For many small business owners, the day-to-day operations of running the business can be overwhelming. It can be hard to think about properly structuring and documenting every transaction in the midst of keeping the business running, but small business owners especially need to think about properly documenting all business transactions. This can not only save financial headaches in the case of an audit, it can also help position the company better for growth or sale in the future.
In one common example, small business owners often make loans from their personal accounts to their business. With the expectation of getting paid back as their business grows, many owners do not bother properly documenting this loan as a loan. In a C Corporation, a properly documented loan would result in the shareholders or owners receiving payments with interest from the corporation. The corporation could then deduct the interest on those payments as an expense, and the owners avoid paying taxes on the principal and avoid paying double taxes in the process.
If that loan is not properly documented, however, small business owners could face problems. They won’t be able to produce documentation of the transaction, which may cause the IRS to reclassify the transaction as a dividend in the event of an audit. The loan interest is no longer deductible by the corporation and the owners will have to pay double taxes on the interest. The IRS may also reclassify the principal payments as dividends, requiring the owners to pay income taxes on the principal payments.
Improper documentation can also stunt growth. When potential buyers perform due diligence, they may be negatively swayed by lack of documentation. It can be enormously expensive and time-consuming to clear up the fallout from incorrectly documented transactions, and potential buyers or investors may be turned away if the company has too much baggage of this kind, even if it’s from early days.
Other examples of situations where small business owners need to properly document include:
Leases, even when the business is operating out of the basement or another room on the owner’s property,Employment agreements for people who perform work for the business in any capacity,Asset purchases or sales, even if it’s for small “assets” like office furniture, etc.
It may seem like overkill or an imposition to properly document everything when the business is small, but it is much easier to set up proper financial structures in the beginning than to clean up issues from improper documentation when the company is poised for growth or sale. Talking to business law and tax professionals can help small business owners navigate tax code and ensure the legality of their actions.