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Author Archive for Kim M. Larsen EA CTFS – Page 5

Knowing the Rules Can Boost Your Travel Deductions

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

Traveling for business can be a tricky situation when it comes to taxes. How do you know what can be deducted? And, what counts as a tax-deductible business day? The IRS actually has some fairly easy rules, so once you know how to define “business days”, it becomes much easier to understand your deductions and get the most from them.

Personal Days vs Business Days

Why is it so important to understand the difference between personal days and business days? For starters, any travel done on business days (by the IRS definition of the term) allows for deductions on gas, lodging, and food. That can mean significant savings for you when documented correctly.

Let’s lay out the business day rules and what they mean for your deductions (you only need to meet one of these requirements):

  • You Work More Than Half a Day—If you work for more than four hours on any particular day of your trip, that day counts as a business day. Typically, a full work day is eight hours, so that means doing business for more than four hours constitutes the majority of your possible work day[1].
  • You Spend the Day Traveling—Let’s be clear about this. You must spend the majority of your day traveling for business. Even if you perform no other business activities that day, your business travel day is counted as a business day[2]. Just make sure the majority of you trip qualifies as business.
  • Your Presence is Required—If one of your business associates must have you present for necessary business reasons, your travel and expenses for that day are deductible, even if you did not spend four hours working[3]. Associates include your partner, employer, customers, or clients.
  • You Were Prevented from Working—Things happen, and your day does not always go as planned. Luckily, the IRS plays fair on this. If you tried to conduct business but were prevented by circumstances beyond your control, you can still deduct your business travel expenses[4].
  • Holidays, Weekends, and Other Necessary Standby Days—Sometimes your travel may stretch over a period that includes non-business days. When it’s not practical to return home and travel back again, your expenses for these days are deductible. To prove the necessity, keep records indicating that travel time would have been unreasonable or the expense would have been greater to travel back and forth than simply to stay over[5].
  • Days that Save Money—Sometimes you score a travel discount for traveling a day or two earlier or later than needed. As long as you can show that the amount you saved outweighs what you spent on staying an extra day or two, your costs count as business day travel expenses[6].

As you can see, it’s fairly easy to create a business day out of what would have been a personal day. Knowing the difference between the two is the key to boosting your deductions. Just be sure to keep accurate records that indicate how you spent your time, how much money you spent, and why the activities were for business purposes.

Primary Travel Expenses

Now that you know which days are business days, you need to understand what expenses are covered on those days. Certain expenses are pretty much a given on business trips, so we’ll take a look at how those common expenditures figure into your deductions:

  • Food and Lodging—Anything you need to sustain yourself during travel is called a life expense. Your meals and hotel stay are life expenses. However, be careful that you only deduct these expenses for business days, not personal days.
  • Transportation—Unlike life expenses, transportation cannot be partially deducted (i.e., divided between personal days and business days). If the majority of your trip was for business purposes, you deduct all of your transportation expenses. If the majority of the trip was for personal reasons, you cannot deduct travel[7].
  • Business Expenses—Business expenses are the exception to the business day vs personal day rule. These are expenditures that can be deducted regardless of whether the day was primarily spent doing business. Some examples are shipping costs, communication costs, and printing costs.

Now you know the rules for what constitutes a business day and which expenses are considered tax deductible for business travel. Before making these deductions, you should always check that the trip qualifies. That means the majority of days on your trip should be business days, and some expenses (such as food and lodging) can only be deducted for days that are actual business days. When you’re mixing business and leisure, you cannot deduct these expenses on days where the majority of your time was spent in non-business related activities.

Sample Itinerary

It really doesn’t make sense to avoid fun and experiences just because you’re on a business trip. By planning ahead and documenting your time, you can spend plenty of time enjoying yourself wherever you may be conducting work activities. Look at this example to see how the deductions add up:

  • Days 1 and 2—You rent a car to drive from Maryland to Orlando, stopping overnight at Georgia in between. Both of these days are deductible for business travel.
  • Days 3 through 5 (Friday, Saturday, Sunday)—You are staying in Orlando. Normally, these would be considered personal days, but if you set up a meeting with colleagues or potential clients on Friday, you can turn all three days into business days.
  • Days 6 through 9—This is the week of the business conference, and you are staying at a Disney Resort. You can deduct the price of the resort stay and your meals for these days.
  • Days 10 and 11—You leave Florida to drive back home, and you stop over at Georgia again. Like the trip to Florida, these days are business travel days.

With an itinerary like this, you have eight business days if you do not conduct business on the first Friday. Even with eight of the eleven days, your trip is primarily business and you can deduct all transportation expenses. You can deduct the resort stay and meals (life expenses) for the eight business days. Or, if you make that first Friday a business day (thereby converting the weekend to standby days), you can deduct life expenses for all eleven days! The next time you’re planning a trip (whether business or personal), ask yourself what you can do to make it a business trip and still have fun.

  1. Reg. Section 1.274-4(d)(2)(iii). ↑
  2. Reg. Section 1.274-4(d)(2)(i). ↑
  3. Reg. Section 1.274-4(d)(2)(ii). ↑
  4. Reg. Section 1.274-4(d)(2)(iv). ↑
  5. Reg. Section 1.274-4(d)(2)(v). ↑
  6. PLR 9237014. ↑
  7. The technical rule is “primary purpose,” which does not necessarily mean the majority of days. ↑
Categories : Business Expenses, Tax Planning, Travel

Understanding Travel Deductions for Educational Seminars

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

If you’re considering going out of town for an educational seminar, you may want to ask yourself a few questions to determine whether the expense is justified[1]. First, is the trip primarily for the purpose of continuing education? If so, how many hours of each day there will actually be spent in educated-related activities? If not, then is the trip part of a vacation or leisure trip?

To deduct your travel for a business-related education seminar or event, you have to show that obtaining business education is the primary reason behind your travel[2]. Not only that, you must also keep in mind that for tax law purposes, the term “travel” refers only to trips that take you out of town long enough to require a stop for sleep[3].

Is the Trip Business or Personal?

Of course, sometimes you combine business and personal time on a trip out-of-town. It would be silly not to take advantage of new sights if you have the opportunity. But, what do you do about deducting expenses in these situations? It’s actually not that difficult.

