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

Selling and Repurchasing Stock the Right Way

By Kim M. Larsen EA CTFS
Tuesday, February 3rd, 2015

There’s a big difference between the interest you earn on your bank account and that earned from your stock investments. Specifically, you have to pay taxes every year on the interest from your bank account, but tax law allows you to wait until a “taxable event” (like when you sell it, for instance) to pay taxes on your stock gains. This is a huge advantage, and may allow you to save a ton on capital gains taxes if you use your advantage right.

How Low Can You Go?

It’s up to you to determine when you’ll pay taxes on your stock gains, so make the most of it! When is the best time to pay taxes? The best time is when they’re the lowest, of course. And, capital gains taxes can go all the way down to zero percent.

You can be one of those people who qualifies for the zero percent tax bracket on capital gains. This advice will guide you through the process. Would you like to know something even better? You won’t even have to permanently dispose of your stock to do this; you can keep right on earning from it.

Understanding the Rules for Stock Sold at a Gain

All right, so you want to avoid high capital gains taxes, and you’re thinking about selling and repurchasing your stock to accomplish that goal. But wait, won’t that be a wash sales transaction that’s disallowed by tax law?

It’s not! For any stock that you sell at a gain, the wash sales tax rules don’t apply.[1] It is perfectly legal (and smart) for you to sell stock that has appreciated and repurchase it right away.

Let’s take a look at how that works. For our example, you purchased $1,000 worth of stock several years ago that is now worth $10,000. You also notice that you are currently in the zero percent tax bracket for capital gains. You sell the stock for its current value ($10,000) and turn around and re-purchase it for the same price. Under tax law, this is a taxable event. You may now pay taxes at the zero percent rate (i.e. you pay no taxes).

Had you been in a higher tax bracket, you would have paid taxes on $9,000 (the gains you made from selling a $10,000 stock bought at $1,000). By doing this, you not only pay no taxes, but you have also re-established your stock’s basis as $10,000, meaning if you have to pay taxes in the future, it will be on subsequent gains. You have permanently banished taxes on that $9,000 in gains! (And, if your stock value decreases in the future, you can sell for a tax loss.)

Which Bracket Do You Fit In?

Okay, so you’d probably like to know whether you fit into this magical zero percent tax bracket. The brackets for capital gains (long-term) range from 0 to 20 percent.[2] In 2014, the zero percent bracket applies to these levels:

  • Single filers with taxable income from $0 to $36,900 and
  • Joint filers with taxable income from $0 to $73,800.

Taxable income is the dollar number you get after taking certain deductions that are available to all. You can also figure the numbers using adjusted gross income (AGI):

  • Single filers with AGI from $0 to $47,050[3] and
  • Joint filers with AGI from $0 to $94,100.[4]

Important note: To qualify for capital gains rates, you must hold the stock for a minimum of one year before selling it. If you don’t, you’ll be paying taxes at the much higher ordinary income rates. It’s a good idea to play it safe. If you buy stock on July 31 of this year, hold onto it at least until August 1 next year. Don’t get in a rush. Make sure you’ve owned that stock for a year before selling—remember, investments are long-term.

By planning your stock sales correctly, you can save thousands of dollars in taxes over the years. You don’t have to sell all of your stock shares at once, by the way. Just calculate the amount of gain you can safely recognize without paying taxes, and only sell that amount. Tax law allows you this benefit, so take advantage of it by selling intelligently.

  1. IRC Section 1091. ↑
  2. Rev. Proc. 2013-35. ↑
  3. $36,900 + $3,950 (exemption) + $6,200 (standard deduction) = $47,050. ↑
  4. $73,800 + $7,900 (exemption) + $12,400 (standard deduction) = $94,100. ↑
Categories : Capital Gains, Investments, Tax Planning

If You Have an IRS Audit Coming Up, Make Sure You Have the Tax Law on Your Side

By Kim M. Larsen EA CTFS
Wednesday, January 28th, 2015

When you have to go toe-to-toe with the IRS, make sure you keep the fight clean. The only way to succeed when arguing your case with an auditor is to follow the IRS’s own procedures. And, the primary way to do that is—you guessed it—keeping proper documentation. With this article, you’ll better understand where tax authority is derived, what rules the IRS must stick to, and what rules the IRS accepts.

