Archive for Cars, Trucks & SUVs

Increase Your Tax Deductions—Switching from the IRS Mileage Rate to Actual Expenses

Do you feel like you’re not getting as much as you should from your business vehicle mileage deductions? For some business owners, gas and maintenance for a vehicle can be significant business expenses. If you’re not already using the actual expense method to calculate your mileage deduction, that may be your ticket to getting more from your vehicle expenses.

Usually, you’ll make a decision once regarding whether to use the IRS mileage rate for your deductions or to use the actual-expense method. If you choose the IRS mileage rate, you also lose out on MACRS depreciation.[1] However, you’re not locked into your choice forever. You have two different options for switching to claiming actual expenses.

Option 1: Amending Your Tax Return

If you realize fairly quickly that you’ve made the wrong decision in choosing to use the IRS mileage rate, you can act quickly and change your decision. That means you’ll have to file an amendment to your tax return before its original due date (if you filed extensions, the deadline includes the extensions).[2]

This option is fairly easy to enact. You’ll file the amendment, electing actual mileage expenses, Section 179 deductions, and MACRS depreciation. But, you have to act fast. This method essentially replaces the election on your original tax return.

Option 2: Straight-Line Depreciation

If you’ve already missed out on your chance to amend your return, you do have other options. You could still switch to the actual-expense method with MACRS depreciation, but you’ll have to get permission from the IRS commissioner . . . if you enjoy wasting time and money with the possibility of rejection.[3] Let’s be smart here; the commissioner is not a good option.

Instead, you can opt for straight-line depreciation for the remainder of your vehicle’s useful life.[4] This allows you to make the actual expense deductions. For calculating the straight-line depreciation, you’ll need the following information on your vehicle:[5]

  • Its Adjusted BasisThis is typically the original cost of the vehicle minus depreciation. When you use the IRS mileage rate, depreciation is included in it (22 cents per mile in 2014 and 24 cents per mile in 2015).[6] If you pay $30,000 for your car and drive it 5,000 miles for business (with no personal miles), you would calculate your depreciation at 5,000 miles x $0.22, which equals $1,100. Your adjusted basis is $28,900 ($30,000 – $1,100).
  • Its Estimated Remaining Useful LifeYou don’t need to think too hard about this. It’s simply how long you expect to keep the vehicle.[7] We’ll call it 5 years for our example.
  • An Estimate of Its Salvage Value when the Useful Life EndsTo get a salvage value, you should use a respected pricing source, such as Kelly Blue Book. In our example, the value is what you estimate you could sell the vehicle for in 5 years (the remaining useful life). Let’s say this number is $4,000. Don’t forget to document where you get this number from!

Now, when you switch to actual mileage expenses, the IRS gives you a bonus on the salvage value if you plan to keep the vehicle for more than three years. Our example vehicle meets that requirement, which means you can reduce the salvage value by $3,000 (10 percent of the basis). If 10 percent of the basis exceeds the salvage value, that’s no problem. You’ll simply claim a salvage value of zero.

An Additional Consideration

When claiming actual expenses, you’ll have to pay attention to the luxury vehicle depreciation limits. These apply to passenger vehicles, and the limits differ between cars, vans, and trucks. You’ll need to find the amounts for the year you placed your vehicle in service.

For 2014 the limits for cars placed in service that year are:

The limits for vans and trucks are:

Note: These are amounts for used vehicles only. If your leased or purchased a new vehicle, use the tables in Rev. Proc. 2014-21 . Regardless of the type of vehicle or whether it is new or used, you must reduce the limit by your personal use. So, if you use your car for 80 percent business and 20 percent personal purposes, your first year limit is $2,528. If these limits affect your depreciation, you can simply claim the rest of the depreciation in a later year—you do not lose it.

Some vehicles are exempt from the luxury limits. Your truck, van, crossover, or SUV may be exempt if it 1) is classified as a truck by the Department of Transportation, and 2) has a gross vehicle weight rating over 6,000 pounds. Note that some passenger trucks are not classified as a “truck” by this definition.

