Recordkeeping Hotline

Recordkeeping Alert

As a result of Tax Reform, recordkeeping is now necessary in some areas that never required records before. Crucial: Keep flawless records.

IRA contributions. For most people, the new rules have cut out deductible Individual Retirement Account contributions. If you or your spouse has a company pension plan and your Adjusted Gross Income is greater than $50,000 ($35,000 for single taxpayers), your IRA contributions aren’t deductible. However, nondeductible contributions to IRAs are still slowed (generally up to $2,000).

Recordkeeping alert: Taxpayers who have both deductible and nondeductible IRAs must now begin keeping special, detailed records of all their contributions for tax purposes. Reason: When you withdraw money from your IRA, the IRS aggregates all your IRA accounts together and treats the withdrawal as if it were both from your deductible and your nondeductible contributions, even if they were in separate IRAs. Result: Part of every withdrawal is going to be taxed, and part of every withdrawal is going to be tax-free.

Since the deferred earning on IRAs are taxed at withdrawal, every withdrawal must be broken down into three parts to figure out the tax:

Earnings on the IRA. (100% is taxed at withdrawal whether the earnings are from deductible or nondeductible contributions.

Return of a deductible contribution (i.e., contributions made before 1987, while you were still allowed to deduct the contribution on you tax return). It’s taxed at withdrawal because it wasn’t taxed in the year you made the contribution.

Return of a nondeductible contribution (i.e., contributions made in 1987 or after that will not be deductible on your tax return). It’s not taxed at withdrawal because it was taxed in the year you made the contribution.

   Income shifting. Gifts to children under age of 14 that generate investment (unearned) income over $1,300/year will be taxed at the parents’ tax rates.

Recordkeeping alert: Avoid mixing this type of unearned income with the child’s earned income (which is always taxed at the child’s own rates no matter how much he/she earns). Put the unearned income into an account that is separate from the earned income so there will be no question as to how to treat the income for tax purposes.

Meal and entertainment expenses that you incur in the course of your business are only 50% deductible. This limit applies whether you are eating out alone or entertaining clients in order to get new business. Included in this limit: Food, beverages, cover charges, gratuities, taxes, theater tickets, etc.

Exception: An employment who is reimbursed for these expenses by his employer doesn’t have to worry about this rule once he has properly accounted for them to his employer. The employer, rather than the employee, takes the 50% deduction.

Recordkeeping alert: Don’t lose or misplace a single receipt for meal and entertainment expenses. Keep a diary to record the details, especially if you entertained others. Carry this diary around with you at all times.

Interest Recordkeeping Requirements

The IRS requires that you document fully the flow of funds for all loans you take in order to determine the deductibility of the interest.

Personal mortgage interest on two residences is fully deductible up to certain limits. The deductibility of other interest depends on how the funds are used.

For example, funds you borrow for the purpose of making investments are deductible to the extent of your investment income. Personal interest isn’t deductible. Interest that you pay on funds used to purchase a passive activity or real estate is lumped with the gains or losses from that activity. To the extent that there’s a net loss, the interest may not be deductible because of the limitations inherent in those transactions.

The recordkeeping requirements are very stringent. In the past, if you borrowed money on a margin account, the IRS presumed that the interest was for investment purposes. Now the burden is on you, the taxpayer, to show proof of the flow of funds.

Advice: If you borrow money and want to get a tax deduction for the interest, keep careful records to indicate the uses and applications of the monies borrowed. Also, keep records proving you repaid the principal. Obviously, if you have a choice of which loan to repay first, you should repay the loan that gives you the least deductibility of interest.

Retaining Records

Most records have to be held for only three years after the due date of you tax return. That’s when the statute of limitations expires for tax audits by the IRS and refund claims by the taxpayer. But some records should be kept indefinitely, especially those relating to the acquisition of property, whether by purchase, gift, or inheritance. Reason: If you ever sell the property, you can’t determine profit or loss without proof of its original cost or other tax basis.

Lost Records

John and Louise Kranc deposited all their records with their accountant in order to prepare their tax return. The accountant lost the records. The Krancs then argues that the substantiation requirements for their deductions should be waived because it wasn’t their fault that the records had been lost. Tax Court: The Krancs were out of luck. They should have kept copies of the records they gave to the accountant.