Small Business Tip: Audit Proofing Your Business Financials Part 1

So today we’re talking about audit proofing the business. Record keeping is very fundamentals of keeping good, audit proofing your business. Record keeping is a discipline of keeping track of what is going on in your business. The goal of good record keeping is to, one provides information that helps you make good business decisions and two meet your legal obligations to the tax authorities. Record keeping is useless if good information cannot be pulled from your records. It is important that you do not fully delegate the record keeping function. You’re responsible for knowing what’s going on in your business. Even if you have a bookkeeper! If you never look at the records or understand how it is done it becomes easy for money to leak up your business without your knowledge.

Now let us move down the different kinds of records you need to keep. Let’s start with cash. As we all know, cash is the lifeblood of a business. You can’t run a business without cash. So, there are two types of cash do you need to keep track of. Cash in the bank and cash in hand. For some business types there’s barely any cash in hand because everything is electronically done. So, they hardly have cash transaction. Well they’re still a business that really deal with cash.

So, how do you deal with cash in a bank and how do you prove cash in the bank? Well, you prove cash in the bank with the bank statements and your bank reconciliations. So, at the end of every month when you get your bank statement it should be reconciled to what you have in your accounting software. If it’s QuickBooks, Zero or whatever you use, make your reconcile.

How about cash in hand? Well cash in hand obviously the bank is not going to help you keep track of that what you had to do it yourself. Which means, you have to be your own bank. You would need a cash register to keep track of cash in hand and some kind of cash lockbox. It’s important you never leave the cash in it open. It’s important that you count the balance at least once a week. Have a cash register where you track additions, which are also cash. Every time someone puts money in or takes money out that should be signed. Unless you need a large amount of cash for your business, go ahead and deposit your cash in the bank. It’s just less headache for you. I mean you don’t want to really act as your own bank. After all, you’re not in the banking business unless you’re in the banking business.

So, be sure to you keep the cash register as part of business record because if you have to prove cash, cash sales, whatever you do with cash. This cash register coming very, very handy.

Now, what are your legal obligations regarding keeping track of revenue and expenses? This is the biggest one because if you have to prove something, the IRS will either have you prove revenue expenses. So, you need a system in place to make sure that you followed a system to keep track of revenue, keep track expenses. If they are procedural in the system and you’re very consistent, then they trust your records more. But, if there’s inconsistency between your records and your system, then they’re like,”Uh, something’s not right here honey. I’m sorry, we’re going to go on our estimates and based on our estimates, here are your tax do.

You don’t want that to happen. You want to make sure you have a system of recording revenue and a system recording expenses. So, in other words if you invoice customers. At the minimum, if you don’t have a software, maybe just starting out. Get an invoice book or use sales receipts. Something that you have a systematic way of recording transactions from every customer.

So what about expenses? Expenses, copies of original copies… copies of original receipts are needed. Now, it’s okay if you go ahead and scan it and throw away receipts, that’s fine. Electronic receipts also acceptable. It’s not, the bank statement is not sufficient proof an expense. You actually, the IRS actually wants to see the receipts that the expensed, backup the expense. And there’s a special little rule for meals. Now for meal is not just enough to not have a receipt, you have to write on the receipt who the lunch was with and the purpose of the lunch.

Now let us talk about money. You the owner puts into your business. Money you put in the business could either be capital contributions or loans. This is sometimes necessary when the business does not generate enough cash to run the day to day. In instances like this, it is important the owner might need to put some money, just to keep the business going. When this is done, the business owner needs to specify, is this a loan I expect the business to pay? Or, is this a contribution to the business where, “Well, I’ll get my payments back in dividends and when I share my shares in the business.” So, you need to specify that.

Capital contribution. For the capital contributions, you better make sure you document that in your annual meeting. They should be in your agenda and meeting minutes. Also, the system or the occasions that give rise to capital contributions should be well documented in your operating or shareholders agreement. Or, bylaws depending on your structure. It’s important that when you have capital contributions you have a log which you give to your bookkeeper, so they know when they see contributions coming, not to classified that as income. This is a very common mistake. For s-corporations contributions play an important role in determining any gains to be recognized on distributions. Because, you cannot take more than you put into your business. And when you take more than you put into your business, that’s a gain and that is taxable.

Now, let’s talk about if you put your money and you want it back. This is a loan to your business. Be sure to draw up a loan agreement and just like a contribution, document that in your agenda and minutes in your meeting.