If your trip otherwise qualifies as a tax deductible business trip, and you take, for example, a three-hour hike through the mountains while you’re there, you can just handle any hiking costs as personal expenses. This does not cancel the validity of your business trip[4]. All you need to do is document which expenditures went towards business events and which were for personal activities.

Matters aren’t much more difficult for personal travel that includes business. If you take a vacation or other personal trip and end up spending a day working on business matters, you treat the travel expenses and the majority of the trip as personal for tax purposes[5]. Then, you keep track of any expenses for the business day and note them as business expenditures. Note: This does not mean you can deduct food and lodging for a day of your vacation because you took a one-hour conference call. But, if you spend a full seven hours of one day trying to work out business issues during your vacation, then you can count that day as business.

If your trip is fairly evenly mixed between business education and personal activities, it may be more difficult to determine whether travel and lodging expenses are deductible. IRS regulations state that the important thing is to weigh the relative amount of time spent to each in order to determine the primary purpose of the trip (in particular, you can look at regulation 1.162-5(e)(1)). Now, look at that last sentence. You will see that time is the determining factor, not importance of the educational activities. The division of time is what the IRS will consider.

Another example may help to clear up how this works. In revenue ruling 84-55, a taxpayer took a trip for educational classes sponsored by his alumni association. The educational meetings only lasted about two hours per day, and the rest of the time he spent with his family. The IRS ruled the trip a family vacation. However, he was allowed to deduct expenses for the cost of the classes. Nothing of the hotel stays, meals, or back and forth travel was allowed to be deducted.

Other cases have been ruled in much the same way (see Holswade[6]). You should understand that if the number of hours spent on business education is minimal, the trip will be considered personal. In this case, you will likely only be able to deduct the costs of the educational course itself. It is only when more than half the day is spent on business that you can consider it so[7].

Time is easy to measure. When you’re going on a mixed-purpose trip, be sure to track your time consistently. This is the only way you have an argument for deducting expenses for lodging, meals, and travel.

How to Document Your Trip

Be aware that the IRS is not going to just take your word for it that you spent more than half your time conducting business. You may be asked to provide documentary evidence of your business activities during the trip. In that case, each of the following items is useful:

  • Receipts—Obviously, you will file all the receipts from your trip. This shows both the business-related expenses and how you paid for them. Tax law absolutely requires that you save receipts and document the business reason for each day (e.g., attending a specific seminar) if expenses exceed $75. Be sure to note what each receipt is for—breakfast, gas, etc.
  • Brochures—Most education seminars will provide an event brochure. Hang on to this, and put it in a folder with other information regarding your travel. This is especially useful if the brochure outlines how the seminar is useful for your business purposes and has a clear outline of benefits.
  • Notes—You may not remember every detail of your outing. This is where taking timely notes comes in handy. Once you are back from your trip, or even better, during the trip, take time to note which activities you took part in for business and how long they lasted. You can also jot notes down on your brochure if it’s not clear how the seminar benefits your business.
  • Travel Log—What format you use for your log does not matter. What is important is that you have somewhere (a notebook, calendar, or app) that allows you to your activities during your stay. This should include all events that you attend, contacts you meet, and how you otherwise spend your time. You can find several good software applications for this.
  • Summary of Benefits—If you haven’t noted this in any other journal, you may want to outline the benefits you received from the seminar after the trip ends. This allows you to state clearly what you got from the trip and how you will apply it to your business. This works as a supportive document that explains why the travel was business related.

With the proper documentation, you should be able to prove that your trip is eligible for business tax deductions. Just remember the half-day rule and to keep thorough records. A business trip does not have to be “all business,” so relax—figuring out eligible expenses is not all that difficult.

  1. Rev. Rul. 84-55. ↑
  2. Reg. Section 1.162-5(e)(1). ↑
  3. Rev. Rul. 75-168; U.S. v Homer O.Correll (1967, S Ct) 389 US 299; IRS Pub. 463 Travel, Entertainment, Gift, and Car Expenses (2005), p. 3. ↑
  4. Reg. Section 1.162-5(e)(1). ↑
  5. Ibid. ↑
  6. Holswade v Commr., 82 T.C. 686 (1984). ↑
  7. Reg. Section 1.274-4(d)(2)((iii). ↑
Categories : Business Expenses, Education, Receipts, Records, Tax Planning, Travel

You Can Deduct Clothing and Laundry Expenses—Legally!

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

Most of us don’t wear the same thing we wear on the weekend or out to dinner at night as office apparel. Since you’re likely spending extra money to have appropriate clothing to wear to work, it makes sense that you can count it as a business expense. In fact, the IRS allows tax deductions both for the purchase of work clothes and their laundering—as long as you follow the rules.

What Clothing Qualifies

You could be spending several hundred dollars per year on work clothes, plus more for dry cleaning or other laundry expenses. Of course, the IRS isn’t just going to let you buy whatever fancy duds you want and write it off. So, check if your clothes fit into one of these categories before determining whether you qualify:

  • The clothing has a business logo or is a uniform, scrubs for example;
  • You frequently wash or dry-clean your work clothes at your expense; or
  • You are required to wear protective gear or protective equipment for work.

If you already fit one of these requirements, then make sure you’re using this strategy to save on taxes. If not, maybe you should look into purchasing qualifying clothing items. The savings could really add up—even just for the laundry expenses. Not only that, but you’ll extend the life of your non-work clothes by not needing to wash them as often.

Sounds too easy, right? Well, there is a little more to it than that. If you know anything about the IRS, you know that they like to have proof. Here are the rules for making sure the cost of your clothing and its maintenance is deductible:

  1. The clothes are either required or essential for the work you do.
  2. The clothes are either protective or distinctive.
  3. They are not appropriate for wearing outside of work as everyday clothing.

You must provide evidence for all three of these criteria in order to get the deduction[1]. You may need to get a little creative with some of these requirements, but as long as you provide reasonable proof, you can make this deduction work for any type of business. Basically, the IRS wants to see that you are not gaining any personal benefit from the clothing. Let’s take a look at how to meet these criteria.

