Business ownership is no longer the domain of a small percentage of the population, at least not according to the IRS. If you freelance or have a side gig, you have a business. Today, over one-third of the workforce runs a business in addition to having a full-time job. Without any other documentation, you are likely operating an unregistered business. The IRS still wants a cut of what you make, however, and that means you need to know how much you made—and be able to back it up. As well, running an unregistered business is not the best tax strategy.
There are many compliance matters that a small business owner must understand when setting up their business. This article will specifically focus on what a small business owner or freelancer needs to know when setting up a tax-ready accounting system.
At minimum, a business accounting system needs to generate reports that can be used to file the required tax returns each quarter or year. Using tax filing requirements as a minimum standard for your accounting system is advisable since it applies to all businesses. Past this, an accounting system can get very complex and is beyond the scope of this article.
The following accounting system best practices don’t need to be done in any particular order, and you may find you already have some of these steps completed. So, focus on the steps you missed or address the ones you started but didn’t complete. The first part of this article focuses on steps that should be taken before or in the early stages of starting your business, while part two centers on practices that are ongoing.
1. Separate business and personal accounts. First-time business owners often fail to segregate personal and business funds. This is especially true when a business is a “side gig” or freelance work. The first step in setting up any accounting system is to treat the business as a separate entity, which it is, and have separate checking accounts and/or credit cards.
Don’t mix business and personal accounts. If you fall behind in your bookkeeping, or neglect it completely, commingled funds will make it very difficult to identify legitimate business expenses. In addition, in case of an audit, it will be next to impossible to substantiate your deductions—meaning the auditor will likely disallow them and you’ll pay more in taxes. It’s simple to set up separate accounts and it will save you many headaches later on.
2. Pick a payroll service. Most businesses will have to pay employees, usually starting with the owner. On the surface, many payroll providers offer the same service. Providers are distinguished by the strength of their support when you encounter a problem or get a tax notice, how much help is provided in the setup process, and the quality of their HR and related services.
Online payroll services such as QuickBooks Payroll and Gusto will provide the tools you need to run payroll and some limited support, but not much else. They are cost effective but you have to know what you’re doing. Other services like professional employer organizations (PEO) will take care of most, if not all, of the paperwork, since the PEO becomes the employer instead of you.
Payroll typically requires timely payments, usually within a week or two, as well as monthly or quarterly reports. A business owner must ensure that these are properly handled by the payroll company to avoid filing fees and penalties. It’s recommended to get professional help in setting up your payroll system, such as from a CPA firm or payroll company.
3. Understand tax registrations and business licenses. In the United States, a popular type of legal business structure is the limited liability company (LLC). It’s the easiest to set up in most states and provides a versatile and flexible tax structure. Currently, the most advantageous structure for many businesses is an LLC that is treated as a Subchapter S Corporation (S-Corp) for tax purposes. However, this may not apply to all businesses, such as real estate investors, so your best choice is to consult with a tax professional when setting up your business.
In addition to the legal establishment of the business, you must have the required business licenses and tax registrations. Many times, these two services overlap and are indistinguishable. There isn’t a comprehensive guide to tell you what you need to be registered for, and many businesses operate for years without the proper licenses in place—usually due to ignorance rather than negligence.
One helpful tool for business registration is your local chamber of commerce or county office. The government wants its taxes so they are happy to tell you what to pay. Try not to rely on other business owners, as many are not compliant themselves. Just because another business has been “doing it this way for years” doesn’t mean it’s compliant with the law.
4. Choose a bookkeeping software. While you can use pen and paper for bookkeeping, it’s not recommended and you’ll save yourself a lot of time by properly setting up a bookkeeping system. As with any software, you can choose between desktop and cloud-based versions. However, there are few desktop providers now and they lag behind in ease of use compared to cloud-based providers. If you plan to do it yourself, choose a simple solution with lots of online help.
Keep in mind that bookkeeping software is almost always designed for accountants or bookkeepers, not business owners. You can easily outsource your bookkeeping to save yourself long hours learning the software and entering data. Also realize that some bookkeeping software features, like inventory tracking, can be time intensive and not financially beneficial.
Bookkeeping software is designed to keep track of all aspects of a business. However, that doesn’t mean it’s beneficial to track everything. You want your bookkeeping to provide enough data to file taxes; anything beyond that should pass a cost-benefit analysis. Be strategic about which software features you will use and don’t try to use them all.
For day-to-day management of your company, use an alternative management system like the envelope method or Profit First to avoid having to constantly log into your bookkeeping software. Usually, financial reports generated by software will be days or months out of date. This would be considered “timely” for a large company, but that’s not the case for a small business that’s trying to avoid bounced checks.
5. Document transactions and scan receipts. At the end of the year, business owners often rely on just bank and credit card statements to determine how much money they made and how much tax they must pay. While it’s acceptable to compile your financial data purely from statements, that may not be enough to substantiate your deductions in an audit. In addition, there are other tracking requirements for deductions such as mileage or per diem for lodging and meals.
Businesses are not required to provide proof or receipts in the regular course of conducting business, filing taxes, etc., but they must be able to produce those documents in case of an audit or other legal dispute. Almost all transactions are digital now, and thus easily traceable, and those that aren’t can be easily scanned. Know what to keep and to discard.
To round off your document tracking system, set up a system to track non-financial data as well. Most small business owners use their personal car for business purposes and must maintain a mileage log. If you spend time away from home on business, the trip must also be documented. In addition, you may choose to directly pay or reimburse yourself for those expenses or perhaps use the standard per diem rates if they are more favorable. Lastly, nearly all business owners will partake in a business lunch which, again, must be substantiated with a receipt and brief description about the business discussed (e.g., “Lunch with John Smith to discuss proposal”).
6. Check your numbers. At minimum, an accounting system needs to provide the necessary data to file taxes—this is the lowest bar to set. It can easily be expanded to provide better and more actionable data to a business owner and to get more insights into your company’s operations. In addition, the reports generated by your accounting system need to be verified against hard data to validate they have been entered correctly.
First, check the bank and cash balances listed on your balance sheet. In most cases, these balances should exactly match the bank statements. So, if your balance sheet says you have $5,000 in your bank account, but you only have $1,000, something is off and must be corrected. This also applies to other assets as well as loans and liabilities.
Second, check your net income statement. For most businesses, your net income amount should be how much money you made. There isn’t a hard number to verify this against, and the addition of non-cash income and deductions can make it hard to pin this number down. However, if you couple the income statement with the statement of cash flows, you should be able to tie your income in with the amount of cash actually going through your bank account.
Lastly, check your intuition against hard facts to validate what you are facing as a business owner. If you know your operating expenses should be $750 per month, for example, but your accounting system consistently states your operating expenses as $900, then you are forced to either reanalyze and reduce your operating expenses or accept that your operating expenses are $900 and not $750 and adjust your budget accordingly.
Setting up a business accounting system can be overwhelming. There are a lot of moving parts and compliance issues to address. While this might seem like overkill for a side gig, it’s required for tax purposes. However, you only need to do the initial setup once, and there are many resources at your disposal. Most CPA firms that specialize in business returns can help you with most of these best practices. Once the system is set up it only needs periodic maintenance which can easily be outsourced.
It’s important for business owners to understand the steps to setting up a tax-ready accounting system. You must have a thousand-foot view of your business, as you are the one who is ultimately responsible. You have to know how to verify key accounting information and rely on experts to help you navigate the details of your accounting system when needed. But as any good business owner knows, you should always delegate tasks not suited to your strengths and focus on what will make your business successful.
This article originally appeared on Forbes