You generally must withhold federal income tax from your employee's wages. To figure how much federal income tax to withhold from each wage payment, use the employee's Form W-4 (discussed later under Hiring Employees) and the methods described in Publication 15.

Social security and Medicare taxes pay for benefits that workers and their families receive under the Federal Insurance Contributions Act (FICA). Social security tax pays for benefits under the old-age, survivors, and disability insurance part of FICA. Medicare tax pays for benefits under the hospital insurance part of FICA. You withhold part of these taxes from your employee's wages and you pay a matching amount yourself. To find out how much social security and Medicare tax to withhold and to pay, see Publication 15.

The federal unemployment tax is part of the federal and state program under the Federal Unemployment Tax Act (FUTA) that pays unemployment compensation to workers who lose their jobs. You report and pay FUTA tax separately from social security and Medicare taxes and withheld income tax. You pay FUTA tax only from your own funds. Employees do not pay this tax or have it withheld from their pay.

Have the employees you hire fill out Form I-9 and Form W-4. If your employees qualify for and want to receive advanced earned income credit payments, they must give you a completed Form W-5.

After the calendar year is over, you must furnish copies of Form W-2, Wage and Tax Statement, to each employee to whom you paid wages during the year. You must also send copies to the Social Security Administration. See Information Returns, later, for more information on Form W-2.

Purchases, sales, payroll, and other transactions you have in your business generate supporting documents. Supporting documents include sales slips, paid bills, invoices, receipts, deposit slips, and canceled checks. These documents contain information you need to record in your books.

It is important to keep these documents because they support the entries in your books and on your tax return. Keep them in an orderly fashion and in a safe place. For instance, organize them by year and type of income or expense.

Expenses.   Expenses are the costs you incur (other than purchases) to carry on your business. Your supporting documents should show the amount paid and that the amount was for a business expense. Documents for expenses include the following.

• Canceled checks.

• Cash register tapes.

• Account statements.

• Credit card sales slips.

• Invoices.

• Petty cash slips for small cash payments.

  

A petty cash fund allows you to make small payments without having to write checks for small amounts. Each time you make a payment from this fund, you should make out a petty cash slip and attach it to your receipt as proof of payment.

What if I don't have a canceled check?   If you do not have a canceled check, you may be able to prove payment with certain financial account statements prepared by financial institutions. These include account statements prepared for the financial institution by a third party. These account statements must be highly legible. The following table lists acceptable account statements.

IF payment is by...	THEN the statement must show the...
Check	Check number. Amount. Payee's name. Date the check amount was posted to the account by the financial institution.
Electronic funds transfer	Amount transferred. Payee's name. Date the transfer was posted to the account by the financial institution.
Credit card	Amount charged. Payee's name. Transaction date.

  

Proof of payment of an amount, by itself, does not establish you are entitled to a tax deduction. You should also keep other documents, such as credit card sales slips and invoices, to show that you also incurred the cost.

A good recordkeeping system includes a summary of your business transactions. (Your business transactions are shown on the supporting documents just discussed.) Business transactions are ordinarily summarized in books called journals and ledgers. You can buy them at your local stationery or office supply store.

A journal is a book where you record each business transaction shown on your supporting documents. You may have to keep separate journals for transactions that occur frequently.

A ledger is a book that contains the totals from all of your journals. It is organized into different accounts.

Whether you keep journals and ledgers and how you keep them depends on the type of business you are in. For example, a recordkeeping system for a small business might include the following items.

The business checkbook is explained next. The other items are illustrated later under Sample Record System.

Business checkbook.   One of the first things you should do when you start a business is open a business checking account. You should keep your business account separate from your personal checking account.

  The business checkbook is your basic source of information for recording your business expenses. You should deposit all daily receipts in your business checking account. You should check your account for errors by reconciling it. See Reconciling the checking account, later.

  Consider using a checkbook that allows enough space to identify the source of deposits as business income, personal funds, or loans. You should also note on the deposit slip the source of the deposit and keep copies of all slips.