If you don’t like the choice you made for your mileage deductions, you can fix it. If you catch it early, you’ll still get all the additional benefits that come with the actual-expense method (Section 179 expensing and bonus depreciation). However, if you make the switch later, you can still get some benefit from actual expense deductions with straight-line depreciation. What you need to know is that the choice to switch is available to you.

  1. Rev. Proc. 2010-51; IRC Section 168(f)(1)
  2. Reg. Section 301.9100-2(d)
  3. Rev. Proc. 2011-14, Appendix 6.02
  4. Rev. Proc. 2010-51
  5. IRS Pub. 534, Depreciating Property Placed in Service Before 1987, (Rev. Nov. 1995), p. 7
  6. Notice 2014-79;,-Medical-and-Moving-Announced
  7. IRS Pub. 534, Depreciating Property Placed in Service Before 1987, (Rev. Nov. 1995), p. 7

Own Two Cars? Claim Business Tax Deductions on Both!

If you use your car for business, you’re well aware by now that you can deduct your business mileage. If you have a tax-deductible home office, you can even deduct your commute to and from work each day. But, did you know that you might also be able to claim expenses for more than one vehicle? For business owners who fit the requirements, you can significantly increase your tax savings with deductions on both your vehicles.

Marriage Status Makes a Difference

It seems like married couples often get the most benefits when it comes to tax savings, but deducting business mileage for two vehicles is actually easier for the single folks. A single person who drives more than one car has a good chance of deducting expenses for both. The married person, on the other hand, will have a bit of a harder time justifying this deduction on their tax return. It can be done, though.

Here’s what you need to prove for the deduction if you’re married:

  1. You drive more miles than your spouse.
  2. Most of your miles are business miles.
  3. The two vehicles are of comparable value.

Figuring Out if You Qualify

So, either you’re a single person with two cars, or a married person who uses both vehicles for business miles. Either way, you’ll need to know four numbers regarding your vehicles and mileage. They are:

  1. How many business miles you drive,
  2. How many total miles you drive,
  3. The cost of each vehicle, and
  4. The estimated proceeds if you were to sell each of the vehicles.

These numbers should be pretty easy to produce. After all, you are keeping track of your business mileage already, right?

Get ready for some really easy math. It turns out the deductions work the same regardless of whether you’re married, single, a sole proprietor, or the owner of a corporation. No matter your circumstance, you can take those four numbers above and determine whether the two car deduction creates an advantage for you.

Tip: One thing that does make a difference is if you have the car on a lease. In the case of a lease, you must use IRS mileage rates and cannot use the formula below.

How to Do the Math

Let’s do an example. For this example, you own two cars: Yellow Car and Blue Car. Yellow Car cost you $23,000 and Blue Car cost you $21,000, so you know those numbers for the formula already.[1]

Say you used to drive only one of the cars for business purposes, and you drove a total of 28,000 miles. In this scenario, you drive Yellow Car 30,000 total miles and Blue Car 8,000 total miles, for a grand total of 38,000. That gives you 93.3 percent business use for Yellow Car and 0 percent business use for Blue Car.

Given this scenario, you are putting more miles on Yellow Car, so it will be worth less at the time of sale—$2,000. Blue Car could sell for $5,000. These numbers, of course, will be an educated guess. Now, you get your total tax deduction by calculating the net cost of your vehicle (purchase price minus sale price), and then multiplying by your business-use percentage. For the single-car scenario, your deduction equals $19,593.

Now, let’s see what happens if you start dividing your business mileage between two vehicles. Your 28,000 business miles are now divided between two cars—14,000 miles each. And, your total mileage is also divided between both vehicles—19,000 total miles each (the grand total remains the same, 38,000 miles). This means you are now driving both vehicles for business use 73.7 percent of the time.

