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Author Archive for Kim M. Larsen EA CTFS – Page 4

You Can Do 1031 Real Estate Exchanges

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

Have you heard about 1031 real estate exchanges? It turns out they are a great way to save money on taxes. You may not realize this, but paying income taxes on the disposition of rental, business, or investment real estate is voluntary. You have another option!

Even people who have heard of 1031 real estate exchanges often don’t take advantage of them. Perhaps it’s because the name makes it sound like something too difficult to mess with. The truth is that the process is simple; don’t let the word “exchange” fool you.

The Basics of the 1031 Exchange

Here is what you need to know: the Section 1031 tax-deferred exchange is merely a sale and a purchase. It involves four parties: 1) the seller (you), 2) the buyer, 3) the seller of your new property, and 4) a qualified intermediary who knows how to qualify your sale and purchase as tax-deferred. The process requires only a few necessary steps:

  • Hire an intermediary.
  • When you sell to the buyer, the intermediary holds onto the money. Don’t touch the money yourself.
  • You then purchase your new property using the funds being held by the intermediary.
  • All of the taxes are deferred as long as you receive no cash and do not obtain debt relief!

Who Can Act as Intermediary

For your sale and purchase to qualify for tax-deferred status, your intermediary must be someone impartial who does not benefit from the exchange. Specifically, you cannot have had a business relationship with the person in the last two years[1]. That means the ordinary people you may think of to help with your finances—your attorney or accountant—won’t work.

Don’t get discouraged. Professional intermediaries are available who specifically handle these kinds of situations on a daily basis. You can do a quick online search for “1031 intermediary” and find plenty of candidates. Because they are fairly common, you can usually get a fairly good price (perhaps less than $500) on hiring an intermediary.

Tip: Be aware that like any purchase of services, hiring an intermediary does carry risk. They are a business, and although it’s not common, it is possible to come across dishonest intermediaries who steal their clients’ money. Be sure you check the company’s background. Also, intermediaries can go bankrupt. This would entirely throw off your sale and purchase if the funds from the first sale are missing. That means you won’t be able to complete the exchange. You’ll have to pay the taxes, and you won’t have the money from the sale—bad news all around.

Most professional intermediaries are legitimate companies that make their money through helping clients to save on taxes. However, you should always protect yourself and your investments. Make sure you go with a company with an established reputation, and check into options to protect your money, such as bonds or an insurance policy. Also, ask the intermediary if they offer some type of protection for your funds.

Time Limits on Making an Exchange

Okay, so most of this doesn’t sound too complicated. Don’t let the simple process make you get lax. Section 1031 sets hard, fast rules about how long you can take to complete an exchange. Be efficient; meet the deadlines. If you don’t, you lose out on your tax-deferred advantage, no exceptions or second chances. Here’s the information you need:

  • Start Date—The date on which you close the sale for the property you are selling triggers the “initial transfer date”. Once you have relinquished the property, the Section 1031 exchange officially begins.
  • Identify Date—Yes, you have a time limit on how long you can take to identify the property you intend to buy. You should formally identify your possible choices by the forty-fifth day after the initial transfer date[2]. Please note that this is not the date by which you must purchase the property; you merely need to have a few specific options picked out.
  • Close Date—The close date is not the day you close the sale on your new property. It is actually the date on which the exchange is fully completed and you have identified the new property title in your name. The closing of the exchange must be completed within whichever of the following two time frames is shorter[3]: 1) 180 days after the initial transfer date, or 2) the due date of your tax return.

Before you begin to panic, remember that you are allowed to extend the due date of your tax return. You may even be able to get the full 180 days by extending your return. So, if your exchange closes after October 17, file the extension to get more time to complete process.

Other options also exist to buy you a little time. When you know it may take a while to find a suitable replacement property, you can delay the start date. How? One way is to offer your potential buyer a triple net lease to occupy the property until you’re ready to close[4].

How to Prove Identification

You may have noticed that you need to formally identify a property by the forty-fifth day after initial transfer. Ugh, more paperwork, right? Fortunately, it’s easy enough to record your identification of a property. Just put down the earnest money, and you have your evidence that purchase of the replacement property is in process. If you haven’t put down earnest money, you’ll have to sign a document that you provide to the qualified intermediary[5].

Keep in mind that you’re allowed to identify up to three replacement properties regardless of fair market value, whether you’re selling one or multiple properties[6]. You can identify more than three new properties if the total fair market value of the properties does not exceed 200 percent of the fair market value of the properties you sold. The deadlines may be strict, but these rules allow plenty of flexibility in choosing new properties. Even better, the Section 1031 rules work for pretty much any real estate (rental buildings, vacant land, business facilities), as long as it’s domestic and not for personal use[7].

In fact, you can even build on vacant land or rehab a building with a build-out or construction exchange[8]. When identifying the replacement property, you simply include plans for the structure or build-out you will have constructed (make sure this is completed within the designated 180-day period). The qualified intermediary then pays out the funds to the contractor as work is completed.

All you have to remember to qualify for tax-deferral is that all of the proceeds from your original sale must be used to acquire a replacement property. Do not collect cash on the deal. Do not attempt to reduce your debt through the exchange. If the property you purchase is a fixer-upper and did not cost the full amount you sold the original property for, simply complete enough improvements (through your intermediary) within the 180 days in order to use up all the funds. Otherwise, you have all the same options for selling real estate that you normally would, including owner take-backs[9], also completed through the intermediary.

Special Rules about Buyers and Sellers

You may be wondering if certain individuals, like relatives, are excluded from taking part in the sale and purchase. The good news is you are allowed to make the exchange transaction with someone you are related to, but you will be disqualified for tax deferral if an exchanged property is sold again within the next two years[10]. This only applies in cases of siblings (full and half), parents, grandparents, spouse, and descendants (biological and adopted)[11]. Entities in which you own (directly or indirectly) more than fifty percent in value are also considered related parties for this purpose.

Selling a property is not always easy. You’ll be happy to know that Section 1031 also allows “reverse exchanges”[12]. This simply means your intermediary can buy the new property with money you put up in advance before you have sold your original property. Be aware: the 180-day time frame still applies, with the start date taking place once you close on the new property. You’ll need to sell your original property by then to avail the tax advantage.

