What specific financial and operational records must my small business keep to be prepared for a California tax audit?

To be prepared for a California tax audit, you must keep complete and accurate records that support all income, expenses, deductions, and credits claimed on your tax returns. California law requires you to maintain all records necessary to determine your correct tax liability. Here are the steps to ensure you have the required documentation: Step 1: Collect All Gross Income Records You must save all documents that show the sources and amounts of your business's gross income. These include sales invoices, cash register tapes, bank deposit slips, credit card processing statements, and bank statements. Step 2: Document Every Business Expense Keep detailed records for all business expenses you deduct. This includes canceled checks, cash receipts, vendor invoices, and credit card statements. Organize these by category (e.g., rent, utilities, supplies, advertising) and by year. Without a receipt, an expense may be disallowed. Step 3: Maintain Employment and Payroll Records Per the Employment Development Department (EDD), you must keep payroll records for at least four years. These include employee W-4 forms, timecards, payroll registers showing wages and deductions, W-2 copies, and evidence of payroll tax deposits. For independent contractors, keep all 1099 forms and signed contracts. Step 4: Preserve Asset and Property Records Keep all records related to business assets, such as vehicles, equipment, and real estate. This includes purchase invoices, closing statements, and records of improvements. These documents are essential for calculating depreciation and any gain or loss when you sell the asset. Step 5: Organize Sales and Use Tax Records If your business sells tangible goods, you must maintain records for the California Department of Tax and Fee Administration (CDTFA). Keep a sales journal, resale certificates from customers, purchase invoices for items you resell, and all records showing the amount of sales tax you collected and paid. Important details and nuances: You must generally keep all records for a minimum of four years from the date the tax return was due or filed, whichever is later. Digital records are acceptable as long as they are legible and can be provided to an auditor in a readable format. It is critical to keep your business finances entirely separate from your personal finances. Warnings and limitations: The burden of proof is on you, the taxpayer, to support all items on your return. If you lack adequate records, an auditor can disallow your claimed deductions and credits, resulting in additional taxes, penalties, and interest. Different state agencies (Franchise Tax Board, EDD, CDTFA) can conduct their own separate audits. This is general information and does not constitute legal advice. For complex situations, consult with a qualified California attorney.