Your estimated sales proceeds in this case are $3,500 for each vehicle, since they are being driven the same number of miles. Now what are the tax deductions for each car? Yellow Car: $19,500 (net cost, or basis minus proceeds) multiplied by 73.7 percent equals $14,372. Blue Car: $17,500 multiplied by 73.7 percent equals $12,898. This gives you a total tax deduction of $27,270.

You just added an extra $7,677 to your tax deduction! When you file your tax return, these deductions will be claimed (and adjusted) under depreciation, Section 179 expensing, and/or gain or loss on sales. These three elements equal the business percentage of the net cost of your vehicle. Before you decide to start using two cars for business, run the numbers through this easy formula, and see if it would save you money. Regardless of whether you claim these deductions using IRS mileage, actual expenses, or Section 179 expensing, the formula accurately determines whether claiming expenses for two vehicles is a better solution for you.

  1. If you traded in an older vehicle for one of these, you may want to use the adjusted basis rather than the original basis, or cost of the vehicle.

Did You Know Your Car Can Accelerate Your Tax Savings?

Would you like thousands, or even tens of thousands, more dollars in tax deductions every year? Of course you would! To boost your deductions, you can count on your vehicle to be a deduction generator if you use it to drive from one business location to another. The only thing you have to do is keep the right records in order to prove your business mileage. Your tax records, like your car, require regular maintenance in order to function properly.

The Documentation You Need

We can look at the court case of salesman, Marcus Crawford, for an example of what a difference minor deviances in documentation can make.[1] Crawford spent much of the work day driving to meet customers. He tried to defend is vehicle deductions in an amount greater than $20,000 by providing 1) destination notes on his daily calendar, and 2) saved gas receipts. Although this sounds like decent record keeping, the IRS rejected this documentation and Crawford got none of the deductions. Zero.

Unfortunately for Mr. Crawford, the IRS is pretty strict about documentation for vehicle deductions. Here’s what you actually need in order to qualify:[2]

  1. A mileage log
  2. Receipts that support your mileage log

Crawford’s proof didn’t work because it failed to document the true number of miles spent driving to each location and how the location was related to his business activities. A proper log divides mileage into the appropriate categories:

  • Personal mileage
  • Commuting mileage
  • Business mileage
  • Investment mileage
  • Rental property business mileage

Here’s a hypothetical example:

Note that rental property mileage should be calculated separately from other business mileage. This is so you can determine Section 179 expensing for your vehicle. Additionally, you see that the miles marked for the trip to the grocery store are zero. Why? It’s because the stop was located on the way between two other stops, so it does not generate any additional mileage.[3] Although the grocery trip is a personal stop, you would have had to drive the same distance from one office to the other whether you stopped for groceries or not.

In some cases, it may be more convenient to group the mileage together for multiple stops. This is perfectly fine as long as you document it that way. For example, a real estate professional may make a note indicating multiple stops to show the same client six different properties. These six stops can go together on one line of your mileage log.

Simplifying Your Record-Keeping by Sampling

Writing down every single stop you make every day for the entire year sounds fun, right? Not so much. If tracking your mileage is starting to sound like too much work to even be worth it, keep reading. Per the IRS, you are allowed to track your mileage for only part of the year, and then use that sample to calculate your total business mileage for the rest of the year. You have two options:[4]

  1. Keep a mileage log one week out of every month, or
  2. Keep a mileage log for three consecutive months.

By using the second option, you can log your mileage for one three-month period and then forget about it for the rest of the year. This is the better way to go because the one week a month method increases your risk of missing a month, and when that happens, the IRS no longer accepts your records. It does not accept “almost” with mileage logs.

There is one little catch. If you use the three consecutive months method, those months must be representative of your driving habits for the entire year. For those of you who work in a business with noticeable seasonal fluctuations in your business mileage, you’d better stick to the one week a month strategy.

Supporting Your Log

Okay, so you’ve logged your mileage and labeled its category for either three consecutive months, or one week out of each month for the year. You’re all set, right? Not so fast. The IRS isn’t so trusting that it will just accept the records you’ve individually recorded. So, you’ll have to back up your mileage sheets with evidence from other sources that match your records.

