The tax law requires all businesses to keep records to support the gross income, deductions, and credits claimed on their income tax returns.
What records? All businesses should have a permanent set of books which summarize individual deposts, disbursements, and items of adjustment. These records should be retained indefinitely. Permanent records also include those needed to prove the basis (cost) of depreciable assets.
Supporting documents may be needed to validate the journal entries if you returns are examined by the IRS. The general rule is that supporting documents should be retained at least until the statute of limitations for a tax year has passed.
The supporting documents the IRS reviews include bank statements, cancelled checks, payroll records, invoices, and the like. You should also retain documents supporting deposits whish do not reflect income, such as loan documents. If storage is a problem, consider scanning these documents.
What happens if your records are inadequate? If you fail to retain adequate records to support the items claimed on your returns, the IRS has authority to reconstruct your income using one of several methods, including estimating increased net worth, looking at bank records, or estimating the raw materials used in manufacturing. Whatever method the IRS uses, you have the burden of proof if you dispute thei estimate. Without adequate records, proving the IRS estimates wrong is difficult, at best. You could end up with an assessment for additional taxes, plus penalities and interest.