Required or Essential Clothing

As a business owner, this is a pretty easy requirement to meet. After all, you make the rules on work attire for your company, and that includes what you and your employees wear. No employees? Don’t worry about it. You can still qualify and meet this criterion as a sole proprietor who works alone[2]. In fact, case law offers a few examples of how individuals have qualified:

  • A dairy salesman who was self-employed decided to wear a uniform on his routes—green trousers, shirt, and hat, all stitched with the name of his company, “Mortrud Dairy”. His deduction was approved by the court[3].
  • A professional violinist was required to wear formal wear, including sequined gowns, for performances with the Los Angeles Chamber Orchestra and Long Beach Symphony. The court approved her clothing deductions, noting that the clothes were “quite formal” and not “adaptable for general and personal wear.”[4]

Protective or Distinctive Clothing

Fortunately, for this requirement you only need to prove one or the other, that your clothing is either protective or distinctive. Protective items include equipment, such as safety gloves, hard hats, or painter’s smocks. Distinctive is a fairly simple case to make. Examples of distinctive attire would be items with a company name or logo, or uniforms that affiliate you with a particular profession, such as scrubs for medical professionals.

So, combine this with the first requirement, and you’ve got a pretty easy solution. Put your logo on the clothing and make it a rule that employees must wear it. When you do these two things, the clothing becomes a work uniform.

If you’re uncertain of whether your apparel counts, look at these two case examples:

  • A carpenter attempted to deduct his shoes and work overalls; however, the court ruled that the items were not deductible. The white overalls did not contain a logo and were ordinary work clothes that could be worn outside of work (they did not meet the “distinctive” requirement). The shoes were also deemed ordinary, as opposed to protective shoes[5].
  • In another case, a salesman was able to deduct some, but not all, of his clothing. His employer required a tailor-made cap, jacket, and shirt with the company logo on all three. These items were deemed deductible by the court. However, his socks, shoes, raincoat, and overshoes were not deductible since they were not specifically part of a uniform[6].

In the case of armed services employees, military uniforms meet these requirements and are eligible for deduction. The established requirement for military personnel is that you have to be full-time active duty and not allowed to wear the clothes during off hours[7].

Not Appropriate for Usual Wear

As you’ve probably guessed, this is the hardest requirement to prove. It’s somewhat subjective since you must determine whether the average person would want to wear these clothes outside of the workplace. You have a better chance of proving this requirement to the IRS if the clothes veer further towards unusual or distinct from everyday wear.

Tip: Do not wear your work clothes outside of work activities if you plan to make a clothing deduction. No matter how distinctive they are from ordinary clothes, you will not win the deduction if you wear the clothes for non-work purposes. Of course, it’s okay to wear them while commuting.

Let’s start with an example of a case in which the individual did not meet this requirement:

  • A saleswoman for a high-end clothing store was required to buy the store’s clothes and wear them at work. Although she claimed she only wore them to work and nowhere else, the court denied her deductions because the clothes were suitable for wearing every day[8].
  • In another case, a dental office manager had her deductions approved for both the cost of purchasing and laundering her uniforms, which were not considered ordinary clothing[9].
  • A physician was also able to deduct his purchase and laundry costs for scrubs. He was expected to wear them while at the hospital where he worked, and they were not appropriate as ordinary clothes[10].

On Employee Uniforms

Here’s some good news for employers. After wrapping your head around all these stipulations for deducted clothing expenses, you’ll be happy to know that when you purchase uniforms for your employees, these are always deductible expenses[11]. You have no need to worry about any of the above criteria.

Your employees, however, should still be concerned about the three criteria above, and here’s why. If the uniforms meet all the criteria, your employees get to treat the clothes as a tax-free fringe benefit as part of their working conditions[12]. If, on the other hand, the above rules are not met, then your employees will have to treat the apparel as taxable compensation[13].

So, is it worth the expense for you to purchase clothing specifically for your work? It really depends on your situation. If you’ll be spending a significant amount on the maintenance of such clothing (i.e. dry-cleaning or laundry expenses), it may make up for the expense of buying work-only clothes. And, if you’re already wearing clothes devoted exclusively to your business, then make sure you meet the three rules and get the deductions you’re qualified for. You know what they say; dress for success—and deductions!

  1. IRS Publication 529, Miscellaneous Deductions (2013), dated November 13, 2013, ps. 7-8. See also Tyler v Commr., TC Memo 1982-160. ↑
  2. Mortrud v Commr., 44 TC 208. (Self-employed business owner could deduct the cost of his uniform.) ↑
  3. Mortrud v Commr., 44 TC 208. ↑
  4. Katia v Popov, TC Memo 1998-374. ↑
  5. Jim McNamee, 12 TCM 1131. ↑
  6. Marshall J. Hammons, 12 TCM 1318. ↑
  7. IRS Publication 529, Miscellaneous Deductions (2013), dated November 13, 2013, p. 8. ↑
  8. Barry D. Pevsner v Commr., 628 F.2d 467 (CA5). ↑
  9. Floyd Gilbert Bickel II, TC Memo 1966-202. ↑
  10. Lynn Crawford, TC Memo 1993-192. ↑
  11. IRC Section 162; Rev. Rul. 72-110. ↑
  12. IRC Section 132(d). Section 1.132-5(a)(1)(v) ↑
  13. Rev. Rul. 80-322. ↑
Categories : Business Expenses, Receipts, Records, Tax Planning

Tackle the Gray Area and Claim a Home Office Deduction on Your Rental Property Business

By Kim M. Larsen EA CTFS
Sunday, January 25th, 2015

For those of you who run a real estate rental business, you may find that the IRS is a little tougher on you about claiming a home office deduction. The sticking point is that, depending on your circumstances, the IRS may consider your real estate business an investment rather than a business. In order to claim this deduction, your home office must be connected to a “trade or business”. So, the trick is to provide documented evidence that your rental endeavors are a business you run.

The Gray Area

A home office can save you thousands on taxes because you are able to deduct a percentage of your mortgage interest, property taxes, and even utilities as business expenses. However, when you’re lurking in the shadows of this gray area in tax law, you can find yourself arguing with an auditor who simply does not believe that your deduction is legitimate.

That is exactly what happened to Dr. Edwin Curphey, who owned a rental property business and had his home office deduction rejected. He ended up taking his case to court and winning his deduction.