Some documents the IRS may request during an audit include:[5]

  • Inspection slips, repair receipts, and any other records that record your vehicle’s total mileage
  • A copy of your calendar or appointment book that indicates your business activities for the year
  • A copy of your mileage log

Each of these proofs will be cross-referenced with each other to ensure that everything matches up. That means if your gas receipt shows you were in Henderson, NV on a day your mileage log shows you staying in Riverside, CA, you’ve set off a red flag that may cancel your deductions.

What If You Don’t Keep Paper Records

Certainly many business people are switching over to digital record keeping. If you prefer to track mileage on an app, that’s no problem. However, it may be a good idea to keep paper print-outs as backup until you’re certain the app’s records meet the requirements of the IRS. Always keep some kind of backup of your digital records. You never know when a glitch, virus, or hacker may delete all your records, or render your app inactive.

Tracking your vehicle mileage isn’t too difficult once you set up a system for yourself. Remember, you only have to do it for part of the year. The IRS mileage rate for deductions is $0.56 per mile, so with the right documentation, you can claim thousands in deductions just by going about your normal work routine.

  1. Marcus O. Crawford, TC Memo 2014-156.
  2. IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses (2013), Dated Jan. 14, 2014, p. 25-27.
  3. Reg. Section 1.274-5T(c)(6)(i)(C).
  4. Reg. Section 1.274-5T(c)(3)(ii)(A).
  5. Internal Revenue Manual Exhibit 4.13.7-20 — Examination Documentation Requirements Paragraphs – Cont. 6 [09-01-2006].

Make Your Records Rock Solid to Avoid Audit

This article isn’t about any particular way to save money on your taxes. However, it will make a huge difference in your taxes no matter what strategy you use for your tax return. Even the absolute best tax methods can leave you at the mercy of an auditor when you don’t properly document and keep records. Sure, you may think it’s a hassle, but is putting in a few hours up-front on an organized record-keeping system worth thousands, even tens of thousands, of dollars in tax savings? You bet!

The Rules of Record Keeping

Here’s the fact—the IRS is never just going to take your word for it that you spent X number of dollars on justifiable and legal business expenses that are now tax-deductible on your return. Sorry, no documentation, no deduction.

So, with that in mind, here’s the first rule you need to know.

Rule #1 Always keep your accounts separate. In fact, you should have separate checking accounts for:

  • Each spouse,
  • Each corporation,
  • Each Schedule C business you report, and
  • Your rental properties (you may even want a few separate accounts for these if they are very different kinds of rentals).

How about an example of why this is so important. Let’s say you own a sole proprietorship, and you cover your spouse under a Section 105 medical reimbursement plan. If you’re using one checking account jointly for your household and your business, you would have to write the reimbursement check to yourself—and that negates your Section 105 plan.

That’s exactly how Darwin Albers lost out on deductions for his 105 plan.[1] Keep your business and personal accounts separate—just do it.

Rule #2 Earnings go to the account belonging to the business that earns the money. Do not take payments in your personal name. If you do, they cannot be assigned to your corporation. The person or entity that earns any given income is taxed for said income.[2] If you follow the rule above, then it’s easy not to mix personal receipts into your business account and vice versa. Although it’s possible to argue with the IRS that some receipts in a given account are not taxable, it’s not worth the frustration and wasted time.

Rule #3 Keep track of your deductible expenses each day. Don’t wait until two weeks from the purchase to write down your expenses (or save them in your file). For one thing, it increases the chance that you may miss something. For another, the IRS requires that deductible expenses are recorded within one week. The idea of doing daily record keeping may make you want to just toss your files over your shoulder (don’t—you’ll hate reorganizing them up later), but it really is good practice. After all, how hard is it to save a receipt and make a note about why you spent the amount?