If you’d like to take advantage of these tax savings, be sure to contact a knowledgeable intermediary who can ensure the correct process is followed. Special rules exist for particular types of property, such as those being converted to rental properties, so make sure you’re working with someone who has experience with your type of situation and understands all the details. The rules get more complicated when you start trying to exchange personal property (e.g., office equipment) or intangibles like a business personality. Keep it simple with real estate exchange to get maximum return for the least effort.

  1. Reg. Section 1.1031(k)-1(k). ↑
  2. IRC Section 1031(a)(3)(A). ↑
  3. IRC Section 1031(a)(3)(B); Reg. Section 1.1031(k)-1(d). ↑
  4. Private Letter Ruling 8118023. ↑
  5. Reg. Section 1.1031(k)-1(c)(2). ↑
  6. Reg. Section 1.1031(k)-1(c)(4)(i). ↑
  7. IRC Section 1031(h). ↑
  8. PLR 200842019. ↑
  9. IRC Section 453(f)(6). ↑
  10. IRC Section 1031(f)(1). ↑
  11. IRC Sections 1031(f)(3); 267(b); 707(b)(1). ↑
  12. Revenue Procedure 2000-37. ↑
Categories : Capital Gains, Exchanges, Rental Properties, Tax Planning

Your Guide to Tax Deductions on Business Entertainment

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

When you own a business, you’re likely to entertain a few partners, associates, or clients throughout the year. These informal meetings are a great way to brainstorm ideas outside the office. It also allows you to build rapport with the people most important to your business. However, the IRS has rules for exactly where you can reasonably conduct business when it comes to tax-deductible business entertainment. Simply put, some places are considered a business setting, and others are not. Fortunately, the rules are pretty straightforward.

Entertaining in a Business Setting

What exactly constitutes a business setting? It used to be that a “quiet business meal” was a tax-deductible activity[1]. That meant you were not required to actually discuss business in order to get a deduction. Although that is no longer the case, the business meal has set standards for defining business settings.

A business setting, by IRS definition, is a place where you can discuss business without significant distractions from the conversation. Settings considered conducive to business talks include[2]:

  • At your home
  • At a restaurant or hotel dining room, as long as there is no distracting entertainment
  • At hotel bars or cocktail lounges, as long as there is no distracting entertainment

Basically, anywhere you can sit down and have a conversation without distraction constitutes a good setting for business discussions, as far as the IRS is concerned. The IRS also considers the hospitality room at conferences clearly to be a business setting; therefore, displaying or discussing your products there is always deductible entertainment that creates goodwill for your business[3].

To deduct your expenses, you must establish (through documentation) that the expenses were directly related to your actively conducting business or were attributable to an actual and substantial business discussion. This includes business meetings at a convention[4].

What exactly is entertainment that is directly related to business? It means that two things must be true prior to committing to the expenditure[5]:

  1. You expected a specific business benefit other than goodwill in the indefinite future, such as the generation of income (note that you do not have to actually get the expected result).
  2. You participated in an actual business meeting, discussion, negotiation, or authentic transaction at the location (or you were prevented from doing so by circumstances beyond your control).

Attending a convention or professional association meeting fits under these guidelines[6].

Entertaining in a Non-Business Setting

Occasionally, you may find yourself talking business in a location that the IRS does not approve for business entertainment. Do you remember that “no distracting entertainment” stipulation? If the IRS thinks a location offers little or no possibility for actively engaging in a business discussion, they don’t consider the meeting tax-deductible. These places include[7]:

  • Sporting events, theaters, night clubs, and social events (e.g., cocktail parties)
  • Meetings with a disinterested party (or parties) at a country club, athletic club, golf course, cocktail lounge, or vacation resort, even if other relevant parties are present
  • Restaurants, bars, or other dining establishments that have distracting entertainment

Putting the Rules in Practice

This advice should give you a basic understanding of which expenses you can deduct. How about a practical example? Let’s assume you have a friend who installed a new phone system for his business. This system both saves him money and makes his business look more professional. You decide to take your friend to lunch to discuss how he purchased the system, as well as how it works and is maintained.

In this case, your lunch with your friend is deductible because 1) it took place in a business setting and 2) you met with the intention of gaining a benefit to your business, which you may or may not have actually gotten.

In addition, you can also deduct entertainment expenses that are associated with a business discussion in your office, directly related entertainment (as defined above), or a convention or professional association meeting. For example, if you took that same friend to a golf resort directly following lunch, you may deduct the golf as associated entertainment. That’s handy information, right?

Associated entertainment is a legitimate business deduction because it is a way for you to build your business. If you and your associates or clients both like golf, then it makes sense to use golf as a way to build your business relationships. The only price you have to pay for these tax benefits is taking the time to thoroughly document your activities.

Recording Your Proof

As always, you will need to provide proper documentation regarding your tax-deductible business entertainment. Wherever you keep records for expenses, be sure to note all the details, including who attended, where you met, what was purchased, when it occurred, why the meeting was planned, and how much everything cost. By keeping the appropriate records, you audit-proof your directly related entertainment deduction.

As a final tip, be sure to record all this information within one week of the activity. One week qualifies your records with the IRS’s timely records safe harbor[8]. As long as you’ve kept notes, you don’t even need a receipt for expenses under $75[9]. So, get out there and enjoy yourself while you build up your company!

  1. Reg. Section 1.274-2(f)(2)(i). ↑
  2. Reg. Section 1.274-2(f)(2)(i)(b). ↑
  3. Reg. Section 1.274-2(c)(4). ↑
  4. Reg. Section 1.274-2(a)(1). ↑
  5. Reg. Section 1.274-2(c)(3). ↑
  6. Reg. Section 1.274-2(d)(3). ↑
  7. Reg. Section 1.274-2(c)(7). ↑
  8. Reg. Section 1.274-5T(c)(2)(ii)(A). ↑
  9. Reg. Section 1.274-5(c)(2)(iii). ↑
Categories : Business Expenses, Entertainment, Receipts, Records

You Can Deduct Rental Losses by Qualifying as a Real Estate Professional

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

Do you manage rental properties on the side? Even if real estate is not your primary profession, you can benefit from tax advantages by qualifying as a real estate professional. Rest assured, your primary employment does not necessarily inhibit your ability to qualify; however, qualification does depend upon how many hours you put into property management versus other employment. You can even gain the same advantages if your spouse qualifies as a real estate professional (if you file taxes jointly).

