A Simple Filing System: Where Did I Put That Stuff?!!
Let’s face it. There are hundreds of “filing systems”, probably more like millions. Unfortunately, the most common system, employed by the majority of horse owners, is one I call the PITCHFORK ACCOUNTING SYSTEM. This system consists of throwing your receipts on the counter when we come home or in a drawer or some other "logical place" and forgetting about them until tax time rolls around. Then we load them all up (the ones we can find) and give them to our C.P.A. to magically turn into a tax return. Heaven forbid that he should fail to pick up some deduction that we feel we have coming, whether the receipt is there or not (It should be, I remember spending the money!), or that he charges us more than we think we deserve for this menial task he performs.
And, what happens come audit time? Surely the IRS will just take our word for it, that we spent that money, isn't that the reason they asked us in, to agree with us about our taxable income and the deductions we took two or three years ago? Am I getting the point across!!? No matter how boring or distasteful filing is (and I agree it is), we had better find a system that we can understand and use it.
The system I will describe to you might best be described as falling somewhere the drawer or "Modified Pitchfork System" and a truly first class or "Executive Secretary System", where nothing is ever out of place.
We are going to set up two basic types of files. The first are the PERMANENT FILES. These file are used to store our balance sheet information such as:
1) Operating Account bank statements and bank reconciliations. A cancelled check still in a bank statement is just barely better off than being lost in an audit. Cancelled checks should be attached to the related invoices and kept in the appropriate file related to the expenditure as detailed on the cash disbursements journal.
2) Fixed Asset acquisitions such as equipment, horses, buildings, land, etc. Files should be kept showing the original purchase price of each asset including such support as the original invoices for each along with non-expensed depreciable farm improvements such as fences and roads. A separate file should be kept on each major asset on the farm. The more detailed your files the better off you are, whether or not they are ever needed for a tax audit.
a) Land should include such information as a copy of the plat, deed and closing documents from the purchase.
b) Land improvements; buildings; equipment; horses; etc. are depreciable and should therefore include documentation supporting the costs of all asset acquisitions. Separate files should be kept for each major asset group and for each asset in certain cases. For example, all information on the addition of roads, fences, ponds, etc. should be kept in the Land improvements file. The same goes for tractors, hot walkers, mowers, etc. in the farm equipment file and so on. In each case it is necessary that we be easily able to establish the cost basis of any asset on the farm if and when required to do so by the IRS or at the time of a possible future sale.
Because we are in the Horse business, it would also be a wise decision to keep a separate file on each horse owned by the operation. This should include copies of the registration papers (the original registration papers should be kept in your safety deposit box), breeding and vet records, acquisition contracts, a listing of all show, racing or other awards won by the horse or where possible its get and all other records related to that particular horse.
This information is not only important in the case of an audit, it is also very useful information when evaluating the horse's contribution, or lack of same, to the operation as well as marketing information when we are trying to sell. It is also helpful when trying to determine the cost associated with a particular horse sold to see if you indeed made any money of the transaction. That is what we are in the business for, right!
3) Prepaid or other Assets.
4) Contracts, notes and so on.
The second category of files to be maintained is the CURRENT FILES. These files consist of the support for each year’s current Income Statement accounts. It is necessary for us in the case of an IRS audit to be prepared to produce documented support for each income and expense item shown on the farm's tax return.
To successfully satisfy the Service that the amounts taken on the tax return are legitimate deduction or income amounts, assuming we have successfully answered any Hobby Loss and Active Participation issues (see the related chapters on each), are legitimate, the taxpayer must be able to produce support for each of these amounts. The best support, we could produce, would include a cancelled check attached to an invoice detailing the nature of the expenditure, to whom it was paid and the amount of the charge. We must also be able to explain to the satisfaction of the agent the business purpose of the expenditure if not readily evident.
A separate file should be kept for each revenue and expense category on the Income Statement. In cases where more than one expense is paid on a given invoice or check, the expense or revenue accounts being charged should be coded directly on the support documents prior to being filed along with notes concerning any out of the ordinary items or problems related to the documents. When possible a copy of each invoice paid should be attached to the related cancelled check or a copy of the check and placed in each appropriate file. ALWAYS ASK FOR A RECEIPT OR INVOICE AS SUPPORT, FOR EVERY BUSINESS EXPENDITURE YOU MAKE! This combination of invoices and cancelled checks is the most conclusive support you can produce for the audit.
Remember, these files are your memory as well as our support. You may not have to explain the reasoning behind a check or invoice for years, if ever. However, if the situation does arise, having the original support and explanation of the transaction available to show the agent or other interested party upon demand is going to have a much greater effect on their opinion of your credibility than your trying to pull something out of the air under pressure.
The taxpayer who arrives at the audit with complete files including copies of their cash receipts and disbursements journals or computer transaction reports listing each expense paid and receipt received backed up with files containing all the related cancelled checks and invoices and expense receipts is well on his way to having a successful audit. It is also much less expensive to prepare for an audit if you can provide your C.P.A. with this sort of ammunition to work with. It can turn a normally harrowing experience into a relatively tolerable one.
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