Rule #4 Keep a log for each set of expenses. For most deductions, you need evidence that proves your business use or business purpose for the expense. Want to deduct vehicle expenses? Keep a log to track daily mileage. Want to deductions on your rental properties? You’d better keep track of how you materially participate in your real estate or how you qualify for status as a real estate professional. Planning to make deductions for your home office? Again, you need a log, this time to keep track of how many hours you spend working in that office. You’ll have to consistently spend more than 10 hours per week working from your home office in order to claim it on your tax return.[3] By keeping track on a daily basis, you can take advantage of the sampling method of calculating your deductions in some cases (such as vehicle mileage); this method allows you to take a sample from a three month period rather than calculating the exact sums.[4]

Rule #5 Keep track of travel and entertainment costs. For travel expenses, you have to prove (with documentation) where you were each day and why. Your business entertainment costs also need proper documentation, including what you spent money on, how much, when, and where the expense occurred. Your receipt will cover all of those, but you’ll additionally need to note who you entertained and why (i.e. the benefit to your business).

In the case that you operate your business as a corporation, you’ll have to turn the expenses in to your company. You can do this by paying with a corporate credit card, or you can have the corporation reimburse you for the expenses. Making sure the company pays is important; otherwise you’ll only get employee-business deductions for those expenses.

What to Remember

No matter what kind of business costs you incur, you need to remember these two primary pieces of information: 1) prove what you bought and 2) prove that you, in fact, paid for it. As mentioned above, a receipt or paid invoice covers the first part of this. In order to prove payment, you can use a credit card receipt or statement, canceled check, or bank statement (for electronic transfers). Note: An item is considered paid for when you charge it to your credit card, regardless of when you pay the amount to your card.[5]

Don’t pay with cash. It makes things more difficult for you. If you pay with cash, an auditor will want to know where the cash came from, how you can show cash trail and tie it to the payment, whether you can prove an ATM withdrawal, and most importantly, did you really pay for something in cash or are you just making up a deduction? Paying with pretty much any other method is much less of a hassle.

A Note on Petty Cash

Petty cash works for some small businesses. If it’s what you’re accustomed to and you haven’t had any problems, then by all means continue using the system. However, many small business owners end up kicking themselves in the pants with a petty cash system. You’ll likely find it easier to use a reimbursement system.

With the reimbursement system, your company simply writes you a check for the expense when you provide documentation for it (a receipt or expense report, for instance). Because you have to present documentation for reimbursement, you’re less likely to get caught without evidence for your spending, as you could with petty cash.

Statutes of Limitations and How Long to Keep Records

The IRS has statutes of limitations on when either you or it can make changes to a tax return (this is not just the period during which they can audit you). Here are the time frames given in IRS publications:[6]

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

If you have employees, you need to save your employment tax records for four years after whichever date comes later, the date payroll taxes were paid or the date they were due.

Because these statutes of limitations also indicate how long the IRS can audit your return, you need to ensure that you hang on to all of your records until the risk of audit has passed. This could mean keeping records for a period of multiple years. In the case of assets, like office equipment and office buildings, the records are relevant throughout the asset’s entire depreciable class life. As long as you are still depreciating an asset, it will be in that year’s tax return. When using Section 179 to expense an asset, you also have a potential recapture throughout the depreciable class life.

Here’s an example. You buy a desk for $1,500 and depreciate it over the MACRS life of seven years. This depreciation actually takes eight years, so you need the original purchase receipt in year eight in order to prove your deduction. Additionally, you will need to retain that purchase record for three years after that when the statute of limitations expires (for a total of eleven years). It works the same with Section 179, except that you also have recapture exposure during those eight years of depreciation.

Would you like an easy way to keep track of this? Just make a permanent file for any assets with a life greater than one year. This way, you don’t need to keep track of class lives or time frames on the statutes of limitations.

And, here’s another quick tip for keeping those records organized:

Simplify your file system by devoting separate drawers for each tax year. In those drawers, you’ll put any information on assets, income, and other information applicable to your return. This method is for assets other than those you keep in your permanent file. The first drawer will be where you put all documents as you acquire them throughout the year. The next drawer is last year’s tax documents. The drawer after that contains documents from three years ago, and so on until you reach the year at which your statute of limitations expires. Each year, you move the drawers down one level and dump the one at the bottom of the line. You can also use this method for any employee tax files.