What Are the Benefits?

Once you are classified as a real estate professional, you are eligible for passive loss tax deductions. These require the government (as your partner) to pay their portion of the taxes. When you have the proper tax advisor helping you to plan accordingly, you have a good chance of getting your IRS partner to provide their portion earlier. This means you’ll have more money free to invest and build your profits with.

As a qualified real estate professional, you can deduct your rental properties’ passive losses immediately, regardless of each property’s income level. If you do not qualify, you may not be able to deduct rental property losses until after the property is sold (unless your joint income is less than $150,000).

How to Qualify as a Real Estate Professional

Qualification depends on your rental property management spending for the course of the year[1]. You or your spouse will qualify if you:

  • Spend greater than 50 percent of your personal service work time participating in real property businesses that you materially take part in or in real property trades; or,
  • Spend greater than 750 hours of your investment analysis and personal service work time participating in real property businesses that you materially take part in or in real property trades.

Here’s an example. Let’s say you work 926 personal service hours throughout the year managing your properties and 920 hours on your W-2 job running your law firm (not including sick days, holidays, or vacations). In this scenario, you would pass both requirements to qualify as a real estate professional. That means you if you materially take part in your rental properties, you may deduct their losses. Just keep in mind that time spent on investment analysis counts toward the hours requirement but not the greater than 50 percent requirement[2]. Also, one spouse must completely meet the requirements. You and your spouse cannot combine your hours together. However, tax law deems that if one spouse qualifies, then both are considered real estate professionals for tax purposes[3].

What Exactly Is “Real Property Businesses or Trades”?

You may have noticed that the requirements hinge on your time spent in real property businesses or real property trades[4]. The terms apply not only to rental properties. In fact, any of the following count toward your service hours:

  • Rental
  • Leasing
  • Conversion
  • Management
  • Operation
  • Brokerage trade or business (including real estate agents)
  • Construction
  • Development
  • Reconstruction
  • Redevelopment
  • Acquisition

Please note: Any work performed as an employee does not count towards the service hours requirement. The exception to this is if you, as an employee, are a five percent owner in the business[5] (i.e., you own more than five percent of your employer’s capital or profits interest, outstanding stock, or outstanding voting stock.

How Do You Prove It?

Now you know what the requirements are, but the IRS obviously requires proof on your part. They will not simply take your word for it that you spent X number of hours working on your business and trades. Fortunately, the IRS has an audit guide for rental properties that lists two proofs an examiner will check for[6]:

  1. You must log the hours spent and services performed during those hours, and provide this documentation when requested. The requirement to track your service hours is discussed in Reg. Section 1.469-5T(f)(4). Acceptable forms of evidence[7] include identification of provided services and approximate hours spent based on narrative summaries, calendars, or appointment books. Just find a way that works for you to track your time and stick to it.
  2. You must provide documentation detailing the amount of time logged in other activities. This allows the examiner to see whether the claimed hours make sense.

To sum things up, you can increase your legal share of government subsidies pertaining to your rental properties. One way is for your total income to be below the threshold. In that case, you can deduct losses up to $25,000. Otherwise, you must qualify as a real estate professional.

  1. IRC Section 469(c)(7)(B). ↑
  2. Reg. Section 1.469-9(b)(4). ↑
  3. IRC Section 469(c)(7)(B)(ii). ↑
  4. IRC Section 469(c)(7)(C). ↑
  5. IRC Section 469(c)(7)(D)(ii). ↑
  6. IRS Passive Activity Loss Audit Technique Guide (ATG), Training 3149-115 (02-2005), pp. 2-5, 2-6. ↑
  7. Ibid., p. 4-7. ↑
Categories : Cost Segregation, Depreciation, Passive Income & Losses, Rental Properties, Shared Equity, Tax Planning

You Can Get Big Tax Deductions from Your Home Office

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

Have you considered making deductions for your home office, but figured it wasn’t worth it? You should probably consider it more seriously. Even a small home office can save you thousands in out-of-pocket taxes. In fact, you can claim these deductions even if another office for your business is located outside your home. The IRS actually has special rules that allow the tiniest of offices to qualify. Don’t believe it? A man named Albert Mills actually (and successfully) defended a deduction for his office stationed in a 422 square-foot apartment[1].

Of course, there is a catch. You can’t just throw together any set up and tell the IRS you have an office in your home. They do have requirements you’ll have to follow to get the tax benefit. As long as you follow the tips in this article, you can also find out why small home offices can generate big money savings.

Let’s Find the Deductions

With an office in your home, you’ll be able to make deductions for two main types of tax savings. First, you can deduct a portion of your home expenses, like mortgage, property taxes, rent, and utilities[2]. Second, you can deduct the miles for the commute back and forth between your home office and your outside office[3].

How does this add up in terms of dollars? Let’s say you have an office about fifteen miles from your home. With a home office, the commute between the two now counts as business miles, which are deducted at a rate of $0.56 per mile (the standard mileage rate). So, your two-way commute generates a deduction of $16.80. Making this commute five days per week for fifty weeks generates a $4,200 deduction! Think about it—you would have had a $0 deduction for this without your home office.

What Are the Rules?

Important: For the IRS, the main consideration when designating a space in your home as an office is that you use it exclusively for business. This means you cannot use the space for personal reasons at all during the tax year[4]. But, don’t worry. You do not have to designate an entire room as an office. You just have to keep your office area dedicated to business. It doesn’t even require walls or partitions separating it from the rest of the room[5].

Additionally, the IRS actually provides a bit of leniency for those with very small homes. They allow what they call “de minimis” personal use[6]. You still can’t use your home office for non-business reasons, but they allow that passing through the area for personal reasons is fine. In one case, for example, a man had to pass through an office space built in a walk-through closet in order to reach his bathroom[7]. The court decided in his favor.

Just don’t get too lax with the “de minimis” exception. The courts deny this exception in cases of storing personal items in the office space[8] or hosting occasional family meals in it[9]. If you pass through the area, you’re fine. If you’re actually using it for personal uses, you’re probably breaking the exclusive use rule.

