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How to Audit-Proof Your Tax Return Forever

by on
in Tax Matters

It won't be long now and you'll be faced with the necessity of filing your 2010 income tax returns. For many, this annual ritual is about as much fun as a root canal. Sure, paying taxes isn't pain-free, but the process of gathering your records can be.  It certainly isn't rocket science.

Here's a simple six-step bookkeeping system that will put thousands of dollars of 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 the bank account -- pick one credit card that you use exclusively for business expenses.

3. These two accounts (one bank account and one credit card account) should only be used for business. Never "co-mingle" business and personal 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 business credit card account are business expenses.

4. For each major income and expense category, create a simple filing system each calendar year -- one file folder for each major category. Every time you write a check or use the credit card for a business expense, you assign that expense to the appropriate expense category and file the supporting documentation (receipt, invoice, cancelled check, or whatever) into the corresponding file folder.

5. Keep a separate file folder for all monthly bank account statements and credit card statements.

6. Use a simple bookkeeping software program to record all deposits, checks, and credit card charges. Input all transactions and assign each transaction to the appropriate income or expense category. The importance of this categorization process cannot be stressed enough -- it's the key to the whole system.

Using a software program is also a tremendous time-saver. Once you've input all your individual income and expense transactions, and assuming you've assigned each transaction to the appropriate category and filed the documentation, you've already completed all the work necessary to audit-proof your income tax return.

One final comment: If you aren't computer-savvy, that's OK. You can still use good old pencil and paper to categorize your business expenses.

I have clients who use nothing more sophisticated than a spiral notebook. Each year they buy a new notebook and label each page with a particular income or expense category.

Every transaction gets written down in the notebook on the appropriate page. At the end of the year, they add up the totals for each page, and presto, they give me an annual recap of all major income and expense categories.

Get the picture? It doesn't have to be fancy. It just has to be in writing, accurate, and supported by actual paper documents.

Whether you use your computer or not, the end result is the same: Every single transaction has been assigned to the appropriate category, and every transaction has the corresponding paper trail -- every receipt, invoice, cancelled check and credit card charge has been filed into the appropriate file folder. Should the IRS question any income or expense amount on your return, you'll be ready.

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