Remember Who You’re Dealing With

As you prepare to make your case by checking the appropriate tax rules, remember that the auditor will be your primary audience. You want to build evidence that convinces the IRS. Although it’s possible that your audit could go to court, most do not. It is likely that the auditing process will stay with the IRS, so prepare yourself for that likely scenario.

A good place to start is with the IRS forms themselves, as well as guides, instructions, and other IRS publications. These are not a source of “substantial authority”,[1] but you can begin your research with them in order to get an overview of the particular tax issue you’re looking at. Just be sure you don’t end your research with these documents because they don’t always give the full story. When using these as part of your argument, however, you can be assured knowing that the IRS is unlikely to go against its own advice, even from a non-technical document.

Another type of non-technical documentation is internal IRS guides. These are made for employees, but copies are available to the public. Some examples include the Internal Revenue Manual, chief counsel advice, and audit manuals. They will give you an idea of how the auditor may be evaluating your situation.

Although both public and internal guides are easy to read compared to technical documents, you don’t have much support if you depend solely on them. To support your tax strategy more effectively, you’ll need a document with greater authority.

In order to make your best case, you should remember the following tax-document hierarchy:

  1. Statues and Regulations. Both the IRS and the courts can be persuaded by appropriate statutes and regulations.
  2. Case Law. Prior case law is often the next most convincing proof with the court.
  3. IRS Documents. For the IRS, the next best source is IRS documents, but some are better than others.

It is important to remember that tax laws change all the time. No matter how good you think your authority document is, it does little to help you if a more recent law has been enacted. New statutes even supersede prior Supreme Court rulings. When you need to back up your tax return during an audit, always make sure you check for any updates in the laws.

Here are some specific examples of good authority documents:

  • Tax Codes—Statutes in the tax code are always the best authority with the IRS. If possible, find the particular statute (i.e. tax code provision) that specifically addresses your situation. Throughout the process, keeping your argument focused on that provision. As mentioned above, tax statutes are the highest authority in these situations, so if the relevant law does not uphold your case, then don’t try to use a next best authority. Instead, attempt to settle with as little payment due from you as possible. The time that another source of authority comes in handy is when the language in the pertinent tax code is too general (as it often is), and you need additional support for your tax strategy.
  • Treasury Regulations—Regulations have almost the same weight as statutes, but the statute takes precedence in the case of any differences between the two.[2] Regulations fall into one of three categories: 1) final, 2) temporary, or 3) proposed. When Congress passes a new statute, the Treasury drafts temporary regulations that are valid for three years. After that, they expire. However, for the period they are valid, temporary regulations are equal in authority to final regulations.[3] In addition, older temporary regulations never expired, and you may find some that are still being used. Proposed regulations carry less weight than the other two types. Their strength is in persuading the IRS because they represent its official position, but they don’t mean as much in court.

A note on out-of-date regulations: Treasury regulations are not updated every time the tax code changes. Because of this, it’s not uncommon to find regulations intended for a law that no longer exists or exists in a newer version. But, that doesn’t necessarily mean the IRS has stopped using the regulation. Even the courts may treat these as relevant law! The only way to know if a regulation is still in use is to research cases, legal treatises, and IRS documents.

Strategy for Talking to the IRS

At the start of your audit, you’re going to be discussing the issues with auditors and agents. These are the typical IRS worker bees. They are knowledgeable about what they do but will be mainly concerned with IRS documents. They probably won’t delve into statutes or court cases. If your case advances, you will then deal with the supervisors and officers, who bring in the tax code and regulations (and possibly court cases). Just remember that at all levels, IRS employees put emphasis on IRS documents.