And don’t say because you’re a sole shareholder, you don’t have a minutes. When you form your corporation, that was kind of a contract you formed with your state. So, you are expected to have these minutes, even if it’s just you. I do recommend you do this with your accountant in attendance. Your accountant in attendance, so it’s not just you having this meeting. And, be sure you have a loan agreement and systematic pay back the money with interest. If not, the IRAs can say, “Well this is not a loan to the business”. You have to be very systematic about it. You cannot be random.

Now, let us talk about money you the owner get out of the business. Money you the owner gets in business can either be paycheck, distributions, loan repayments reimbursements. And, the personal expenses part is kind of mixed up with the others. I just wanted it to have his own line item because it’s some place I see a lot of problems. So, I want to talk about it separately.

So, paycheck. Paycheck is one way you can take money out of your business. Not for the sole provider. This does not apply to you because you don’t have to be in payroll. For S-Corp, C-Corp, LLC taxed as C-Corp, you do have to be on payroll. You have to pay yourself before you can actually take distributions out of your business.

Another way you can take money out is through distributions. How do you take money through payroll? Now, if you’re a sole provider, this is ‘owners draw’. If your corporation is dividends and corporation’s kind of have the staffing where they get trouble, tax double tax on their income and dividends, so it’s kind of double taxation. But you know what? Even with that, with a lower tax rate it is still a better deal for some people. Distributions are more like reward that business owner gets for running a profitable business. So, guess what? If you don’t have profit, you don’t have distribution. Because distributions can only come from profits, it’s a reward for profit. Distributions should be done quarterly, semi-annual and annually. Distributions is not, you don’t just take money out of your business just because you feel like it. It has to be systematic. You can’t, you have to remember, when you form a corporation, you form a separate entity. The business is one entity because when you went to Secretary of State and you signed the paperwork, guess what you did? You gave birth to a baby and that baby is his own person. And just because you kind of control that person does not make you the same as the person. You still have to keep things separate. And, what you do for you is for your and what you do for the business is the business. So, you can’t just treat your business as a pocketbook. When you have distribution, you should have to make sure this is documented in your meeting. It has to be declared. And, you have to go through some formal processes for doing that. Don’t get into the habit of taking money out of your business randomly. Bad habits lead to bad solutions. So, if you want better cash management in your business, the systems actually make it so much easier to manage your cash.

Loan repayments we talked about putting money in as a loan. So, the loan repayments is another way to get money out of your business plus the interest. That’s a little extra that you have. Obviously, interest is taxable so don’t think it’s free, tax free money.

Reimbursements. If you ask that we write a check from your business or you write a check from your business. You can be reimbursed. Or if you run, use your personal vehicle for errands for the business, you can reimburse yourself using the standard mileage rate. You have to make sure that you have an accountable class, accountable planning reimbursement plan in place because this protects you. We’ll talk about that in another session.

Now personal expenses. Like I said personal expenses is kind of one, wound up in the other parts but I wanted to have the line item because this is the area I see a lot of people get themselves in trouble. Like I said earlier the business is a separate entity. So, when you have personal expenses for your business. If you use your business for personal expenses, what can you do? And I’ve done it, so, well how can you, what do you do? Well, you can treat it as part of your payroll expenses. That’s one way. You can treat it as an owner draws if you’re a sole proprietor. As a maverick sole provider, a lot of these things don’t really apply to you because you’re not really separate from your business. It’s just one, you can treat it distributions. It’s not recommended, but you know if you have to. Just don’t do it too often, because what can happen is the IRAs can recharacterized as income as payroll. And then you have to be subject to payroll taxes. You can treat is as dividends if you’re a c-corporation or, this is what I recommend, just reimburse the business. Just write a check to the business and get it done with and that way you cover it. And also, if you’re going to do that, you know the records you need to keep in payroll. Keep the payroll records. Owners drawn and distribution, keep distribution of owners draw log any if reimbursed, write a memo on the check. This is how you protect yourself.

So that wraps it up for this list. I hope you learn something from this. I mean you’d learn how to properly keep records for cash, for expenses and revenues. Money you take out of the business. Money you keep in the business. As you learn how to properly categorize, expenses, assets or how to keep good records. This is an area of confusion. And we’ll learn how to properly do that, so you protect yourself. We also learn another biggie, which is… is someone you hire, are they an independent contractor or employees. Where’s the difference. Because if you wrongly classify, that’s a place you really expose yourself to audit risk.

What about in video three? Policies you should have in place to protect you. And then we go down to four, how to properly conduct your annually meeting. You don’t want to miss any of this, because you need to protect yourself as a business owner. You never know when the time comes when you might have to prove something to the IRS. So please don’t miss any episodes and I hope to see you in the next video!

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