns too. The full table is in how long to keep business records.

What does a shoebox of unsorted receipts cost me later?

Unsorted receipts can cost forgotten expenses and deductions you cannot support, and if the records end up inadequate, a penalty.

• Forgotten expenses. Publication 583 says you may forget expenses when you prepare your return unless you record them when they occur (Publication 583).
• Unsupported deductions. The burden of proof is yours: you must be able to prove certain elements of an expense to deduct it (IRS: Burden of proof).
• Penalty. The regulation says negligence includes a failure to keep adequate books and records or to substantiate items properly (26 CFR 1.6662-3). The accuracy-related penalty is 20% of the part of an underpayment attributable to negligence (IRS: Accuracy-related penalty). Whether it applies depends on the facts, and the IRS may remove or reduce some penalties for good faith and reasonable cause.
• Sorting work. Whoever prepares the return must sort first. If a quote for books or a return is higher because of unsorted records, ask what sorting it includes.

For the full picture, see penalties for not keeping business records. If receipts are already gone, see lost receipts for business expenses.

Example

All amounts are in US dollars and are illustrative.

A photographer with one account and one folder per month

A photographer earns US$60,000 and spends US$18,000. All business money goes through one business account and one card. Each month the photographer reconciles the statement, matches each charge to a receipt and adds a one-line purpose, such as "memory cards, wedding shoot." At year end each of the US$18,000 of expenses has a receipt and a purpose note behind it, in twelve monthly folders with twelve reconciled statements.

A contractor paying some jobs from a personal card

A contractor pays some job costs from a personal card and others from the business account, so each statement mixes the two and every line raises the question "business or personal?" Opening a business account and paying all business costs from it, starting next month, lets the account do the sorting from then on. The earlier months stay mixed and still have to be sorted.

A seller with 200 loose receipts in December

A seller reaches December with 200 loose receipts and a year of bank feeds showing 600 transactions. All 600 transactions need review and a category, with the matching sales record, purchase receipt or transfer record found for each, and the 200 receipts are in no order. Matching them in one sitting depends on memory of the whole year. The same work done monthly is about 50 transactions at a time, with the receipts fresh. A preparer who has to sort the 200 receipts first may quote extra for that work.

Different for you?

• A year or more of receipts and bank activity is unsorted, personal and business money are mixed, or a preparer quotes extra to sort a shoebox: every line generally has to be sorted and matched to a statement before the books show business income and expenses clearly, and a monthly routine set so the next return starts from organized books. See catching up on overdue books, or rebuilding books from bank statements if you have only statements; also fixing commingled business and personal funds and what drives catch-up bookkeeping cost. For the sorting itself, get bookkeeping help.
• Returns for earlier years were never filed: see Schedule C expenses for unfiled years. Records for several years have to be assembled before those returns can be prepared; bring them to bookkeeping help.
• The IRS sent a letter or opened an audit: see an IRS notice to your business and an IRS audit of a small business. Reply by the date printed on the letter; the records it asks for have to be found and sorted first. Bring them to bookkeeping help if they are not in order.
• Your business is a corporation (including an LLC that elected to be taxed as one), or an LLC with partners: this page covers Schedule C filers; see S corporation bookkeeping, books after an S corporation election and partner capital accounts.
• You are paid by clients abroad or pay costs in other currencies: see income from foreign clients without a tax form and expenses paid in foreign currency.