One of the best sources to build your argument with is an official pronouncement from the IRS. These are sent out in the Internal Revenue Bulletin, which is “the authoritative instrument of the Commissioner of Internal Revenue for announcing official rulings and procedures.”[4] All of these bulletin pronouncements are binding for the IRS, so you have a good case if one of the pronouncements supports your audit strategy. The problem is that they can be confusing to read. You’ll want to make sure you’re clear on what the actual IRS position is.

Here are several types of official pronouncements that provide good backing (the highest on the list are the best sources):

  • Revenue Ruling—These are the IRS’s own examples of how they apply their rules to particular sets of facts.
  • Revenue Procedure—These are IRS instructions on how to use their documents. Revenue procedures also include updates to monetary amounts to adjust for inflation.
  • Acquiescence or Non-Acquiescence—A good item to have if you plan to use a court case as evidence, these are statements of IRS agreement or disagreement with a particular court ruling.
  • Notices and Announcements—Providing the least authority (but still useful) are notices and announcements, which indicate the IRS’s official position regarding present issues.

Non-binding documents can also be useful. If you’re uncertain about a tax strategy you plan to use, you can request a private letter ruling (PLR) from the IRS prior to filing your tax return.[5] This allows you to get the okay for your strategy before filing, thus avoiding tax penalties. You will have to pay for the PLR. Technical advice memoranda (TAM)[6], which can be initiated either by the IRS or by you, are also an option and have the same level of authority as a PLR.

If you receive a PLR or TAM, you’ll see a disclaimer at the bottom that states “This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) provides that it may not be used or cited as precedent.” This is the IRS’s way of telling you that this is only their opinion on the law and that you should not rely on it. Regardless, these rulings (though not binding) are important guidance. Since it comes from the IRS, it is directly useful in dealing with auditors or agents. Furthermore, these documents can be useful in court if no better authority exists for the issue in dispute.

Speaking of court, when do prior court rulings come into play with the IRS? Here are two reasons you’ll want to include them in your research, even if your audit does not go to trial

  1. Lawyers are well-known for including as many words as possible, and their evidence is thorough. From case law, you can often find all of the regulations, statutes, and forms or other documents needed to support your own argument. Go ahead and pluck those citations right out of the case documents!
  2. If your audit goes to appeals (the highest level of review at the IRS), appeals officers will consider court cases when making their decision.

What If Your Case Goes to Court?

In the event that your case does go to court, your previous research for the auditing process will help immensely. For the most part, you’ll need all of the same types of documentation. The biggest difference is that prior court cases will now be a higher authority than IRS documents. Statutes and regulations will still be your best sources of documentation.

Be aware that your case will not necessarily go to tax court. Federal tax cases can also be taken to:

  • A federal district court,
  • A court of appeals,
  • The court of federal claims, or
  • The Supreme Court (but this is rare).

What is important when choosing the right cases as support for your tax strategy is to choose those that come from the same court your hearing is at, or those from a court of higher authority. Since the tax court specializes in tax law, it is the most cited source. Make sure you know how much authority your particular example case carries. The cases from tax court will be cited as follows:

  • T.C. or TC—This is a regular tax court decision, and the only kind that counts as official precedent.
  • T.C. Memo, TC Memo, or T.C.M.—The tax court memorandum can help your case, but they carry less authority.
  • T.C. Summary Opinion or TC Summary Opinion—Documents labeled summary opinions are not particularly helpful. They carry little authority and do not count as precedent.

It is possible to take your tax dispute to an appeals court after the initial hearing. Keep in mind that different judges make different judgments. That means what a judge in another jurisdiction decides may not be the same as the conclusion the judge in your circuit (i.e. region) comes to. In most circumstances, the tax court will rule in accordance with the circuit where your tax issue originated,[7] but the job of judges is to interpret the laws, and interpretation varies. Tread carefully by being as prepared as possible.