It usually seems like the IRS has no end to specifications and rules to follow. However, in the case of deducting a home office for your rental property business, the law is fairly vague. This gray area leads some auditors to interpret such situations in different ways, so you have to be prepared with the right knowledge when tackling this deduction.

Unfortunately, no set method exists for proving your claim. You can, however, piece together information that will help in making your case. In order to determine whether you qualify for the deduction, your best bet is checking out precedent cases to see who has previously won the deduction and who has not.

Gray Area Guidelines

What’s the main difference between an investor and a business owner? It’s pretty simple. An investor collects money without having to perform any work, but a business owner actively works with a property. That means to be considered a business, you need to show the IRS that you do more than simply handle money[1].

Here’s where the fuzzy requirements come in. In order to qualify, you have to present evidence of activities that indicate you are doing work with your rental properties, but there is no definite set of activities that are required by the IRS. Some actions that indicate actual business activity may include[2]:

  • Management
  • Making repairs
  • Performing cleaning tasks
  • Advertising
  • Resolving tenants’ problems

You may not do all of these in association with your real estate rental business, but your chance of making a successful deduction increases with the more you do. The good news is you can still claim your rental property income on the Schedule E (just like investment property) while making the case that it’s a business. This means you’ll be able to avoid the self-employment tax, unless you offer your tenants significant services, such as a housekeeper[3]. In that case, you’ll need to use the Schedule C[4].

What If You Run Multiple Businesses?

If you run multiple businesses, you may be using the same home office space for all of them. In that situation, you’ll have to be extra careful because each business has to meet the home office requirements in order to qualify your office space for a deduction[5]. When one of the businesses does not qualify, you should find a separate office space for it, if possible. Otherwise, you’ll lose your legitimate deduction for the business or businesses that do qualify!

Three simple requirements must be met for the home office deduction:

  1. The home office must be your principal place of business;
  2. You must use it regularly; and
  3. The space must be used exclusively for business purposes.

In general, the requirements for deducting a home office are not hard to meet. Owning rental property, however, is a little different from other businesses. Don’t let a misunderstanding of the rules keep you from claiming your legal deductions. If you’re operating your real estate rental business and performing regular business activities for it, then it qualifies, regardless of whether you have another full-time job.

  1. Neill v Commr., 46 BTA 197. ↑
  2. Curphey v Commr., 73 TC 766. ↑
  3. Reg. Section 1.1402(a)-4(c)(2). ↑
  4. Schedule E Instructions (2013), dated Dec. 4, 2013, at p. E-5 (under “Line 3”). ↑
  5. Hamacher v Commr., 94 TC 348. ↑
Categories : Business Expenses, Home Office, Investments, Rental Properties, Tax Planning

Why Running a Corporation Increases Your Cell Phone Tax Deductions

By Kim M. Larsen EA CTFS
Sunday, January 25th, 2015

It’s no secret that how you run your company—as a proprietorship, an LLC, or a corporation—affects your tax deductions. In many cases, corporations get the biggest advantages, and that is the case with business cell phone expenses. This article will give you advice for getting the most out of your corporate advantage on cell phone deductions, as well as the requirements for other business owners.

History of Cell Phone Deductions

Did your corporation pay for, or reimburse you for, a business-purpose phone? If so, your corporation gets to deduct both the cell phone’s cost and its usage charges. Does that sound like a good deal? Well, it is—because sole proprietors and single-owner LLCs do not have this advantage! (Keep in mind, however, that partnerships and LLCs run as partnerships are eligible for the same deductions as corporations in this scenario.)

Why are corporations the only entities to cash in on this situation? It goes back to the listed property rules. These tax rules were applied to cell phones all the way back in 1989, and although listed property creates several hoops for taxpayers to jump through, the one that applied to cell phones was the requirement to log both business and personal use. You may be familiar with this requirement in the form of your business vehicle’s mileage log.

But, that’s just where the situation started. In 2010, cell phones were removed from the listed property category. Legislators realized that they simply do not fit in this group. The removal was accomplished through the Small Business Jobs Acts[1].

Corporate Advantage

So, why are some small business owners still getting the shaft? First off, the newer act did not address how to tax personal cell phone use. Then, in 2011, the IRS laid down cell phone guidelines. And, they address cell phone use for employees. As the owner of a corporation, you are considered an owner-employee because your corporation is a fully separate entity from you—not so for the owner of a proprietorship or LLC.

Here’s what the IRS decided[2]:

  • No records need to be kept regarding personal vs. business use of employees’ cell phones, and employer-provided cell phones will not be taxed for personal use.
  • To qualify for this tax advantage, the reason for providing an employee with a cell phone must be mainly for “noncompensatory business purposes”. That means one of the following (or a similar situation) must apply:
  1. The phone allows the employer to contact the employee regarding work-related emergencies at any time;
  2. The employee is required to speak with clients when away from the office; or
  3. The employee is required to talk to clients in other time zones, which may fall outside regular workday hours.

For a corporate owner-employee, it should be fairly easy to meet at least one of those requirements. In fact, your company doesn’t even need to purchase a cell phone for you. You can use your personal cell phone and have the corporation reimburse you or provide a cash allowance for phone usage[3]. That means no logging usage for you (or your corporation), and you still get the deduction! That’s right. As long as you pay a fixed monthly fee (not pay as you go), then your corporation can reimburse you for the entire amount—even if you use the phone for personal calls, too.

What about Other Business Owners?

Because of the differences in business structure, sole proprietors and LLC owners are not considered owner-employees. That means these hassle-free tax breaks apply to your employees and not to you. However, you can still deduct your monthly business-related cell phone costs. You’ll just have to calculate the amount for personal use. Your business-related cell phone use will be deducted like any other business expense, and you depreciate your cell phone’s cost.

Basically, you still benefit from cell phones no longer counting as listed property, but you do have to log usage. So, if you tally up the usage hours for the year, and 80 percent of those were business-related hours, then you can monthly fee and depreciation deductions are for 80 percent of the total.

Important: You will need to document those calls to prove the 80 percent business use. But, don’t droop your head! You can do this easily by simply taking a pen to your phone bill and marking which calls were business and which were personal[4]. Here’s another bit of good news: you don’t need to pour over every phone bill for the entire year. The IRS allows you to take a sample, three months for instance, and apply it to the year if you make about the same number of business calls each month[5]. Or, just save yourself some time and get two phone numbers for your cell.

