Digital Recordkeeping for Modern Businesses: Apps, Tools & IRS Requirements
In the modern business world, the days of keeping shoeboxes full of crumpled receipts are fading. Most new business owners prefer to manage their finances through apps, cloud software, and digital scans. But before you shred that paper receipt, you need to know exactly what the IRS expects from your digital records.
Here is your guide to staying compliant while going digital.
1. The "Golden Rule" of Electronic Records
The IRS acknowledges that modern businesses use electronic storage systems. However, the fundamental rule is simple: All requirements that apply to hard copy books and records also apply to electronic storage systems.
If you choose to keep your records digitally, your system must be able to do five specific things:
- Index the data.
- Store the data.
- Preserve the data.
- Retrieve the data.
- Reproduce the data in a legible format.
Most importantly, your electronic system must provide a complete and accurate record of your data that is accessible to the IRS if they need to inspect it.
2. Choosing Accounting Software: What Matters?
While you can buy various software packages online or in stores to help with recordkeeping, the IRS does not endorse specific brands. However, they do provide criteria for what your computerized system must achieve to be compliant.
When choosing software or "apps" for your business, ensure they meet these standards:
- Legibility: The system must produce sufficient legible records to verify entries made on your tax return.
- Traceability: The records must provide enough detail to identify the underlying source documents (like the original invoice or receipt).
- Reconciliation: The machine-sensible records must reconcile with your books and your tax return.
The Documentation Requirement
Buying the software isn't enough; you must understand how it works. You are required to keep a complete description of your computerized system, including:
- The functions performed as data flows through the system.
- The controls used to ensure accuracy and prevent unauthorized changes to records.
- Detailed account descriptions and charts of accounts.
3. Going Paperless: Scanning and Storage Protocols
Can you scan a paper invoice and then destroy the original? Yes, but there is a catch.
You may destroy original hard copy books and records only if your electronic storage system has been tested to establish that it reproduces the hard copies accurately. You must also have procedures in place to ensure the system remains compliant with IRS rules over time.
The Risk Factor:
The IRS has the right to test your electronic storage system, including your equipment and software. If your system fails to meet requirements—and you have already destroyed the paper originals—you may be subject to penalties for non-compliance.
If you aren't 100% confident in your digital backup and retrieval capabilities, the safest route is to maintain the original hard copies.
4. Proof of Payment in a Digital Age
If you bank online, you might not have physical canceled checks. The IRS accepts certain financial account statements as proof of payment if they are "highly legible" and contain specific details.
- For Electronic Funds Transfers (EFT): The statement must show the amount transferred, the payee’s name, and the date the transfer was posted.
- For Credit Cards: The statement must show the amount charged, the payee’s name, and the transaction date.
Important Note: Proof of payment (like a credit card statement) only proves you spent money. It does not prove the purchase was a business expense. You must still keep supporting documents, such as sales slips or invoices, to show what you bought.
5. How Long to Keep Digital Records
Just because records are digital doesn't mean you can delete them whenever you want. You must maintain electronic storage systems for as long as they are material to the administration of tax law.
Generally, this means keeping records that support an item of income or deduction until the period of limitations for that tax return runs out—usually 3 years if you owe additional tax, but up to 6 years if you underreport income by more than 25%.,
Summary Checklist for IRS Compliance
To keep your digital recordkeeping "bulletproof":
- Ensure your system can index, store, and retrieve legible data.
- Keep detailed documentation on how your software processes and protects data.
- Do not destroy paper originals until you have tested your digital system for accuracy and compliance.
- Always keep the underlying invoice or receipt, not just the bank statement proof of payment.
DISCLAIMER: This content is for educational purposes only and should not be considered personalized financial advice. Always consult with a qualified financial professional before making financial decisions.