The Minimalist Home Office

Tax law states that your home office must be the principal office for your business in order to qualify for this deduction. This means you should be performing most of the administrative and management activities for your business at the office in your home. The good news is you don’t need a lot of space to make the area your principal office.

Would you like to know how to create a one square-foot office space? Just buy a tall, narrow cabinet or shelf that extends all the way to the floor. Store all your business documents, files, and supplies there. When working at home, you can simply pull up a small table and chair, and voila! You have a home office that cost you little time or money.

Whatever room your mini office is in, you can engage in personal activities anywhere in the room except where the cabinet is. Then, claim only the area of the cabinet space on your tax deductions. You can claim as much space as you use exclusively for business use. A mini office won’t generate big savings on home expenses, but it can create significant deductions on vehicle expenses.

Now, you see why even a small office space can be beneficial. The size of your business space makes no difference. Just devote some space in your home exclusively to business purposes and make sure it qualifies as the principal office for your business. Rather than just commuting to the office when you leave your home, you’ll be racking up miles of deductions for your vehicle expenses.

  1. Albert Victor Mills, TC Memo 1991-592. ↑
  2. IRS Form 8829. ↑
  3. Rev. Rul. 99-7. ↑
  4. Sam Goldberger, Inc. v Commr., 88 TC 1532. ↑
  5. Prop. Reg. Section 1.280A-2(g)(1). ↑
  6. Lauren E. Miller, TC Summary Opinion 2014-74. ↑
  7. Carl D. Hughes, Jr., TC Memo 1981-140. ↑
  8. Elmer Stalcup, TC Memo 1995-43; but see Ronald Culp, TC Memo 1993-270, in which the court did allow the de minimis exception for storage. ↑
  9. Paul M. Sengpiehl, (1998) TC Memo 1998-23. ↑
Categories : Business Expenses, Home Office, Tax Planning

Tips to Increase Your Home Office Tax Deductions

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

Although it may not seem like it, the IRS is not out to make tax preparation as difficult as possible for you. If you make errors, it causes them headaches, too. That’s why they try to accommodate your reasonably documented calculations for home office deductions. According to the IRS in its home office deductions publication, “You can use any reasonable method to determine the business percentage” of your residence[1].

Methods Suggested by the IRS

In that same publication, the IRS then goes on to suggest two methods that may be easy for small business owners to implement:

  • Number of Rooms—This method is just what it sounds like. If all your rooms are approximately the same size, you can divide the number of rooms used for business purposes by the number of rooms in your house. It’s actually fairly simple; however, the calculations will be less precise than with methods in which you measure the size of your office space.
  • Gross Square Footage—For a slightly more in depth calculation (but still relatively simple), you can calculate gross square footage. Multiply the office’s length by its width. Then, divide that number by the total area of your house.

Either of these methods works fine, but it turns out there’s a different calculation that may better benefit your finances.

Net Square Footage

When you calculate net square footage, you only calculate the useable portion of your home. It takes a little more figuring, but you’ll come up with a more accurate number that increases your deductions and save you money. How? Because when you take away from the calculations the parts of your home that cannot be used as office space, you reduce the denominator by which you’re dividing. And, that equals a greater percentage of your residence being considered business space.

Areas that are subtracted to find net square footage include bathrooms, stairways, hallways, outside walls, water heaters, foyers, and heating and cooling equipment. This method is used in cost accounting standards[2] and in commercial real estate[3]. This means you have documented standards for using net square footage to calculate assignable space in your home, since cost accounting standards are used with government grants and contracts.

As long as you keep accurate records, you’ll only have to make this calculation once—unless, of course, you move or change your office space. Tip: Simply measuring the square feet of each assignable room will give you the same number as taking out measurements for bathrooms, hallways, and other spaces that are not available for use.

Form 8829

Despite the fact that the IRS itself states any reasonable calculation method may be used, the IRS Form 8829 only shows an option for the gross square footage calculation[4]. Don’t let that fool you. The instructions for this form clearly specify that you may use other reasonable calculation methods so long as they accurately reflect your business percentage.

Let’s check out an example so you can see the benefit of taking a net square footage measurement. For the example, assume you have a 2,600 square-foot home with eight rooms, excluding bathrooms. When you subtract the common areas that are unassignable space, you have 2,000 useable square feet, of which your office takes up one, 270 square-foot room.

Calculating gross square footage, you divide 270 by 2,600, getting 10.38% business area. Calculating by number of rooms, you take 1 divided by 8 and end up with 12.5% business area. However, the net square footage method takes 270 divided by only 2,000, making your business area 13.5% of the total house.

Using the number of rooms method, you actually allot 20% more space to your office. But, using net square footage, you increase the office portion by 30% more than using gross square footage. As you can see, that can increase your deductions significantly when you consider that accounts for 30% more of your mortgage interest, property taxes, rent, insurance, utilities, pest control, maintenance and repairs that benefit the whole house, or depreciation.

If the IRS allows you multiple options for deducting home office expenses, it makes sense for you to explore them. Under the right circumstances, the number of rooms method can yield greater deductions than gross square footage, and it’s simple to use. But, net square footage will always increase your deductions over the gross square footage method. Make sure you consider your options and get the most tax savings possible!

  1. IRS Pub. 587, Business Use of Your Home (2013), p. 10. ↑
  2. http://www.whitehouse.gov/omb/procurement_casb/ ↑
  3. http://www.cfcre.com/glossary.htm#N. ↑
  4. IRS Form 8829, Expenses for Business Use of Your Home (2013). ↑
Categories : Depreciation, Home Office, Tax Planning

You Can Make the Most of Tax Deductions on Employee Parties

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

If you’re going to throw an employee party, know that you are entitled to a tax deduction for this business expense. However, be careful in how you go about it. It turns out that there are two different kinds of deductions for business-related entertainment expenses—50 percent deductible or 100 percent deductible.

When tracking entertainment deductions, it’s best to keep these two types separate from the beginning. That means keeping two separate accounts for them. So, what is the difference?

50 Percent Deductible Entertainment

Most expenses for entertaining employees or other business contacts will fall into the 50 percent deductible category. You can consider this your usual account for these types of expenses. Here’s an example. Let’s say you take a team out to lunch following a training session. The lunch tab falls into the 50 percent deductible classification.