For employees: Be aware that cell phones given as an incentive or morale booster are counted as taxable income[6].

A Note on Independent Contractors

If you are an independent contractor, you get tax-free, tax-favored employee status for your cell phone, as long as your cell phone is reimbursed by or given to you by an employer. That employer can be a broker, customer, client, etc.[7] In all other circumstances (your phone usage is not reimbursed), you are considered a proprietorship and must prove your usage for deductions.

With all its distinctions for various groups and categories, tax laws will always end up providing an advantage to one group or another. In the case of cell phones (and many other fringe benefits) corporations and their owner-employees get the edge on tax deductions. Whatever type of company you run, make sure you know the rules so you can get the most from your tax return.

  1. P.L. 111-240: IRC Section 2043. ↑
  2. IRS Notice 2011-72; See also IRS Publication 15-B, Employer’s Tax Guide to Fringe Benefits (for use in 2012; updated Dec. 7, 2011), p. 12. ↑
  3. IRS Memorandum for All Field Examination Operations, Sept. 14, 2011. ↑
  4. Umit Tarakci, T.C. Memo. 2000-358. ↑
  5. Reg. Section 1.274-5T(c)(3)(ii)(C), Example 1. ↑
  6. IRS Notice 2011-72; see also IRS Publication 15-B, Employer’s Tax Guide to Fringe Benefits (for use in 2012; updated Dec. 7, 2011), p. 12. ↑
  7. IRS Regulation 1.132-1(b)(2)(iv). ↑
Categories : Business Expenses, Listed Property, Receipts, Records, Tax Planning

Legal Tax Benefits for Your Small Business at Year’s End

By Kim M. Larsen EA CTFS
Saturday, January 24th, 2015

Many people see the IRS as an entity that only seeks to take away their hard-earned cash. But, think of it this way. In a game of basketball, is the other team just going to let you win? No, but most teams will play fair, meaning you have an opportunity to score, just as they do. It’s the same with the IRS. Of course the IRS is going be aggressive in making sure you pay what you owe; however, it also expects you to play just as hard by making sure you receive the money owed to you.

5 Smart Tax Moves

The amount of potential savings is going to vary depending upon your company’s cash flow and its need for supplies and equipment. By playing the game correctly, you could save your business thousands in taxes. What you need is a smart strategy that can be implemented easily and safely, so check out these 5 tips for immediate savings:

  1. Stop Billing at the End of the Year—If your business operation is based on the calendar year, simply don’t send out invoices in November and December. Wait, instead, to request payment for those services at the beginning of January. With no invoice, insurance companies or customers are unlikely to send payment, which means less taxable income on your return. By waiting to bill, you’ve postponed those taxes.
  1. Purchase Office Equipment—After much anxious waiting from taxpayers in 2014, the IRS raised Section 179 expensing back to $500,000, as it had been in previous years. Unfortunately, the smaller $25,000 cap has been reinstated for 2015[1]. However, the limit in 2014 was not raised until nearly the end of the year, so pay attention towards the end of the year to see if the limit is raised again. If so, it will pay to go forward with equipment purchases rather than waiting.
  1. Pay Expenses in Advance—You have the IRS tax-deduction safe harbors to thank for this advantage. According to IRS Regulation 1.263(a)-4(f), cash-basis taxpayers can deduct qualifying expenses up to twelve months in advance[2]. Here’s an example of how it works. Let’s say you pay $2,000 per month in office space rent. To immediately get a $24,000 deduction, on December 31st you just send a check for the entire payment for the next twelve months.

What happens is you get the deduction in the year you paid the money (not the year the money is due). Your landlord, however, does not have to report the payment until the following year since it was not received by mail until January. To prove that you mailed the check in the current tax year (and remember, the IRS always requires proof!), you can send the check certified or by registered mail so that you get a dated receipt.

Tip: Make sure your landlord understands what you are doing. You don’t want this strategy derailed because the landlord thinks it’s an error and your check is returned. Also, don’t send payment too early. Your landlord will not be happy to receive the check before January 1st and have to claim the full amount on the current tax return.

Remember, you can pay expenses for the upcoming tax year in advance, but no further out than that. That means you could not pay two years, or even eighteen months, of expenses in advance. Qualifying expenses for cash-basis taxpayers include office and machinery rent payments, business and malpractice insurance premiums, lease payments for business vehicles, and others.

  1. Pay with Credit Cards—For sole proprietors, expenses are deductible as of the day they are charged to their card. This method allows for immediate deductions of office supplies and other business necessities, and it has the advantage of proof in the form of your credit card statement. For those who own a corporation, this advice works in the same way as long as you have a credit card under your corporation’s name. However, if the card is in your personal name, the expenses are not eligible for deduction until you submit your expense report and the company reimburses you, so plan accordingly.
  1. Don’t Worry that You’re Taking Too Many Deductions—As long as you’re following the rules, you have no reason to hold back on your deductions. A great basketball player doesn’t hold back for fear of scoring too many shots. It is possible that your business deductions exceed your business income. When this happens, it’s called a “net operating loss” (NOL)[3].

Fortunately for you, in the case of NOL tax law allows you to claim refunds from as far back as the previous two tax years[4]. So, you may actually get back money you previously paid in taxes! Not only that, but if you still have unused losses after going back two years, you can carry those losses forward for up to twenty years[5]. That’s an astounding twenty-two year window during which you can benefit from the deductions made in one year, and it works that way no matter how you run your business (proprietorship, corporation, or other methods)[6].

Now that you understand just how much of an effect your deductions can have on your lasting tax benefits, you know to make those deductions count. Don’t avoid deductions for fear of a tax loss. Just because you have an NOL on your return does not mean your business is not thriving and successful. More deductions mean less regular tax paid and less AMT tax paid. So, keep documenting those deductions!