  1. Reg. Section 1.6662-4(d)(3)(iii). ↑
  2. Mayo Foundation v U.S., 131 S.Ct. 704. ↑
  3. IRC Section 7805(e). ↑
  4. This is in the introduction of all bulletins. See a list at http://apps.irs.gov/app/picklist/list/internalRevenueBulletins.html. ↑
  5. Rev. Proc. 2013-1. ↑
  6. Reg. Section 601.105(e)(iii). ↑
  7. Golsen v Commr., 54 T.C. 742. ↑
Categories : Audits, Business Expenses, Precedent, Receipts, Records

You Can Deduct Your Vacation—Just Learn the Tax Rules!

By Kim M. Larsen EA CTFS
Wednesday, January 28th, 2015

Get ahead and get packed because you’re about to get advice on how to deduct your vacation expenses. We’re not talking about a lame, business conference vacation here. This is bona fide advice for getting legal tax advantages for even a luxury vacation. And, you can count the steps on one hand! It’s true. You only need to understand these five tax rules to legally deduct items like your plane ticket and hotel suite:

  • Business Motive—By a business motive, the IRS means a plan for how this trip will contribute to your ability to make a profit. The profit does not have to be immediate, but you should be able to show that you had a reasonable expectation of monetary gain from the trip.
  • Overnight Stay—As with any business travel, you can only deduct expenses for trips that last, at least, overnight.[1]
  • Importance of the Trip—Ask yourself this: are the business activities you will engage in during your trip important enough that you would take the trip purely for business reasons? If it would not make sense to take the trip, except for the personal pleasure of it, then you’ll have difficulty deducting the expenses.
  • Pass the Primary Purpose Test—This test applies to any business travel in the United States. Basically, you need to make sure that the majority of your days on vacation count as business days. To do this, you need to conduct business on more than 50 percent of the days you are away. Additionally, for any single day to count as a business day, your business activities must take up at least four hours of that day (half of a standard workday).
  • Keep Records—Most importantly, record everything about the trip, including notes about the other four rules above.

If you meet these five requirements, then you can justify the business purpose of your trip.

Doing Business in Luxury

It turns out that your business trips can be as luxurious as you desire. With the right planning, you can both accomplish important business tasks and take a well-deserved break. Consider some of the expenses that can be deducted when you follow the five rules:

  • Rental car expenses (even a Rolls-Royce, if you want!)
  • The best suite at your choice of hotel
  • Airfare (even first-class)
  • Boat tickets (cruise travel, too[2])

As you can see, there’s no need to skimp on luxury, relaxation, or adventure when you turn your vacation into a business trip. Plus, you get huge tax savings that are not available for a personal vacation.

Types of Deductions

Business travel allows for to primary types of deductions, transportation expenses and life expenses. The cost to actually travel to and from a location is always a full-expense deduction or no deduction at all. You cannot pare out part of the deduction for personal and part for business. Remember the rule about primary purpose? If you pass those requirements, then you’re clear to deduct all your transportation costs. However, if most of the days on your trip are personal days, then you cannot deduct any of those expenses, even if you conducted business on some days.

The second set of deductions, life expenses, refers to the costs associated with sustaining your life while you’re away from home. That includes your hotel stay (or other lodging) and your meals. Unlike the transportation deduction, however, life expenses can only be deducted on business days. So, if you take a whole day to visit a historic downtown district, any meals for that day and the hotel stay for that night are not deductible, even if the day before and after are devoted to business.

You can see why good record keeping is so important. The IRS is not just going to believe that you spent every day of a vacation in Maui taking care of business.

Getting Business Travel Right

The tax code is unhelpfully vague when it comes to what constitutes business travel. The language states that you can deduct expenses that are “ordinary and necessary” for conducting business.[3] Unfortunately for those of us trying to get the most from legal deductions without incurring the wrath of the IRS auditor, the courts don’t do much to narrow down these broad terms. To support the reasons for your travel deductions, the best you can do is check out the rulings in previous tax cases.