The Employee Party and 100 Percent Deductible Entertainment

Unlike business lunches, other expenses are exempt from that 50 percent cut, meaning they are 100 percent deductible[1]. The primary example of this is the employee party. When an entertainment expense is chiefly for the benefit of your employees, it may qualify as 100 percent deductible entertainment. Read on to determine whether your party qualifies:

  • Which Activities Qualify—According to the IRS, qualifying activities include holiday parties, annual picnics, and summer group outings. You can also deduct the cost of maintenance for employee benefit, such as keeping up a golf course, swimming pool, bowling alley, or baseball diamond. The important thing to remember about this is that in order to qualify, the IRS must deem that these expenses are primarily for the benefit of your employees[2].
  • What the Law States about Benefit—How do you know if your use of time or facilities meets the definition of employee benefit? A sample case may make the term clearer. During one year, American Business Service Corporation rented a powerboat at a rate of $1,000 per day on forty-one separate days. The boat was used for single-day recreational cruises both for employees and their guests. Any employee was eligible to sign up in advance, and the choices were made on a first-come, first-served basis. The court’s decision indicated that the full $41,000 was deductible. Here’s why[3]:
  1. The cruises were primarily for employees.
  2. The decision on who participated did not favor owners or other highly-compensated employees over other employees.
  3. Documentation was kept that recorded who participated and when.
  4. And, the activities sufficed for the “ordinary and necessary” business purpose test.

How Does This Fit into Your Business?

For tax law purposes, the term “primarily” means greater than 50 percent[4]. So, if you take two employees (who are not your family members) on a recreational cruise, then that activity is more than 50 percent for the benefit of employees because employees make up two-thirds of the group.

This definition does not only apply to numbers of people participating. For instance, if you own a vacation home, and you allow your employees to use it more days out of the year than you do, your vacation home now qualifies for an entertainment deduction! You simply make clear that the home was used for an ordinary business-use reason.

Normally, recreational expenses are not something we think of in terms of business expenditures. Unlike, for instance, traveling for a conference, your employee entertainment[5] does not need to fit any definitions for being directly related to business. The terms for employee entertainment are a bit looser. You simply need to pass the “ordinary and necessary” business purpose test[6]. All this means is the expense should be appropriate to and helpful for your business[7]. Keeping your employees motivated and making your business a competitive employer are perfectly sound reasons for providing employee entertainment.

Exceptions to Watch Out For

You must keep in mind that these activities and facilities must primarily benefit employees. Given this stipulation, you need to understand that certain individuals are considered a part of “tainted groups”. Tainted groups[8] include highly compensated employees (those who earned more than $115,000 in 2014[9]), any person who owns 10 percent interest or more in your business (called a 10 percent owner), or any family member of a 10 percent owner[10]. This includes siblings (full and half), ancestors, spouses, and descendants (biological and adopted).

Obviously, you as the business owner are a member of the tainted group. This does not mean you can’t party with the employees; it just means you have to make sure the partying is mostly for the employees, and watch out for the greater than 50 percent rule. Participants should be more than 50 percent from outside the tainted group for your activity or facilities use to qualify.

Keeping Records

Important: Make sure you document the facility usage or activity attendance[11]. You can use any reasonable measurement, such as the number of days of use, the number of times used, or the number of employees participating. The most important aspect of these measurements is that your records prove the uses.

Here are a couple of tips for making sure your documentation meets IRS standards:

  • Always note the business reason for any entertainment expenditures, whether it’s an annual morale-booster or a celebration for a newly acquired contract. Write this down and keep it with your other account documentation.
  • Let the person who prepares your taxes know that you have two separate categories of entertainment expenses, 50 percent deductible and 100 percent deductible. You can make the whole process easier by keeping separate accountings of each from the outset.

With this advice, you’ll keep your employees pleased and your accounts squared away without much difficulty. Don’t be afraid to join in the fun yourself! Tax-deductible employee entertainment is fairly simple to keep straight as a business expense when you understand what qualifies as 100 percent deductible.

  1. Reg. Section 1.274-2(f)(2)(v). ↑
  2. IRC Sections 274(n)(2); 274(e)(4). ↑
  3. American Business Service Corp. v. Commr., 93 TC 449. ↑
  4. For example, see Rev. Rul. 63-144, Questions and Answers 60 through 66. ↑
  5. Reg. Section 1.274-2(f)(2)(v). ↑
  6. IRC Section 162(a). ↑
  7. E.g., Capital Video Corporation v Commr., 90 AFTR 2d 2002-7429 (CA1) November 27, 2002. ↑
  8. IRC Section 274(e). ↑
  9. http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Definitions ↑
  10. IRC Sections 274(e)(4); 267(c)(4). ↑
  11. Reg. Section 1.274-5T(a)(2), referring to items in IRC Section 274(e), which includes employee entertainment expenses. ↑
Categories : Business Expenses, Employees, Entertainment, Receipts, Records, Tax Planning

How to Make Your Proprietorship a Corporation

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

As a business owner, converting your sole proprietorship to a corporation can have tax advantages. When you’re ready to incorporate your business, the first thing you’ll need to do is prepare and file your corporate documents[1]. You probably already guessed that paperwork needed to be filed, but hold on there—your business is not a corporation yet. Filing the required documents is not the only step in the process.

Transferring Assets

Filing incorporation documents creates an empty corporation. Your business, however, continues operating as it always has, as a sole proprietorship. For your business to fill that empty corporate shell, you have to move your assets over to the corporation in exchange for stock. Basically, when you are incorporating your business, it becomes its own entity rather than an extension of you. Here’s a tip: You don’t have to transfer all of the assets to the corporation. You can keep some under your name. In fact, it would be wise to consult your tax adviser about which assets are better kept in your name.

In the case that you maintain control of your corporation, the exchange of assets for stock is tax-free[2]. How do you know if you control your corporation? For tax law purposes, “control” means that directly following the exchange, you own at least 80 percent of the combined voting power over all the stock and you own at least 80 percent of each of the stock classes without voting rights[3]. This rule of the tax-free exchange always applies, regardless of when you form the corporation.

Be aware: Your family’s stock (including that of your spouse) does not count toward your 80 percent ownership. If, for example, after the exchange you own 70 percent and your spouse owns 30 percent, you do not meet the control criteria. That means you lose the tax-free exchange. Luckily, there are ways around this problem. Your spouse can join you on the transfer, such that both of you are contributing property for the stock. By making the exchange together, you qualify for tax-free status as a group[4].