  1. IRC Section 179(b)(1)(B). ↑
  2. IRS Reg. 1.263(a)-4(f). ↑
  3. IRC Section 172(d). ↑
  4. IRC Section 172(b)(1)(A)(i). ↑
  5. IRC Section 172(b)(1)(A)(ii). ↑
  6. IRC Sections 172; 642(d); 512(b)(6). ↑
Categories : Business Expenses, Receipts, Records, Tax Planning

Use Cost Segregation to Raise Your Net Worth

By Kim M. Larsen EA CTFS
Saturday, January 24th, 2015

Tax planning tips often have two priorities—defer your income and accelerate deductions. Would you like to know an easy way to do the second one? You can make a huge difference in depreciation deductions by using a strategy called cost segregation.

What Cost Segregation Means

Cost segregation allows you to separate a building you own into two components, land improvement and personal property. This lets you to realize deductions on the building more quickly. Cost segregation, essentially, speeds up the depreciation of your deductions. Faster depreciation means more money in your pocket now.

How does it work? Let’s assume you have several buildings depreciating on a 39-year plan. By segregating the costs, perhaps 30% of each of those properties could be depreciated in only 5 years, instead. You can implement a plan like this regardless of when you purchased the building. It could be a place you have already owned for years, a renovation you are undertaking, or even a new property you plan to purchase.

Here’s a break-down of how a property’s costs may be segregated:

  • 20% spent on equipment
  • 20% spent on land improvements
  • 60% spent on the building

You could just lump all the costs together and slowly watch 100% of your investment depreciate over a period of up to 39 years. Or, you could separate the costs out and see 20% depreciated in 5 years and another 20% in 15 years. By depreciating the components separately, you raise your net worth! Getting this time advantage makes a huge cash difference for you.

Why Timing is Important

What do all those numbers mean to you? If you have a property that cost you $1 million, tax law allows you to depreciate the equipment, land improvements, and building all the way to zero. So, your property has the potential to produce $1 million in depreciation. That means deductions for you on your tax return. By using cost segregation, you can use those deductions sooner, giving you an edge on tax benefits. Those tax benefits mean more cash available to you now for investing to your advantage.

You may be asking yourself if it can really make that much of a difference. Consider this example: you 1) earn 6% on your investments after taxes, 2) are in the 50% tax bracket, and 3) have $2 million to depreciate. You can use modified accelerated cost recovery system (MACRS) to depreciate it over 5 years, or you can depreciate it on a straight-line schedule of 39 years. Given those circumstances, in today’s dollars you would have:

  • $852,624 investment earnings from using MACRS depreciation
  • $382,427 investment earnings from using the straight-line depreciation

As you can see, that’s a huge difference!

How to Make Cost Segregation Work for You

The cost segregation strategy may not be right for every property owner every year. Here are a few tips for knowing when it will pay off:

  • When passive loss rules aren’t limiting your real-estate deductions, and you are able to benefit from the advantages of a quicker deduction (cost segregation generates a bigger loss on your tax return, which does you no good if your losses are limited);
  • When you are in a position to benefit from the value over time, that is, you intend to keep the building or continue renting it out for the long-term; and
  • When you will pay less for a cost segregation study than what the actual cash benefits will be.

Let’s put it into real numbers for you. You have, for example, a modified adjusted gross income of $200,000 and are subject to passive loss rules. If you have a $35,000 net loss on your rental properties but no passive income, then the $35,000 is a passive loss. It’s not deductible this year, and you will have to carry it forward to next year to see if you can offset it with passive income then.

Qualifying to deduct passive losses is the number one piece to the puzzle of cost segregation. No current deduction available for your losses means no time benefit to the value of your money. Additionally, the longer the amount of time you keep the building, the greater than financial benefit to you when using cost segregation. You may even be able to apply a 1031 exchange both to defer taxes and take your cost segregation benefits from one building to another, giving you some flexibility in the amount of time you hold onto a property. You’ve got plenty to gain, including:

  • Quicker depreciation
  • Section 179 expensing of personal assets that qualify
  • Reduced transfer taxes (because you separated the costs of personal property and real property)
  • Possible reduced property taxes
  • Asset replacement identification (to write off an undepreciated item)
  • A write-off for the cost segregation study fee[1]
  • Look-back depreciation if you use cost segregation on a building you already own and have not segregated before[2] (Make sure you time this right; the IRS allows one automatically approved accounting method change every 5 years, so you would benefit from completing all cost segregations at one time.[3])
  • Owe no user fee to the IRS[4] (most accounting method changes require payment of $2,700)
  • A one-time chance to make a large adjustment by claiming all of the previous years’ depreciation in a lump sum (IRS Form 3115)
  • The opportunity to increase your benefit from a property inheritance

Just be aware that every financial action carries risk. Personal property’s depreciation recapture tax can be higher than that of real property. You could be looking at up to 10 percent higher tax rates when you sell the property (depending upon your income level), so be sure to consider that when making your decision. Hint: As always, watch out for the alternative minimum tax (AMT). For personal property, you can use a 150 percent declining balance depreciation instead of the AMT’s preferred 200 percent declining balance.

As long as you meet these guidelines, cost segregation can be a terrific option for raising your net worth. You will need to hire professionals to perform the study (typically CPA’s and engineers), so check with your tax advisor about whether this option is a good fit before moving forward. If it looks like you will benefit, you can look for a team to perform the study at The American Society of Cost Segregation Professionals . The cost segregation professionals will take care of all the documentation you need for proving your segregation to the IRS.

  1. See “Cost Segregation Applied,” by Jay A Soled, JD, and Charles E. Falk, CPA, JD,Journal of Accountancy, August 2004. You can write off this cost as a 162 expense. ↑
  2. Reg. Section 1.446-1T(e)(5)(iii). ↑
  3. Revenue Procedure 2006-12 ↑
  4. Revenue Procedure 2012-39 ↑
Categories : Business Expenses, Cost Segregation, Depreciation, Rental Properties, Tax Planning

How Commissioned Employees Have Vanquished the AMT and You Can, Too

By Kim M. Larsen EA CTFS
Tuesday, January 20th, 2015

When it comes time to prepare your taxes, you may have an unpleasant surprise waiting in the alternative minimum tax (AMT). Despite its intention of ensuring that top earners pay their fair share of taxes, the AMT really can be a kick in the pants for employees, who cannot deduct their business expenses. Particularly in the case of commissioned employees, this creates a huge difference in the amount of taxes they pay.