You see? It really isn’t all that difficult to keep your records straight. You’ll be thankful you did when it comes time to prepare your return.

  1. Darwin J. Albers v Commr., TC Memo 2007-144.
  2. United States v Basye, 410 U.S. 441, 449, 451 (1973); Lucas v Earl, 281 U.S. 111 (1930).
  3. John W. and Regina R. Z. Green v Commr., 78 TC 428 (1982), reversed on other grounds, 707 F2d 404 (CA9, 1983).
  4. IRS Reg. Section 1.274-5T(c)(3)(ii)(C), Example 1.
  5. E.g., Rev. Rul. 78-38; Rev. Rul. 78-39.
  6. IRS Pub., 583, Starting a Business and Keeping Records (Rev. January 2007), Record Keeping.

You Totaled Your Vehicle? Tax Benefits You Can Use

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

Understanding Tax Law

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

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

For a Proprietorship

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

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

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

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

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

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

For a Corporation

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

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

Deferring Taxes

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

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

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

Don’t Forget the Documentation

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

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

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

  1. IRC Section 165(h)(1).
  2. IRC Section 165(h)(2).
  3. IRC Section 1033(a)(2).
  4. IRC Section 1033(a)(2)(A).
  5. IRS Pub. 547, Casualties, Disasters, and Thefts (2012), posted Nov. 29, 2012, p. 12.

Don’t Be a Target for the IRS

If there’s one thing the IRS is most known and feared for, it’s the audit. It’s well-known by now that the IRS has had its eye on tax-exempt conservative groups, but what you may not realize is that they’ve now expanded that extra attention to entrepreneurs, owners of small businesses, and high income earners. This is atypical of their past trends, since they had previously focused efforts on watching large corporations. However, the number of revenue agents in the IRS has risen by more than 5,000 people in the last few years.

Who’s at Risk?

This expansion in auditing-capability primarily hits the upper-middle class and affluent individuals. Without raising taxes, this move has allowed the IRS to greatly increase total tax collections because more audits are performed and more revenue officers are available to collect unpaid taxes from citizens. Grumble if you will, but the decision-makers are probably pretty happy with their investment in extra workers. Estimates show that the IRS has an 18 to 1 return rate on each dollar invested in audits and collections.

Are you feeling confident that your business is too small to come under scrutiny? Think again. The IRS conducted a study involving 46,000 taxpayers, and the results indicate a $345 billion tax gap. Guess what else the study revealed—about two-thirds of that gap came from entrepreneurs, small business owners, professionals, and investors. The IRS has grown its means to act on suspicious tax returns, and it’s looking straight at you. That’s right; it’s moving about 30 percent of its auditors away from large corporations and using that workforce to scout out smaller prey.

What IRS Expansion Means for Your Tax Return

An audit can cost you a lot of money in professional fees, back taxes, interest, and penalties, so it makes sense to audit-proof your return now. Don’t assume that you make too little for the IRS to be concerned with you. Although the top earners have the highest audit risk (those earning more than $1 million have seen a dramatic increase in audit rates recently), even individuals making $200,000 are experiencing the effects of increased tax surveillance. Your risk of audit may not be as high as the 1 in 8 chance that millionaires now face, but it is trickling down to businesspeople with more modest incomes.

In order to understand why you may be audited, it helps to understand the process used by the IRS. It has several different methods for selecting returns for audit, and one that has been in use for decades is called the discriminant index factor (DIF). Basically, a mathematical formula is used to score a return, often based on the ratio of income to deductions. The process breaks down like this:

  • You send in your tax return, and the systems at Martinsburg West Virginia National Computer Center run the numbers.
  • Your return gets a DIF score. The higher the score, the bigger the chance that additional taxes may be able to be collected from you.
  • IRS employees audit the returns with the highest score first (i.e. the returns that will bring in the most additional revenue).

