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

How to Make Your Proprietorship a Corporation

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

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

Transferring Assets

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

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

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

Considerations When Doing Business with Your Corporation

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

Here are some scenarios you’ll want to consider:

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

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

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

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

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

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

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

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

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

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

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

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

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

How You Buy

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

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

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

Your Purchase Affects Your Taxes

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

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

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

Issues When Purchasing Stocks

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

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

Things to Consider When Purchasing Assets

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

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

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

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

Understanding the Seller’s Incentives

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

Capital Gain

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

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

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

Protection from Future Liability

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

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

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

What the Statute of Limitations Means for Your Tax Records

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

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

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

Here they are:

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

Keeping Appropriate Records

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

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

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

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

Record Keeping Tips

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

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

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

You Totaled Your Vehicle? Tax Benefits You Can Use

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

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

Understanding Tax Law

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

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

For a Proprietorship

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

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

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

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

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

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

For a Corporation

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

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

Deferring Taxes

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

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

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

Don’t Forget the Documentation

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

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

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

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

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

Are You a “Dealer” or “Investor” for Tax Purposes?

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

Tax law is forever classifying people and making structures that either create benefits or disadvantages on your tax return. Part of getting the most from your return is about understanding the definitions of the IRS. Two that seem very similar, but have distinctly different consequences on your taxes, are real estate dealer and real estate investor.

What’s the Downside of Each?

We’ll start by discussing the disadvantages. That’s right—there is no golden choice when trying to figure out if you classify as a dealer or an investor. In either case, there will be some disadvantages.

As a real estate dealer:

  • Your profits are taxed at both the ordinary income rates (up to 35 percent) AND the self-employment rates (up to 14.13 percent).[1]
  • You may not depreciate property that you are holding with the intention of selling.
  • You may not use the tax-favored installment method to report dispositions of your property.
  • And, you may not use the Section 1031 exchange to defer taxes on properties you hold as a dealer.

As a real estate investor:

  • You are subject to the net capital losses limit of $3,000 (applied after gains are offset against losses).
  • You must treat selling expenses as a reduction in sales proceeds, which means those expenses produce benefits at the capital-gains tax rates only.

Admittedly, the dealer gets the lesser deal when it comes to disadvantages. The investor does get to depreciate property, is allowed to sell using the tax-favored installment method, and may choose to use a Section 1031 exchange, thereby deferring taxes on a disposition.

What about the Up Side?

Every coin has a heads and a tails. And, it’s the same with tax designations. Both dealers and investors gain some advantages from their respective positions.

Advantages for real estate dealers include:

  • You are treated as a business and may treat most expenses as ordinary business deductions (advertising, commissions, legal fees, real estate sales, etc.).
  • Your property sale losses are not limited capital loss cap of $3,000 that limits investor properties.
  • Your losses are deducted as ordinary losses.
  • You get to deduct the entire loss (either immediately or using the net operating loss rules to deduct it over time—these rules allow you to carry back your losses up to five years and forward up to twenty years).

Advantages for real estate investors include:

  • Your sales profits are taxed at 15 percent or less, a tax-favored capital gains rate.
  • You are not subject to the self-employment tax.

Practical Application

So, what does all this mean for you and your business? Let’s run through some example numbers. For the example, we’ll say you have a $90,000 profit from a property sale. Based on the tax rates mentioned above, your taxes as a dealer could be as high as $36,370.[2] Your taxes as an investor might be as high as $13, 500.

You can clearly see that having your properties qualify as investment sales generates a considerable tax savings—potentially $22,870!

However, depending upon your business structure and activities, it may not be possible to define all of your property sales as investment sales. No problem. The IRS has no qualms with an individual taxpayer acting as part dealer and part investor. You read that right; you can balance the pros and cons of each situation. It’s simply a matter of taking each property on a case-by-case basis.[3]

Not so fast. You may think the IRS is giving you some kind of free gift by allowing this pick and choose method, but it’s not quite as unstructured as all that. You will be required to make a clear distinction in your record books. You didn’t think the IRS was going to let you off without documentation, did you? And, this means you must decide before-hand which route you’re going with each property sale. You cannot simply go back over your sales at tax time and assign designations. You will have to establish what your intent was with the sale—dealer sale or investment sale.

Tips on Documentation

Good documentation of your purpose and activities helps you to establish your case with the IRS. You should determine, and make note of, your intent for the property throughout the process:

  • When you purchase the property;
  • During your ownership; and
  • At the time you sell it.

If you keep records throughout the process (not just at the time of sale) it gives your case credibility. It’s important to keep in mind, however, that if your return is challenged in court, they will likely examine the sale when they rule on whether you acted as a real estate dealer or real estate investor on a particular property.[4] None of this means that your purpose may not change between the time you buy a property and sell it, but at least you will be prepared to understand and plan for such a scenario.