Considerations When Doing Business with Your Corporation

Since your corporation is a separate entity from you, you have effectively created a new person for tax purposes. This means that you and the corporation do not share assets, and you cannot use each other’s assets without certain consequences. After all, you can’t just use your neighbor’s assets without compensating the person, right?

Here are some scenarios you’ll want to consider:

  • Using Corporate Assets—What if you would like to use your corporation’s assets? You simply have to arrange the use like you would with any other unrelated business acquaintance. You can treat your borrowing of corporate assets like any of the following situations:
  • Compensation,
  • A fringe benefit,
  • A purchase,
  • A lease,
  • A dividend, or
  • Any other economic arrangement business people might enter into.

You should be aware that because you control these arrangements between you and the corporation, the IRS will keep a close eye on the terms you arrange. If the IRS thinks you are mishandling such an arrangement or interchanging your assets with the corporation’s assets, it has the authority to reallocate your deductions, income, and assets in the manner it approves[5].

Usually, these reallocations will not be to your benefit. So, you need to protect yourself when dealing with your new corporation. That means documenting all your transactions and using fair market value terms to the best of your ability.

  • Contributing Debt—When you incorporate your company, it’s not only assets that you can transfer to the corporation. You can also transfer your business debt, such as mortgages and outstanding loans[6]. For tax purposes, this poses no problem; however, your creditors may have a different opinion.

For an asset tied to debt, such as an office building, you will probably need approval from the creditor before transferring the asset to your corporation. It’s not a big deal if you don’t get approval, though. You can always make arrangement with your corporation to compensate you for the use of assets still in your name (e.g., by paying rent to you).

  • Dual-Purpose Assets—Even after careful doling out of assets, you will probably still have some items that you use for both business and personal uses. Your car is an example of these. In such cases, you will have to make your own reasonable decisions based on how the assets are used. The best strategy is to talk to your tax adviser about your options for dual-purpose assets.

When determining how to classify these dual-purpose assets, you may want to consider liability. Incorporating your business does a wonderful job of protecting your personal assets. This is because business creditors are then limited to dealing with the corporation’s assets.

  • Handling Third Parties—When you transfer assets, some of those may have third parties involved. Any permits, licenses, or bank accounts, for instance, will need to be changed and put into the name of the corporation. They cannot remain under your name. It may cost money to make these changes, but by doing so, you avoid the cost of contract penalties and additional taxes. These costs are just part of changing your business over to a corporation.

This article gives you a good overview of how to handle incorporating your sole proprietorship. Now you know what to be thinking about (and documenting!) when it’s time to make the change. Good luck in your endeavors, and be sure to check with your accountant when it comes down to the nitty-gritty!

  1. The necessary documents and process for filing vary between states. ↑
  2. IRC Sections 351(a); 361(a). ↑
  3. IRC Section 368(c). ↑
  4. See Burr Oaks Corp., 43 TC 635, 651 (1965), aff’d, 365 F2d 24 (7th Cir. 1966), cert. denied, 385 US 1007 (1967). ↑
  5. IRC Sections 482; 7701(o). ↑
  6. IRC Section 357(a), (c). However, in some instances, you may recognize gain. ↑
Categories : Corporations, Depreciation, Receipts, Records, Tax Planning

How to Protect Your New Business Investment and Deduct It from Income Taxes

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

Buying a business is an exciting time. You’re sure to feel the promise of new success; however, don’t let that rush of adrenaline get the best of you. When you invest in a business, remember to keep your head in order to protect your investment.

How You Buy

You have two primary options for buying a business. The simplest way is to just buy all of the company’s stock. If you’re interested in a corporation, all you have to do is purchase 100% of the current owner’s stock. Presto! You now own the corporation.

The other option is to purchase the company’s assets, which can be more complicated. If the business you’re interested in is a sole proprietorship or a single-member LLC (that is taxed as a proprietorship), then stocks are not an option; you will buy assets[1]. However, you can also buy assets when purchasing a corporation. Hint: See the tips below for why you may want to do this.

The big advantage to an asset purchase is that the money you invest increases the basis of the individual assets. What this means for you is that you can depreciate them and eventually recover the investment cost. Any premium you pay that’s in excess of the assets’ value can also be deducted[2].

Your Purchase Affects Your Taxes

One thing to keep in mind is that you usually have multiple options for purchasing. And, each decision you make regarding your business will affect your taxes. So, make sure you understand these two things:

  • Making an Asset Purchase—If you purchase a corporation through stocks, your investment money goes towards basis in the stock. This means you don’t own the company’s assets; the corporation does. However, this is not the best situation for you because you cannot depreciate the stock. The only tax benefit you will get from stock is when you sell it. Furthermore, the corporation’s assets will already have a depreciation schedule.
  • Making Use of Your Depreciation—What you can do instead, to help recover the cost of your investment, is make a hybrid purchase[3]. However, a hybrid purchase is a complicated process, and you will need your tax advisor and an attorney to assist you along the way. Basically, a corporation you already own, or a corporation you form, buys the stock of an S corporation[4]. The difference is you will then treat the purchase like an asset purchase for tax purposes. You will set up the basis of the assets, as normal.

After purchasing the S corporation’s stock, you’ll have to sign an IRS Form 8023[5]. Just keep in mind that all stockholders will need to sign the form[6]. This includes those of the buyer, the seller, and (if you live in a state with community property laws) the stockholders’ spouses.

Issues When Purchasing Stocks

A primary concern when purchasing stocks is protecting yourself from liability, both future and past. If you go the stock purchase route, you could be liable for any problems caused by the previous owner. That’s right—you just bought the history of the company. That means any past grievances brought up by employees and any product issues brought up by consumers can be stacked up against you, and the victims have a right to sue you.

To avoid these situations, make sure you address them in your stock purchase contract. The seller should agree to pay all past debts and taxes. Also, make sure the seller includes language to indemnify you from lawsuits that arise from the time period of previous ownership. Of course, this does not stop people from suing you. They still can. What the contract ensures is that you can then get the previous owner to pay any costs incurred under this liability.