The formula for DIF scores is regularly updated using an analysis of intensive audits, the Taxpayer Compliance Measurement Program (TCMP). It’s conducted every few years. For a TCMP audit, every single piece of information on the return is analyzed. For people reporting business receipts on their personal income tax return (Schedule C and Schedule F), gross business income is used to determine DIF score, not net business income. Red flags that generate a high DIF result may lead to your receiving a letter of inquiry, or even the dreaded examination of your tax return.

Avoiding the Audit

After computer DIF scores are assigned to the returns, IRS employees then select which returns will be audited. This process usually starts later than June. A computer formula may assign you a high DIF, but in the end it is up to classifiers working in the district offices to determine whether your return raises red flags. So, even if a high DIF result brings your return under scrutiny, you can follow some simple rules to keep down your chances of being selected for audit.

Take a look at some basic tips for making your return less likely to be audited:

  • Balance Your Deductions—Risk of being scrutinized increases with the more deductions you take compared to the size of your income. Time your deductible expenses right so that they are fairly even on a year to year basis.
  • Always Respond to Inquiries—If the IRS sends you a letter regarding missing schedules, send a response! Failing to answer makes you much more likely to be examined.
  • Remember Form 8283—When you make a non-cash charitable contribution, you must include this form.
  • File Your AMT—The alternative minimum tax is separate from regular taxes. You’ll need to use Form 6251 and send it in with your 1040.
  • Document Your Casualty Losses—Casualty losses are already a red flag for the IRS. You definitely deserve any deductions you are entitled to for such losses, but be sure to document all information about the date of loss, cost, and any insurance payments you received. And, include this information with the return, not when they’ve flagged you for auditing.
  • Report Any 1099 IncomeIf a client of yours reports a 1099 to the IRS, you’d better make sure you report it on your tax return. When you don’t, it’s considered a matching issue, and you will be contacted about it. In the case that you are contacted about a mismatch issue, respond to the IRS immediately to prevent an escalation of the situation.
  • Use an Entity Structure—Filing a high number of gross receipts for your small business drastically increases your return’s chance of being examined. However, when you switch from reporting these on a Schedule C to reporting them as a corporation, partnership, or LLC, you significantly reduce that risk. Not only does using an entity structure lower your chance of being audited, it also decreases your taxes. It’s an excellent option to consider if you are functioning as a proprietorship or independent contractor.
  • File On Time—This one should go without saying, but turning in your tax return by deadline (including extensions) can help you to avoid examination.
  • File a Paper Return—Filing electronically may seem easy, but there’s a reason the IRS encourages taxpayers to use this method. An electronic return can go right into their DIF scoring system and be ready for analysis immediately. Rumor has it that only about half of all paper returns even get scored in the DIF system. Most taxpayers are required to use the electronic filing system. However, you can opt out by attaching IRS Form 8948 to your paper return.
  • Watch Out for the Big Three—IRS agents are coming down hard on deductions for travel, automobiles, and entertainment expenses. The secret to having these deductions approved is documentation, documentation, documentation. Quick and dirty tip: The IRS requires 5 pieces of documented evidence, but all you really need is your receipt! It covers 1) date of the expense, 2) where the expense occurred, and 3) amount of the expense. Then, you simply write on the back of the receipt 4) the business purpose for the expense and 5) your relationship to the person or group you entertained. Simple! Just don’t forget the receipt—the IRS does not count credit card statements as receipts. For automobile deductions, you’ll also need to keep a mileage log.

Electronic filing has made auditing easier (and a bigger priority) for the IRS. Now that they need fewer employees sifting through paper files, they have allocated a larger portion of their workforce towards audits and collections. With this increased strength, they have turned their eyes toward smaller entities, but you can audit-proof your return by providing accurate documentation and following these tips. Don’t let the IRS intimidate you into forgoing deductions you have a right to!

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

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.