Let’s start with the kind of scenarios that succeed with deductions:

  • Meeting at a Resort—Charles Hinton III solely owned United Title Company, a North Carolina-based C corporation. Every year, he held an out-of-state board meeting in locations such as New Orleans, Las Vegas, and Puerto Rico. He only invited his corporate board members and certain business guests (e.g. bankers, real estate developers, real estate attorneys), as well as their spouse or guest. In addition to the meeting, attendees also discussed business topics, like underwriting policy.

All travel costs were deemed deductible, excluding those for the spouses and non-business guests. Otherwise, the trip was considered for business purposes because the interesting locations ensured that business guests chose to attend. Mr. Hinton’s corporation benefited from the business conversations and from the strengthening of relationships within the field.[4]

  • Expanding Business—Although Raymond Jackson regularly traveled in his business’s sales territory, he was able to deduct travel expenses from outside his normal territory. The additional trips were intended to find new clients and expand his business, thus they were deductible as business travel.[5] Tip: If you are traveling to find initial clients for a new business, those must be considered start-up expenses.
  • The Seminar or Convention—Conventions do provide an excellent excuse to travel, and most take place in areas that lend themselves to vacation activities. Because conventions are set up to be business activities, it is easy to justify your expenses as business-related. Just remember these guidelines: 1) the travel expenses to North American conventions are deductible as long as they advance the interests of your business; 2) any convention that consist of video lectures can only be deducted if the videos could only be viewed at the convention (they could not be streamed or downloaded from home); and 3) travel expenses cannot be deducted for seminars relating to your investment interests rather than your business or trade.[6]

Now, this next set of cases shows you what kinds of scenarios fail at qualifying for deductions (hint: you must have a substantial business reason for your trip):

  • Lack of Business Importance—A custom plywood manufacturer took customers on a trip to New Orleans for four days. The trip included attending the Super Bowl, going on a Mississippi River cruise, and hotel accommodations in the French Quarter. The court deemed the trip merely entertainment, stating that the sporadic business discussions were incidental.[7] The trip did not pass the rule about being important enough to take (and justify the expenses) without the personal element.
  • Lack of Business Motive—A minister took a tour group to Europe; however, no profit motive for the trip was evident.[8] Remember, a business trip must demonstrate the potential increase your company’s profit.
  • Lack of Documentation—A real estate salesperson lost out on deductions for five different trips because she did not keep records to sufficiently prove the business purpose of any of her travel costs.[9]

How can you avoid these scenarios? Just keep proper documentation of your trip and the expenses. It’s not difficult at all. Be sure to include 1) how much each expense cost; 2) when you departed and returned; 3) how many days you spent on business; 4) where you went; and 5) why your trip was business related or expected to generate profit. The IRS requires all of this information in order for your business travel deduction to qualify.[10] Most of this information can be found on your receipts, so keep those in a file. As far as defining your business purpose, you can simply put a note in the file or use some other dated note-keeping system.

You may not be able to include deductible expenses in every vacation, but now that you know the rules, you may start looking at your travels a little differently. If you can reasonably fit in business activities while enjoying yourself, it makes sense to take advantage of the tax savings. Review these five easy rules the next time a travel opportunity arises.

