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5 Reasons to Keep Separate Business Books & Records

Many small business owners have absolutely no idea if they made money last year!5 reasons to keep good accounting records!

It’s very common for small business owners and farmers to mix their personal and business income and expenses and have little to no formal financial information with which to make decisions.

While it’s true that there’s no law requiring you to do so, failing to keep separate records for your business or farm can spell big trouble for you down the road.

Let’s find out why.

Reason #1: You’ll Need to Prove Your Business Income and Deductions in the Event of an Audit

If the IRS decides to audit your return, you will have to be able to substantiate (prove) your income and deductions.

Having separate and accurate records will clearly show the true amount of income and deductions your business generated.  If your income and expenses are all mixed in with your personal account, it will be a lot harder to prove (or even remember) what were deposits from your business versus what was money from some other source.

I can’t even remember what I had for lunch yesterday, much less what I deposited in my bank account 2 or 3 years ago!  How about you?

The IRS commonly performs a bank deposit analysis when auditing sole proprietors.

Having clear records and separate accounts will make an audit go more smoothly and will reduce the chance of having something not business-related (like a gift from your parents!) being classified as taxable income.

Worse, when you mix all of your business and personal activity together and get audited, the Revenue Agent now has access to ALL of your income and expenses, not just the business ones.

That could easily lead to more questions and a broadening of the scope of the audit!

Reason #2: To Avoid Having Your Losses Disallowed Due to Hobby Loss Rules

In this post, I discussed what hobby loss rules are, why you want to avoid hobby treatment, and what you can do about it.

In short, if the IRS determines that your business (or farm) is a hobby, you will not get to deduct any expenses that exceed your business income – no matter how legitimate they are!

Worse, your business deductions get reclassified as  Miscellaneous Deductions, which means that you can only take them if:

  1. You itemize your deductions on Schedule A
  2. Your expenses (combined with your other Miscellaneous Deductions) exceed 2% of your Adjusted Gross Income (AGI)
  3. You lose the benefit of those expenses that add up to 2% of your AGI!

Depending on your circumstances, this can result in all of your business income being taxable with no offsetting deduction for expenses!

Reason #3: To Make It Easier to Convert to Another Form of Business Or Attract Investors

At some point in the future, if your business is successful or if you need to bring in additional partners/investors, you might need to incorporate or start operating as an LLC or partnership.

Good business records will help you:

  • More easily demonstrate the profit and value of the business to potential partners or outside investors
  • Keep track of accurate business asset values, which you will need when you contribute them to your new form of business entity

Reason #4: To Increase the Value of Your Business

How can having good records possibly make your business more valuable?

Put yourself in a potential buyer’s shoes.  Would you be more likely to buy a business with messy records that are nearly inseparable from the owner’s other activities?

Would you pay more for an organized, professionally-run business with accurate records?  I know I would!

Lack of solid business records will lower the value of the business in the eyes of a buyer!

When I perform a business valuation, one reason I would commonly “discount” the value of your business (by increasing your company’s risk factor) is for having poor, inaccurate, and/or unreliable records.

Reason #5: To Make Better Management Decisions

To make smart and timely business decisions, you need to have access to the best possible financial data.

Do you really think that you will ever sit down for an entire weekend to patch together your income and expenses several months after the fact?  That’s even if you can find your records.  If they’re a big mess, you and I both know you’ll put it off and probably won’t even do it at all!

How can you possibly know when you need to bring in additional employees, expand your operations, or whether your newest marketing campaign is working without accurate records?

Relying on incomplete records will lead to you making poor decisions, which will cost you money and could even lead to you going out of business!

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