All businesses should have a permanent set of books which summarize individual deposits, 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 your returns are examined by the IRS. The general rules is that supporting documents should be retained at least until the statue 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 which do not reflect income, such as loan documents. If storage is a problem, consider microfilming 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 manufacture. Whatever method the IRS uses, you have the burden of proof if you dispute their estimate. Without adequate records, proving the IRS estimates wrong is difficult, at best. You could end up with an assessment for additional taxes, plus penalties and interest.