  1. Barry v Commr., 54 TC 1210, aff’d 435 F.2d 1290. ↑
  2. Subject to luxury water travel limits, between $678 and $810 (varies by time of year) per day for 2015. ↑
  3. IRC Section 162(a)(2). ↑
  4. United Title Insurance Co., TC Memo 1988-38. ↑
  5. Jackson v Commr., TC Memo 1975-301. ↑
  6. IRC Section 274(h)(7). ↑
  7. Danville Plywood Corp. v U.S., 899 F.2d 3. ↑
  8. Blackshear v Commr., T.C. Memo 1977-231. ↑
  9. Robinson v Commr., T.C. Memo 1963-209. ↑
  10. Reg. Section 1.274-5T(b)(2). ↑
Categories : Business Expenses, Entertainment, Receipts, Records, Tax Planning, Travel

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

Maximize Your Tax Deductions on Business Repairs

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

When you own business properties, they will occasionally require repairs; that’s just a fact of business ownership. So, whether you need to make repairs on your place of business or your rental buildings, keep these simple truths in mind:

  • You can either increase your net worth with tax-favored repairs.
  • Or, you can decrease your net worth with tax-impaired improvements.

Now, which would you prefer?

Boosting Your Net Worth with the Right Fixes

The fixes that you can label as repairs are vastly more valuable to you than those labelled improvements. That means you need to know the difference between the two so you can a real monetary difference. Of course, it’s important to note that this only applies to an office or rental building that you own.

Fortunately, the IRS released a guide on this subject titled Capitalization v Repairs[1]. Without this guide, some tax deductions linger in an indeterminate gray area, which can be infuriating when it comes time for tax preparation. If you don’t know how the IRS classifies a particular fix, you lose control of your money. However, with the right planning, you can classify particular fixes as repairs and regain that financial control.

Here’s an example of how tax-favored repairs work:

  • Scenario 1: You put an entirely new roof on your office building. Uh-oh! Now you have to depreciate that roof over thirty-nine years, which means you have lost quite a bit of money up-front.
  • Scenario 2: Instead of completely replacing the roof on your building, you replace thirty-five percent of the roof one year, twenty-five percent of the roof a couple years later, fifteen percent of it a few years after that, and then twenty-five percent the following year. Each of those repairs can be deducted immediately, leaving you with a hefty financial advantage.

Defining a Repair

Do you see the difference in the above scenarios? Repairing is maintaining or mending. It is a fix that keeps a property running in its ordinary and efficient operating condition. A repair[2] does not 1) add to a property’s value, or 2) prolong the life of the property by an appreciable measure. You see, a repair ensures that you can continue using a property for the purpose you obtained it for, as opposed to increasing the value for a possible sale in the future[3]. An improvement, on the other hand, is a fix that 1) increases the property’s value[4], 2) prolongs its useful life substantially[5], or 3) modifies the property for a novel use[6].

Take a look at this actual situation to get an idea of how these definitions might play out (numbers are not in today’s dollars). A man purchased a four-unit apartment building (with one tenant residing) that was in poor repair for $30,000 and spent $6,247 for a contractor to fix it up. The contract work included removing tree limbs that were rubbing the roof; repairing water damage; repairing electrical wiring; cleaning the carpets, floors, and exterior; repairing the front porch; and, installing new cabinet doors and new countertops.

When the owner was audited, the IRS deemed the entire amount an improvement. The owner, however, disagreed, and the Tax Court allowed $5,000 worth of repair deductions[7]. The court only required the owner to capitalize $1,247 for the new cabinet doors and countertops.

Why did the court side with the building owner? First, the court noted that a tenant was living in the building. This meant the property was commercially active at the time of the fixes. If you’re repairing a rental property, having tenants in the building is beneficial to your claim of making repairs. Second, the $5,000 in repairs was not considered a large amount of money compared to the initial $30,000 spent to purchase the property. That is, the court could justify the expense as repairs rather than improvements to increase the property value.

Note: There is no defined amount of money that distinguishes a repair from an improvement. Two people could make the same fixes for the same amount of money and get differing tax results. That is why it is important for you to document the facts surrounding your repairs and present those facts when making a case with your tax preparer.