The All Important Point-of-Sale

Important: The point-of-sale is the most critical part of the process in determining your investor or dealer status. It’s often the deciding factor in IRS decisions. Although a single piece of real estate can have features of both dealer and investor property, it can only be treated as one or the other. Take a look at the characteristics of each from a tax standpoint.

  • Real Estate Dealer—First off, dealer property is held with the intention of being to customers in the ordinary fashion of business or trade.[5] If you buy and sell many properties throughout the year, you are likely a dealer regarding those properties.[6] Unfortunately, the IRS has not established any set number for determining dealer status, so it’s all about making your case. In fact, number is only one factor, and in previous rulings:
  1. A company earned dealer status with only one sale because it had already agreed on sale to a third party prior to purchasing the property itself;[7]
  2. A taxpayer, Mr. Goldberg, did not earn dealer status even with 90 home sales in a year.[8] In his case, the homes were built for rentals and used as such prior to the time of sale.

However, in the majority of cases, more sales equal dealer properties. In addition to the influence of the number of properties sold, real estate that you subdivide also has an increased chance of achieving dealer status,[9] except under Section 1237.[10] Removing a lien can also make a property more salable under the ordinary processes of business[11] (recall that dealer property is sold in the ordinary course of business).

Several other traits indicate a dealer business transaction over investment actions. They include active marketing and sales activities,[12] property held for a short period of time (indicating the intention to turn over the property for profit),[13] generally making your living as a dealer,[14] regularly buying and selling real estate for your own account,[15] and buying property with the proceeds from another property.[16]

  • Real Estate Investor—In contrast to dealer property, investor property is held with the intention of producing rental income[17] or appreciating in value. This means that investor properties are typically held for longer periods of time[18] and are not often sold, unlike the quick turnover of a dealer property.[19] Other situations in which a court may rule your property is an investor property include acquiring the real estate by inheritance,[20] dissolution of a trust,[21] or a mortgage foreclosure.[22] It’s even possible for you to make improvements to such property prior to selling it and still retain investor status.[23] [24] Just don’t put the proceeds into more real estate or subdivide the property[25] if you want to maintain that status.

If you don’t make clear in your documentation which type of property sale you are making, the IRS will make the decision based on their interpretation, and that is not the best situation for you! So, look at those characteristics above again. Since you’re going to know at the outset what your purpose is with each property, you can make sure to include as many of the appropriate features as possible well before the sale.

  1. The usual self-employment tax rate times the Schedule SE adjustment. ↑
  2. Assuming the real estate profits were your only income. ↑
  3. Tollis v Commr., T.C. Memo 1993-63. ↑
  4. Sanders v U.S., 740 F2d 886. ↑
  5. IRC Section 1221(a)(1). ↑
  6. Sanders v U.S., 740 F2d 886; Suburban Realty Co. v U.S., 615 F2d 171. ↑
  7. S & H, Inc., v Commr., 78 T.C. 234. ↑
  8. S & H, Inc., v Commr., 78 T.C. 234. ↑
  9. Revenue Ruling 57-565 ↑
  10. IRC Section 1237. ↑
  11. Miller v Commr., T.C. Memo 1962-198. ↑
  12. Hancock v Commr., T.C. Memo 1999-336. ↑
  13. Stanley, Inc. v Schuster, aff’d per curiam 421 F2d 1360, 70-1 USTC paragraph 9276 (6th Cir.), cert den 400 US 822 (1970); 295 F. Supp. 812 (S.D. Ohio 1969). ↑
  14. Suburban Realty Co. v U.S., 615 F2d 171. ↑
  15. Armstrong v Commr., 41 T.C.M. 524, T.C. Memo 1980-548. ↑
  16. Mathews v Commr., 315 F2d 101. ↑
  17. Planned Communities, Inc., v Commr., 41 T.C.M. 552. ↑
  18. Nash v Commr., 60 T.C. 503, acq. 1974-2 CB 3. ↑
  19. Rymer v Commr., T.C. Memo 1986-534. ↑
  20. Estate of Mundy v Commr., 36 T.C. 703. ↑
  21. U.S. v Rosbrook, 318 F2d 316, 63-2 USTC paragraph 9500 (9th Cir. 1963). ↑
  22. Cebrian v U.S., 181 F Supp 412, 420 (Ct Cl 1960). ↑
  23. Yunker v Commr., 256 F2d 130, 1 AFTR2d 1559 (6th Cir. 1958). ↑
  24. Metz v Commr., 14 T.C.M. 1166. ↑
  25. U.S. v Winthrop, 417 F2d 905, 69-2 USTC paragraph 9686 (5th Cir. 1969). ↑
Categories : Audits, Business Expenses, Capital Gains, Depreciation, Exchanges, Investments, Land, Leases, Passive Income & Losses, Receipts, Records, Rental Properties, Self-employment Tax, Tax Planning

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
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