Things to Consider When Purchasing Assets

When you purchase assets, it means you are buying each bit of the company separately. You buy the name, the property, the inventory, etc. During this process, you may have to deal with third parties, which can be a headache. Third party transactions can also end up costing you additional money. Make sure you’re away of the details, including whether you will have to substitute your name on future documents, before signing the final contract.

On a positive note, asset purchase differs from buying stock in that you are free from past liabilities of the business. You buy the business’s parts, not the entity itself. The benefit of this is that any issues arising from past ownership stay with the previous owner; they are not your responsibility. Just play it smart; antifraud laws can protect creditors. You may be at risk for accepting liability in the following cases[7]:

  • You specifically agree to take on past liabilities;
  • The sale is made as a “de facto” merger;
  • Your official status is a “continuation” of the previous owner’s business;
  • The purpose of the sale is to evade liability;
  • The product you manufacture is the same as the seller did.

If one of these situations applies, be sure to made release of liabilities a part of the contract. Just as with a stock purchase, the seller should agree to indemnify you from lawsuits and pay accumulated debts.

Understanding the Seller’s Incentives

Of course, your business purchase is not going to be beneficial only to you. If that were the case, the seller would not go through with the deal. The best transactions are those that are mutually beneficial. So, what exactly is the seller looking for?

Capital Gain

Sellers are looking to make capital gains rather than ordinary gains (those from the operation of the business). The capital gains are taxed at a lower rate, which means the seller benefits when the sale can be classified as such[8]. With a sale of assets, the seller ends up with a mix of gains from income and capital (including losses).

This doesn’t mean a seller won’t negotiate with you on the type of sale, but they will probably raise the price to cover their losses. One situation in which the seller’s return may be negatively affected is the hybrid corporation sale method. If you find yourself in the position of seller, you should check with your attorney and your tax advisor about what tax rates will apply (especially if you face a gains tax from previously operating as a C corporation[9]).

Remember that with the new Obamacare tax (3.8 percent on net investment income), your stock and asset sales will be taxed. If you operate as a C corporation, you cannot avoid this. As an S corporation, you may be able to reduce this tax in the case that the income was active rather than passive[10].

Protection from Future Liability

Just as you want to protect yourself from past liability, the seller wants to be protected from future liability at the hands of your ownership. For this reason, the stock purchase is usually the preferred method for a seller. It means you have taken over responsibility for the company as an entity.

Whether buying or selling, consider the benefits of each purchase type. Gaining an understanding of the options helps to protect your investments and protect you from undue liability. Remember, always have a professional look over the contracts with you.

  1. See Rev. Rul. 99-5, Situation 1 for LLCs. ↑
  2. The amount is generally considered a goodwill amount, which you amortize over 15 years. IRC Section 197(a); (d)(1). ↑
  3. IRC Section 338(h)(10). PLR 200649015. Also see Reg. Section 1.338(h)(10)-1(c)(2). ↑
  4. Reg. Section 1.338(h)(10)-1(c)(1); (d). ↑
  5. Form 8023, Elections Under Section 338 for Corporations Making Qualified Stock Purchases, Rev. February 2006. ↑
  6. Reg. Section 1.338(h)(10)-1(c)(3). ↑
  7. CCA 200847001; Dayton v Peck, Stow and Wilcox Co., 739 F.2d 690, 692 (1st Cir. 1989). ↑
  8. Reg. Section 1.338(h)(10)-1(d). ↑
  9. See this article on built-in gains. ↑
  10. Prop. Reg. Section 1.1411-7(a)(1). ↑
Categories : Business Expenses, Capital Gains, Receipts, Records, Start Up, Tax Planning

What the Statute of Limitations Means for Your Tax Records

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

When you went into business, chances are you weren’t imagining grand evenings filled with paperwork. Maybe you thought tax records were a thing you would think about once a year and have your accountant deal with. But, the truth is, as you progress in business, you come to realize that record-keeping for your taxes needs regular maintenance. In fact, even after you breathe a sigh of relief once that return has been double-checked and sent off to the IRS, you may need to make a change to the document.

That’s where the statute of limitations comes in. It refers to the periods of time during which both you and the IRS may make changes to your tax return (not just audits). Those time frames are clearly delineated in IRS publications[1].

Here they are:

  • No limit if you did not file a return
  • No limit if you filed a fraudulent return
  • Three years after filing if you filed on time (or with extensions), you did not understate your income by 25 percent or greater, and you did not file fraudulently
  • Six years after filing if you filed on time (or with extensions) but you understated your income by greater than 25 percent
  • If you filed an amended return or already made changes to the original return (like a quick refund claim), either three years after filing or two years after paying the tax
  • Seven years from filing for a claim filed for a bad-debt deduction or loss from worthless securities

Keeping Appropriate Records

Aside from letting you know how long you have to make changes to a return, the statute of limitations also lets you know how long the IRS has to audit your return. If an audit occurs, you are going to need all of your tax records to prove your deductions. What does this mean for your record keeping habits? Hang on to those records until any chance of audit has passed.

The following are a few guidelines for making sure you hold on to the appropriate records long enough:

  • Employment Tax Records—If you have employees, you need to save your employment tax records for four years after whichever date comes later, the date payroll taxes were paid or the date they were due. An easy way to do this is simply to keep six separate drawers in your filing cabinet for each tax year. Every year, discard the sixth drawer when it’s statute of limitations expires.
  • Records for Assets—You have certain assets that are pertinent to your tax return for as long as they remain in the depreciable category. Examples of such assets include your office building, computers, desks, and even your car. If you are depreciating those assets, they will be on your tax return. Otherwise, if you are using Section 179 to expense the assets, you may be able to recapture the depreciable class life.

For example, let’s say you purchased a desk for $1,500 and depreciate it over the seven year Modified Accelerated Cost Recovery System (MACRS) life, which takes eight years. You’ll still have to prove depreciation in the eighth year. So, you need the record of the original purchase in the eighth year and through the eleventh year to meet the three year statute of limitations (the time during which this purchase is subject to auditing). The example works the same if you used Section 179. Any assets with more than a one year class life should be kept in a separate, permanent file so they don’t get tossed out with files whose statutes of limitations have expired.