  You should make all payments by check to document business expenses. Write checks payable to yourself only when making withdrawals from your business for personal use. Avoid writing checks payable to cash. If you must write a check for cash to pay a business expense, include the receipt for the cash payment in your records. If you cannot get a receipt for a cash payment, you should make an adequate explanation in your records at the time of payment.

  

Use the business account for business purposes only. Indicate the source of deposits and the type of expense in the checkbook.

Reconciling the checking account.   When you receive your bank statement, make sure the statement, your checkbook, and your books agree. The statement balance may not agree with the balance in your checkbook and books if the statement:

• Includes bank charges you did not enter in your books and subtract from your checkbook balance, or

• Does not include deposits made after the statement date or checks that did not clear your account before the statement date.

  By reconciling your checking account, you will:

• Verify how much money you have in the account,

• Make sure that your checkbook and books reflect all bank charges and the correct balance in the checking account, and

• Correct any errors in your bank statement, checkbook, and books.

  

You should reconcile your checking account each month.

  Before you reconcile your monthly bank statement, check your own figures. Begin with the balance shown in your checkbook at the end of the previous month. To this balance, add the total cash deposited during the month and subtract the total cash disbursements.

  After checking your figures, the result should agree with your checkbook balance at the end of the month. If the result does not agree, you may have made an error in recording a check or deposit. You can find the error by doing the following.

1. Adding the amounts on your check stubs and comparing that total with the total in the “amount of check” column in your check disbursements journal. If the totals do not agree, check the individual amounts to see if an error was made in your check stub record or in the related entry in your check disbursements journal.

2. Adding the deposit amounts in your checkbook. Compare that total with the monthly total in your cash receipt book, if you have one. If the totals do not agree, check the individual amounts to find any errors.

  If your checkbook and journal entries still disagree, then refigure the running balance in your checkbook to make sure additions and subtractions are correct.

  When your checkbook balance agrees with the balance figured from the journal entries, you may begin reconciling your checkbook with the bank statement. Many banks print a reconciliation worksheet on the back of the statement.

  To reconcile your account, follow these steps.

1. Compare the deposits listed on the bank statement with the deposits shown in your checkbook. Note all differences in the dollar amounts.

2. Compare each canceled check, including both check number and dollar amount, with the entry in your checkbook. Note all differences in the dollar amounts. Mark the check number in the checkbook as having cleared the bank. After accounting for all checks returned by the bank, those not marked in your checkbook are your outstanding checks.

3. Prepare a bank reconciliation. One is illustrated later under Sample Record System.

4. Update your checkbook and journals for items shown on the reconciliation as not recorded (such as service charges) or recorded incorrectly.

At this point, the adjusted bank statement balance should equal your adjusted checkbook balance. If you still have differences, check the previous steps to find the errors.

Table 3. Period of Limitations

IF you...		THEN the period is...
1. Owe additional tax and situations (2), (3), and (4), below, do not apply to you		3 years
2. Do not report income that you should report and it is more than 25% of the gross income shown on the return		6 years
3. File a fraudulent return		Not limited
4. Do not file a return		Not limited
5. File a claim for credit or refund after you filed your return		Later of: 3 years or 2 years after tax was paid
6. File a claim for a loss from worthless securities or a bad debt deduction		7 years

You must decide whether to use a single-entry or a double-entry bookkeeping system. The single-entry system of bookkeeping is the simplest to maintain, but it may not be suitable for everyone. You may find the double-entry system better because it has built-in checks and balances to assure accuracy and control.

There are computer software packages you can use for recordkeeping. They can be purchased in many retail stores. These packages are very helpful and relatively easy to use; they require very little knowledge of bookkeeping and accounting.

If you use a computerized system, you must be able to produce sufficient legible records to support and verify entries made on your return and determine your correct tax liability. To meet this qualification, the machine-sensible records must reconcile with your books and return. These records must provide enough detail to identify the underlying source documents.

