How does bookkeeping affect how much you owe in back taxes?
Here’s something many people don’t know: the IRS is very often wrong when they take a stab at guessing what your income and expenses are, which means that what you actually owe in taxes could be far less than what they estimate you owe.
Why? Let’s look at how the IRS figures out how much income you have.
If you’re a business owner who accepts credit and debit cards from your customers, your credit card processor is usually required to issue you a Form 1099-K. They’re also required to send one to the IRS.
Even for personal income that is not connected to your business (for example, interest that the bank pays you for money in your savings account, or investment income from selling stocks), the bank or financial institution will usually issue you a 1099 for this income as well. The IRS gets their copy of these, too.
What this means is that the IRS has a partial picture of your income, through these 1099s and other types of similar tax documents that are provided to them by third parties. The IRS then populates all this information on your Wage & Income Transcript, which you can access online.
Related reading: How Long Can You Go Without Filing Taxes?
That’s the income side of things. What about all the expenses that you pay to keep the doors open? There’s office rent, supplies, payroll, inventory, equipment, fuel, electricity, water, trash, computers, credit card processing fees, training for your employees, and the list goes on.
For most of these types of expenses (except payroll), the IRS has no way of knowing what they are until you report them on your tax return. And the only way to get these listed accurately on your tax return is by having solid, clean, updated bookkeeping.
Nigel’s nursery: an example of how bookkeeping can affect tax liability
Here’s an example of how this plays out in the real world.
Nigel owns a growing nursery and landscape supply store, and he has a team of 5 employees who help him run his store. He’s been in business for 9 years. During the first few years, Nigel was very particular about making sure he tracked all the money that came in the door, as well as all his expenses. His system was a simple Excel spreadsheet with two tabs: Income and Expenses.
At the end of the year, he would give his accountant the spreadsheet, who would then prepare the business tax return. The first three years in business, Nigel filed his tax returns and paid his taxes on time, like clockwork.
Things got busy. Nigel hired employees, and he started forgetting to update his tracking spreadsheet. Several months would go by before he’d remember to update it—but by then, Nigel couldn’t remember the details of all the customer payments he’d accepted, bank deposits he’d made, checks he had written, and other expenses.
By year 5, Nigel had stopped using the spreadsheet entirely. By this time, Nigel felt as though he’d never get caught up—and so he stopped filing tax returns too. In the back of his mind, he worried about the IRS contacting him.
Sure enough, Nigel started receiving CP59 Notices in the mail from the IRS, demanding that he file tax returns for the past 5 years. At this point, he felt panicked. He wondered how he could possibly find the information he needed to file those returns, given that he hadn’t updated his spreadsheet for such a long time.
In a flurry, Nigel decided to Google “business bookkeeping” and came across Bench. Relieved, he discovered that Bench specializes in doing the hard work necessary to compile financial statements for all 5 years, through historical bookkeeping. What’s more, Nigel also learned that Bench partners with tax accountants who specialize in resolving IRS tax problems.
Related reading: Tax Resolution: What You Need to Know
In the end, through leveraging the expertise of Bench and a specialized tax accountant, Nigel was able to not only get his delinquent tax returns filed, but now has ongoing, accurate and current numbers to look over every month. This helps him keep the IRS happy and make informed business decisions that maximize his profit.
There was another perk, too. Nigel ended up with about $50,000 in failure to pay penalties on the back taxes he ended up owing. Through working with an accountant who specializes in tax resolution, the entire $50,000 was removed through a penalty abatement. Needless to say, Nigel was very happy with the outcome. But none of this could have happened without updated bookkeeping.