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A sensible way to organize your paper-based and electronic information for Internal Revenue Service Schedule C, Profit or Loss From Business (Sole Proprietorship), is to create categories that correspond to the schedule's major headings: income, expenses, cost of goods sold, vehicle information and other expenses. Keep handy the IRS instructions for Schedule C, because you'll have to look up your six-digit business activity code. A tax preparation program might also be useful. Finally, you may need access to previous returns if you have deductible carryover expenses.
Gather your gross receipt and sales records, as well as records for any sales returns or allowances, copies of Form W-2 marked for "statutory employee" and 1099-MISC Miscellaneous Income forms. Statutory employees are independent workers who have payroll taxes withheld by their clients. Collect records for any other income items, such as gasoline credits or refunds. You may trigger an inquiry or audit if you fail to list income that has been independently reported to the IRS. Attach a copy of each W-2 to your tax return if you file by paper.
If you keep all your business information in accounting software, call up the program to report all expenses. You should have paper receipts for all business expenses paid in cash and written acknowledgements for any deductible charitable gifts your business makes. You may also need your credit card annual reports and checking statements for your business accounts. If you depreciate property, complete and attach Form 4562. Gather paperwork for employee benefit and pension programs and, if necessary, attach Form 5500. College paperwork that documents insurance costs, interest expenses, travel and entertainment costs, office and professional expenses, rentals and leases, utilities, wages, supplies and repairs. You'll also need records to document any home office expenses you plan to deduct.
Cost of Goods Sold
If your business involves the sale of inventory, gather your records regarding starting and ending inventory, purchases, labor costs other than payments to yourself, materials, supplies and any other costs associated with acquiring, holding and disposing of inventory. If your beginning inventory doesn't match the closing inventory amount on your prior-year tax return, attach a note explaining why.
You'll need a record of the mileage and expenses for the business use of vehicles. An excellent practice is to keep a contemporaneous vehicle expense log and record all expenses as they're incurred. The log should distinguish between business, commuting and personal mileage. The IRS specifically asks on Schedule C whether you have written evidence to support your vehicle deductions -- a good indication that you should retain all fuel and service receipts if you plan to deduct actual expenses rather than use standard mileage. You also may have to file Form 4562 if you deduct vehicle depreciation.
You'll need to keep receipts for any other business expenses. The IRS advises that you hold receipts for at least three years, your employment tax records for four years and records regarding losses from worthless securities or bad debts for seven years. If you fail to declare all income, hold your records for six years. If you do not file a return or file a fraudulent one, hold your records indefinitely.
Preparing for Audit
The IRS uses sophisticated software to determine the reasonableness of the information on your return. For example, it looks at deductible expenses as a percentage of income and becomes curious when that percentage exceeds certain limits. Keeping meticulous and current records, including a business expense diary for travel and entertainment, is the best defense against an investigation. Attach all explanations that the IRS instructions call for when filing your return, including discrepancies between the income and tax statements you receive and different amounts you claim on your tax return. The IRS lists 15 other business-related forms and schedules you may have to file along with Schedule C. Attach Schedule C along with the other required forms and schedules to IRS Form 1040 when you file your tax return.
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