What You Need to Know about the AMT

The AMT was created during the 1986 tax reform, and it basically taxes income that is deductible under the regular tax, such as employee business expenses. Here are just a few of the types of employees who pay their own work expenses:

  • Mortgage brokers and bankers,
  • Insurance sales professionals,
  • Traveling sales professionals,
  • Real estate sales professionals, and
  • Emergency room physicians.

Why are commissioned employees particularly burdened by this tax? It’s because they often have a slew of business-related expenses that they pay out of pocket. Then, here comes the AMT to tell them they are not allowed to deduct any of those expenses. However, independent contractors performing the exact same duties as those commissioned employees can deduct many of their expenses.

What Employees Can Do about It

If your income level boxes you into the AMT, you don’t have to give up and lose thousands of dollars to additional taxes. And yes, it is potentially thousands. Take, for instance, the case of Dan Butts, an Allstate insurance agent. In one year, he paid about $10,000 more in federal income taxes than agents at State Farm.

What did Butts do wrong? Nothing—the difference lay in how he was designated by his employer. Butts was considered a W-2 employee, but the State Farm agents were independent contractors with 1099’s. Look at that scenario again. Butts did the same job, at the same pay, and with the same deductions as the agents at another company, but because of his designation, he paid $10,000 more in taxes.

That is a ridiculous situation for an employee to be in simply because the AMT does not permit deductions for business expenses! Fortunately, if you’re in a commissioned position, like Butts, you can do something about this unfair situation. He simply amended his tax return to put his W-2 employee commission earnings on the Schedule C form that self-employed individuals (including contractors) use. He deducted his expenses and saved that $10,000.

Of course, the IRS noticed that he used the wrong form, and he ended up going to court over the issue. . . and winning! Of note in this case is that the court granted Butts independent contractor status even though he had been employed as an employee with Allstate for years and enjoyed employee benefits[1]. The ruling went his way because he carried a “risk of loss”, just like the agents who were independent contractors.

However, you should keep in mind that using the Schedule C to avoid the AMT may work differently in various fields. For instance, a mortgage loan officer named Dan Cibotti worked for Liberty Trust Mortgage, Inc. as a commission-only W-2 employee. More and more commissioned employees are filing on Schedule C, and Cibotti was one of them. In his case, the court ruled that he was considered an independent contractor, despite having a W-2 that reported his income as an employee, because[2]:

  • He set his own hours and chose his own work location and method of finding clients;
  • His employer did not provide him an office;
  • He claimed a home-office deduction;
  • He was paid 100% on commission;
  • He had the possibility of gain or loss on his business activities; and
  • He received no employee benefits, such as a retirement plan or health insurance.

As you can see, the two situations were quite different, but each involved a commissioned employee who fought for his right to file as an independent contractor and won.

Going Forward

Now that other cases have set the precedent, it is becoming easier for insurance agents and other commissioned employees to avoid the AMT. In fact, the IRS, in chief counsel notice N(35)000-141(a), ordered its lawyers not to challenge individuals who claimed independent contractor status under the Butts precedent, but the IRS can be a stubborn entity. The notice that allowed independent contractor status also instructed the lawyers to:

  • Calculate self-employment tax on the agent’s net income and allow a credit just for the employee share of FICA and Medicare (i.e., employer payments are not included);
  • Calculate taxes on employee benefits, like employer-paid medical insurance and Section 125 contributions;
  • Calculate taxes on 401(k) contributions and make the taxpayer aware that they may not fall back on the Lozon decision, which concluded that such contributions were not taxable until withdrawn[3].

This notice has since expired, but if you plan to pursue independent contractor status, it would be wise to compare AMT savings with the potential tax disbursement outlined in the above IRS strategy.

Other Cases

Several other cases for independent contractor status have gone to court with varying results. Wesley Wickum, a district manager for Combined Insurance Co. of America, amended three years of tax returns and reclaimed $27,000. His salary included commission from his sales, bonuses, and override commissions based on the salespeople he recruited and supervised. In a funny twist, his company had previously considered the salespeople and managers to be independent contractors, but had changed the status out of fear of IRS penalties for wrongly classifying employees as contractors!

You can see the repercussions on business. The AMT hurts a company’s best salespeople—those who make the most commissions. When such a worker is classified as employee instead of contractor, the AMT comes into play, and may cause the best salespeople to leave the company.

A sales agent named Paul Hathaway also amended three years of tax returns after learning of the Butts case[4]. He was a commissioned employee, and although his company provided a W-2 each year and gave him benefits, he paid his own expenses for food, samples, travel, telephone, stationary, and business cards.

William Johnson and Barbara Lewis, on the other hand, lost each of their cases for independent contractor status. Johnson was a full-time hospital equipment salesperson who worked on commission, but the court ruled that he was an employee because his employer 1) restricted him from hiring employees and 2) required that he file daily call reports[5]. Lewis sold hair care products to salons and also made commissions. The court ruled her an employee by status because 1) her employer required her to file daily sales activity reports, 2) her employer supplied her with leads, which she was expected to follow up on, and 3) she had a negligible “risk of loss”[6].

AMT Tax Savings

If you’re going to claim independent contractor status for your commissioned income, take these cases as examples what kind of evidence you need. Remember, your savings could be thousands of dollars. Need an example? Let’s say you’re a mortgage loan officer, like Wickum in the case above. If you made $200,000 and spent $125,000 in business expenses, you have a net income of $75,000.

With regular taxes, those business expenses are reduced by 2 percent, leaving a regular taxable income of $79,000 (.02 x $200,000 = $4,000; $125,000 – $4,000 = $121,000; $200,000 – $121,000 = $79,000). But, for AMT purposes, this employee gets no deductions on those expenses. That means the taxable income is the full $200,000. That’s a huge difference!

So, if the employee files taxes on Schedule A, the amount owed is $45,000. On Schedule C (as an independent contractor), it would only be $15,000. You can see why commissioned employees argue for their contractor status.

If your work situation involves unreimbursed business expenses and a status as employee, you have options to establish your status as an independent contractor for tax purposes. Since the IRS has established a position on this issue, you can start by discussing your status with the local IRS district director. If necessary, you can escalate the situation by requesting a private letter ruling from the IRS. This route does cost money, but it will likely be less costly than going to court. Litigation like the Butts case has not happened in years, so you have a good chance of a ruling in your favor if your circumstances and evidence are sufficient. The AMT seems to be here to stay for the present, so don’t let thousands of dollars slip away from you every year.