Tips on Making a Case for Repairs

By following a few best practices, you can make it easier on yourself to get the right tax deductions. A good way to get a favorable result for deductions on repairs is to get separate invoices for repairs and improvements[8]. This is especially important when you are carrying out a large renovation project. The IRS specifically states in its audit technique guide that repairs are not considered repairs when they are made as part of a general rehabilitation project[9]. So, keep those invoices separate! In fact, you’ll give yourself a lot fewer headaches if you just hire different contractors to do the repair work at different times from the improvements.

Here are some additional tips:

  • Always Document the Reasons for Your Repairs—Repairs, by their nature, are preceded by an event that indicates their need. For instance, you repair a water pipe because it begins to leak, or you repaint an exterior because the weather has faded it. Record these reasons as evidence of the need for repairs.
  • Fix Only Small Parts at a Time—This is pretty self-explanatory. When you replace something in its entirety (i.e., putting on a new roof, replacing an entire wall, installing new flooring), you are making an improvement[10]. When you focus on simply fixing a part of that roof, wall, or floor, you are making a repair[11].
  • Use Comparable Materials—If you want your claim for tax deductible repair work to be accepted, you should replace worn materials with those of similar, or even less expensive, quality[12]. If you’re using higher quality materials, the work may be considered an improvement[13].
  • Consider the Reason for the Repair—Another aspect to consider when making a case for fixes to be considered repairs for tax purposes is the condition of part being fixed up. A repair can only be made to something that is worn out, deteriorating, or broken[14]. If you’re not restoring or replacing a damaged part of the property, or if work expands to parts of the property that are not damaged, it becomes an improvement.

What’s the Main Concern?

Why is the IRS so particular about whether you are making repairs or improvements? They suspect you may buy a property to renovate, and then write off the renovation as repair costs. In its audit technique guide, the IRS distinguishes between money used to “put” or to “keep” the property in efficient operating condition[15]. Simply stated, if improvements need to be made in order to put the property in efficient operating order, then they are capital improvements. But, if they are only made in order to keep the property in efficient operating order, then they are repairs and are tax deductible.

This is not to say that you should not consider making improvements to your properties. Indeed, if you plan to sell, improvements may be exactly what you need. However, this article is a helpful guide for how to get the most out of your tax deductions when you are attempting to repair the buildings you still use. With proper documentation, you can designate whether the work you have done on your buildings is considered a repair or an improvement, and that means you have the power to take control of how much of your money goes to taxes.

  1. IRS Audit Technique Guide, Capitalization v Repairs, LB&I-4-0910-023. ↑
  2. Reg. Section 1.162-4. ↑
  3. Illinois Merchants Trust Co. v. Commr., 4 B.T.A. 103, 106 (1926), acq. ↑
  4. Reg. Section 1.263(a)-1(a)(1). ↑
  5. Reg. Section 1.263(a)-1(b). ↑
  6. Also see Reg. Section 1.263(a)-1(b). ↑
  7. Roger Verl Jacobson v Commr., TC Memo 1983-719. ↑
  8. E.g., Allen v Commr., 15 T.C.M. 464 (1956). ↑
  9. IRS Audit Technique Guide, Capitalization v Repairs, LB&I-4-0910-023. ↑
  10. Reg. Section 1.162-4; e.g., Ritter v Commr., 47-2 USTC Section 9378 (6th Cir. 1947) (new roof). ↑
  11. E.g., Kingsley v Commr., 11 B.T.A. 296 (1928) (patching roof), acq. ↑
  12. E.g., Illinois Merchants Trust Company v Commr., 4 B.T.A. 103 (1926). ↑
  13. E.g., Abbot Worsted Mills, Inc. v Cagne, 42-2 USTC ¶ 9694 (D. N.H. 1942). ↑
  14. Sanford Cotton Mills v Commr., 14 B.T.A. 1210 (1929) (portion of decayed floor replaced). ↑
  15. IRS Audit Technique Guide, Capitalization v Repairs, LB&I-4-0910-023. ↑
Categories : Business Expenses, Investments, Receipts, Records, Rental Properties, Tax Planning

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
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