You must also keep all machine-sensible records and a complete description of the computerized portion of your recordkeeping system. This documentation must be sufficiently detailed to show all of the following items.

See Revenue Procedure 98-25 in Cumulative Bulletin 1998-1 for more information.

Microfilm and microfiche reproductions of general books of accounts, such as cash books, journals, voucher registers, and ledgers, are accepted for recordkeeping purposes if they comply with Revenue Procedure 81-46 in Cumulative Bulletin 1981-2.

Records maintained in an electronic storage system are accepted for recordkeeping purposes if the system complies with Revenue Procedure 97-22 in Cumulative Bulletin 1997-1.

An electronic storage system is one that either images hardcopy (paper) books and records or transfers computerized books and records to an electronic storage media, such as an optical disk.

This summary is a record of cash sales for the day. It accounts for cash at the end of the day over the amount in the Change and Petty Cash Fund at the beginning of the day.

Henry takes the cash sales entry from his cash register tape. If he had no cash register, he would simply total his cash sale slips and any other cash received that day.

He carries the total receipts shown in this summary for January 3 ($267.80), including cash sales ($263.60) and sales tax ($4.20), to the Monthly Summary of Cash Receipts.

This shows the income activity for the month. Henry carries the total monthly net sales shown in this summary for January ($4,865.05) to his Annual Summary.

To figure total monthly net sales, Henry reduces the total monthly receipts by the sales tax imposed on his customers and turned over to the state. He cannot take a deduction for sales tax turned over to the state because he only collected the tax. He does not include the tax in his income.

Henry enters checks drawn on the business checking account in the Check Disbursements Journal each day. All checks are prenumbered and each check number is listed and accounted for in the column provided in the journal.

Frequent expenses have their own headings across the sheet. He enters in a separate column expenses that require comparatively numerous or large payments each month, such as materials, gross payroll, and rent. Under the General Accounts column, he enters small expenses that normally have only one or two monthly payments, such as licenses and postage.

Henry does not pay personal or nonbusiness expenses by checks drawn on the business account. If he did, he would record them in the journal, even though he could not deduct them as business expenses.

Henry carries the January total of expenses for materials ($1,083.50) to the Annual Summary. Similarly, he enters the monthly total of expenses for telephone, truck/auto, etc., in the appropriate columns of that summary.

This record shows the following information.

Henry carries the January gross payroll ($520) to the Annual Summary.

This annual summary of monthly cash receipts and expense totals provides the final amounts to enter on Henry's tax return. He figures the cash receipts total from the total of monthly cash receipts shown in the Monthly Summary of Cash Receipts. He figures the expense totals from the totals of monthly expense items shown in the Check Disbursements Journal. As in the journal, he keeps each major expense in a separate column.

Henry carries the cash receipts total shown in the annual summary ($47,440.95) to Part I of Schedule C (not illustrated). He carries the total for materials ($10,001.00) to Part II of Schedule C.

Henry enters annual totals for interest, rent, taxes, and wages on the appropriate lines in Part II of Schedule C. The total for taxes and licenses includes the employer's share of social security and Medicare taxes, and the business license fee. He enters the total of other annual business expenses on the “Other expenses” line of Schedule C.

This worksheet shows the information used in figuring the depreciation allowed on assets used in Henry's business. Henry figures the depreciation using the modified accelerated cost recovery system (MACRS). He purchased and placed in service several used assets that do not qualify for the section 179 deduction or the special depreciation allowance. Depreciation, the section 179 deduction, and the special depreciation allowance are discussed in Publication 946. Henry uses the information in the worksheet to complete Form 4562, Depreciation and Amortization (not illustrated).

Henry reconciles his checkbook with his bank statement and prepares a bank reconciliation for January as follows.

The only book adjustment Henry needs to make is to the Check Disbursements Journal for the $10 bank service charge. He does not need to adjust the Monthly Summary of Cash Receipts because he correctly entered the January 8 deposit of $600.40 in that record.

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Daily summary cash receipts

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Bank reconciliation