  1. Butts v. Commissioner, TC Memo 1993 478, affd. per curiam 49 F.3d 713 (11th Cir. 1995). ↑
  2. Dean Cibotti v Commr., TC Summary Opinion 2012-21. ↑
  3. Lozon v. Commr., TC Memo 1997-250. ↑
  4. Paul E. Hathaway v. Commr., TC Memo 1996-389. ↑
  5. William O. Johnson v. Commr., TC Memo 1993-530. ↑
  6. Donald J. Lewis, Jr., v. Commr., TC Memo 1993-635. ↑
Categories : AMT, Business Expenses, Cars, Trucks & SUVs, Depreciation, Employees, Entertainment, Home Office, Receipts, Records, Self-employment Tax, Tax Planning, Travel

Passive-Loss Rules Got You Trapped? You can Release Rental Property Tax Losses

By Kim M. Larsen EA CTFS
Saturday, January 3rd, 2015

If you’re feeling the pain from calculating your rental property loss deductions and finding that you can’t get some of that money back, you can thank lawmakers from 1986. That’s when the passive-loss rules came into being. These laws really complicated matters for taxpayers, but this article can help you to understand the ins and outs.

How Passive-Loss Rules Work

Basically, lawmakers have given you three possible tax buckets for any given taxable activity:

  1. Portfolio of stocks and bonds
  2. Active business activities involving material participation
  3. Passive-losses for rentals and other activities you don’t materially participate in

We’ll primarily look at the last one with this article. You’ll be happy to know that you do have some options for getting around the passive-loss problem. With the right knowledge, you can see tax benefits from your rental losses.

Before we delve into the solutions, let’s get an understanding of why you may have issues deducting your rental property losses. In order to get the tax benefit from your rental property loss, you (or you and your spouse) have to meet one of two requirements. To meet the first requirement, you must have passive income, such as from other properties or another source. Otherwise, you have to qualify as a real estate professional and actively participate in your rental property business.

Given those requirements, here’s an example of how your rental property losses can end up trapped and unable to be deducted. For the example, you have only one rental property (i.e. you have no other passive income), and you do not qualify as a real estate professional for tax purposes. If your property has produced a tax loss of $10,000 each year for the past six years, and your taxable income is $180,000, you can’t deduct any of those $60,000 in losses because you don’t meet either of the above requirements, and they can’t be deducted from either of the other income buckets.

Your Options

Let’s take a look at the three options you have for navigating these passive-loss rules. It turns out that even if you don’t meet the above requirements, you may have an opportunity to deduct your losses in certain scenarios.

  • Get Full Loss Benefits—Taxpayers who have a modified adjusted gross income of up to $100,000 can deduct all of their rental losses up to $25,000.[1] As your income rises above $100,000, your deduction is reduced by 50 cents per dollar, and once you reach a modified adjusted gross income level of $150,000, you lose this ability to claim losses easily.[2] For a practical example of how this works, let’s say your modified adjusted gross income from your business was $85,000, and you had rental losses of $21,000. In this case, you would be able to deduct the full $21,000.
  • Waiting for the Benefit—Remember the $60,000 that were trapped in the example above? It turns out that you don’t just lose all chance of benefiting from those accumulated losses. They are still tax-deductible, but you have to find a way to release their ability to be deducted. In fact, here are four possible ways to get that money out of waiting:
  1. Change the rental property from passive to non-passive. If you’re the sole owner of your business, and you also own 100 percent of the rental property, you can simply convert half the rental property for business use (such as office space). Now 50 percent of you trapped losses can be released ($30,000) for use against the business income bucket[3]. If you operate as an S corporation, you’ll have to make a self-rental election.
  2. Produce additional passive income. If you produce, for example, $6,000 in passive income, you can release $6,000 of the trapped $60,000. Now, you just have to wait to release the other $54,000.
  3. Qualify as a real estate professional and prove your material participation in your real estate business. This option cannot release funds that have been waiting to be released because your qualification as a real estate professional is evaluated on a yearly basis. However, by qualifying, you are able to release your losses for the current tax year. So, the $10,000 for the year you qualify as a real estate professional will be offset against your business and portfolio income buckets. Other losses will have to be released using one of the other solutions.
  4. Sell your property. This option is further explained below.
  • Releasing the Full Amount—If you don’t meet the modified adjusted gross income threshold to take full advantage of loss deductions, there’s actually a very easy way to release the full $60,000 of our example losses. All you have to do is sell 100 percent of the property. When you sell to a third party, you can deduct the entire $60,000 at once. Here’s how you might handle this on your tax return:[4]
  1. You list your capital gain or loss on IRS Form 4797. It will be listed with your other Section 1231 gains and losses. A net gain will be taxed at the tax-favored rates of up to 15 percent, and a net loss will be limited to $3,000. But, don’t worry—anything over that amount can be carried forward.
  2. You also list any gain that is attributable to real-property depreciation (Form 4797). This will be taxed at the real-property depreciation recapture rate on Schedule D (up to 25 percent).
  3. You put the $10,000 loss for the current tax year on Schedule E.
  4. And, here’s the best part. You put the prior $60,000 of tax loss (in addition to the current year’s $10,000) on Schedule E, which finally ends up on your Form 1040 and the entire $70,000 offsets all your income.

To break it down for you, when you sell your property, you get to snub the passive-loss rules and pretend like they don’t even exist!

Passive-loss rules are frustrating, but know that you can eventually deduct your losses. You can even elect to group together multiple properties and use these exact same solutions. Getting the most benefit from your tax return is all about planning ahead. Now that you know how to get around the passive-loss restrictions, you can start planning for the techniques that work right for you and your properties.

  1. IRC Section 469(i). ↑
  2. IRC Section 469(i)(3)(A). ↑
  3. Reg. Sections 1.469-9(e)(4), Example (ii); 1.469-1(f)(4)(iii), Example 4. ↑
  4. Instructions for Form 8582 (2011), revised Jun. 8, 2012, ps. 7-8. ↑
Categories : Depreciation, Investments, Passive Income & Losses, Rental Properties, Tax Planning
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