If your online business faces an audit, the IRS is not going to take your word for anything. You’ll have to come up with receipts, cancelled checks, bank statements, and other records to support both the amount of income you claimed and any business deductions you took. You really can throw it all in a shoebox if you want, but most business owners find it easier to use a set of file folders or an accordion file. Youcan buy one that’s already labeled with common business expense categories at an office supply store.
Here’s a brief rundown on what you need to keep as proof of income and expenses:
Income. Keep copies of your bank statements, copies of checks you’ve deposited, copies of any 1099s you received, and, if you have nontaxable income, copies of documents showing the source of that income (for example, from an inheritance). Remember, the IRS is less interested in the business income you reported than in the income it thinks you failed to report. This means your job is not really to prove the amount of income your business earned, but to prove that any income you didn’t report came from a nontaxable source.
Business expenses. Keep records showing what you bought, who you bought it from, how much you paid, and the date of the purchase. In most cases, you can prove this with your receipt and a cancelled check or credit card statement (which proves that the receipt is really yours).
Vehicle expenses. Keep records of the dates of all business trips, your destination, the business purpose of your trip (for example, to meet with a client or scout a retail location), and your mileage.
Meals and entertainment. Keep records of what you paid for, who you bought it from, how much you paid, the date of purchase, who you were with, and the business purpose of your meeting. The first four facts are often included on a receipt; write the remaining two in a datebook or calendar.
Use of property. Keep records of how much time you spent using it for business and using it for other purposes. This rule applies to “listed property,” items that the IRS believes people often use for personal purposes, including computers and cameras. (There really is a list of listed property, and you can find it in IRS Publication 946, How to Depreciate Property.) You might also want to keep track of the time you spend in your home office, to prove that you used it regularly. You can keep these records in a log or journal.
In most situations, the IRS has up to three years to audit you after you file a tax return (or after the date when the return was due, if you filed early). However, if the IRS claims that you have unreported income exceeding 25% of the income you did report, it has six years to audit you. And if you didn’t file a return or the IRS claims that your return was fraudulent, there is no audit deadline; you’re always fair game.
Based on these rules, some experts advise that you simply give up and keep all of your tax records forever. There's no harm in keeping all of your actual tax returns forever; they don’t take up much space and can help you track the financial life of your business over time. You can generally get rid of supporting documents six years after you file your tax returns. They are only required if there is evidence you filed a fraudulent return.