Record Keeping Tips

As mentioned in the section on employment tax records, you can simplify your file system by devoting separate drawers for each tax year. In those drawers, you’ll put any information on assets, income, and other information applicable to your return. The first drawer will be where you put all documents as you acquire them throughout the year. The next drawer is last year’s tax documents. The drawer after that contains documents from three years ago, and so on until you reach the year at which your statute of limitations expires.

In order to use this method, it’s important that you file your taxes on time or file an extension so you know for sure your specific time frames. At the end of each year, the last drawer gets dumped and you move the other drawers down, starting a new drawer for the current year. It’s really simple once you put the system in place. Record-keeping may seem tedious, but remember, it shows you where your business has been and where it’s going, like a runner trying to improve their time. You can’t improve the numbers if you don’t know what they are.

  1. IRS Pub. 583, Starting a Business and Keeping Records (Rev. December 2011), Dated Feb. 17, 2012, p 12. ↑
Categories : Audits, Business Expenses, Capital Gains, Payroll, Receipts, Records, Tax Planning

You Totaled Your Vehicle? Tax Benefits You Can Use

By Kim M. Larsen EA CTFS
Monday, January 26th, 2015

Let’s face it; wrecking your vehicle is a bummer. But, don’t let moping about something that’s done and over with keep you from being smart about the situation moving forward. There’s no need for having a totaled vehicle and missing out on tax benefits.

Understanding Tax Law

Your particular business situation will determine exactly how the tax law views your totaled vehicle, also called an involuntary conversion. Both individuals and corporations, however, have to work with the same rules as far as the business part of the vehicle. The difference lies in the personal use part. For an individual, there is a personal casualty loss. For corporations, there is no personal part; it’s all business.

If you’re confused about which situation applies to you, look at the check made out by the insurance company. When you total your vehicle, they will keep the vehicle and give you a check for its pre-accident value. If the check is made out to you (because you are a Schedule C taxpayer and you own the vehicle), you will divide the money between business and personal use based on mileage for each. A check made out to the corporation is not divided. On the books, the vehicle belongs to the business.

For a Proprietorship

Let’s do an example to see how you would divide the insurance money between personal and business use. In this example, you owned the vehicle for three years. During those three years, you drove it 20,000 miles for business and 5,000 miles for other uses. So, you have 80 percent business use from the time of purchase to the totaling of the vehicle.

You can now use that percentage to determine gain or loss on both a business and personal basis. Since a proprietorship is a Schedule C taxpayer, here’s what you need to know. 1) The business part will have either a taxable gain or a deductible loss. 2) For the personal part, you will pay taxes on any gain, but you cannot deduct a loss.

To clarify the personal casualty loss, you probably will not have a personal deduction if you had insurance. You see, by IRS rules you can deduct whichever is lower of your cost or the fair market value, minus the insurance proceeds. Since insurance will likely reimburse at fair market value minus your deductible, there will not be a personal casualty loss deduction.

Even if you have an insurance deductible, it is unlikely you will come out with a personal loss deduction. That’s because tax law includes these two additional rules regarding personal loss:

  1. The amount of each casualty loss is reduced by $100[1], and then
  2. Casualty losses are only allowed to the extent that they exceed ten percent of adjusted gross income[2].

If you think you might still have a personal loss to claim after these calculations, check with your tax advisor to be sure.

For a Corporation

Your corporation may own a vehicle that you use for both business and personal reasons. In that case, the corporation will assign a value to your personal use. That amount then goes on your W-2, or you will be responsible for reimbursing the corporation. Since you are a more than 5 percent shareholder, you are obligated by specific legal requirements regarding how your corporation determines this value.

Here’s how the example above plays out when the vehicle belongs to your corporation. As far as depreciation, gain, and loss purposes, the corporation owns 100 percent of the vehicle. So, all gains will be taxable, and any loss will be deductible.

Deferring Taxes

In either scenario, you can end up with some taxable gains. Usually, these gains come about because of depreciating the vehicle or expensing deductions claimed on it. When your gain comes from deductions, it’s called “recapture income”, which is taxed at the usual income tax rates. But, here’s a little secret: you can avoid those taxes!

Instead of claiming your totaled vehicle as a gain, you can replace it with other like-kind property. Tax law even allows for two years from the time of the wreck for you to make the replacement[3]. The details are covered under IRS Section 1031 on exchanges of business vehicles, which states that like-kind property for vehicles includes cars, light general-purpose trucks, and vehicles that share characteristics of the two former types (such as crossovers, SUV’s, vans, etc.).

All you have to do to defer the taxes is reinvest all of your insurance money into a new vehicle and properly document this on your tax return. That means if you wreck your SUV, you can take the $20,000 insurance money and replace your SUV with a car. If you don’t reinvest the full amount, you will have taxable income for the amount leftover[4]. So, if that new car only costs $16,000, you’ll have a taxable gain of $4,000. It works this way for both a proprietorship and a corporation.

Don’t Forget the Documentation

In order for your vehicle replacement to be accepted by the IRS (and to avoid taxes), be sure you attach a statement to your tax return (either the Form 1040 or the corporate return) that includes[5]:

  • Details of the wreck, including the date,
  • Amount of insurance reimbursement,
  • How you calculated the gain,
  • The replacement property purchased,
  • The amount of gain that is postponed,
  • The adjusted basis on the replacement vehicle (which is reduced by the deferral of gain), and
  • How much of the gain is taxable (again, if you invest the full reimbursement amount, there is no taxable gain).

So, in order to avoid those gain taxes, replace your vehicle with one of like-kind (which basically means for the same use) and document everything about your wreck, insurance reimbursement, and purchase of the new vehicle. For any business losses, deduct those immediately! Business loss deductions work the same way for a proprietorship or a corporation. You may not like knowing that you totaled your vehicle, but you can rest easy with the knowledge to set your finances straight in the aftermath.

  1. IRC Section 165(h)(1). ↑
  2. IRC Section 165(h)(2). ↑
  3. IRC Section 1033(a)(2). ↑
  4. IRC Section 1033(a)(2)(A). ↑
  5. IRS Pub. 547, Casualties, Disasters, and Thefts (2012), posted Nov. 29, 2012, p. 12. ↑
Categories : Business Expenses, Cars, Trucks & SUVs, Casualty Losses, Depreciation, Exchanges, Tax Planning
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