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Archive for Business Expenses – Page 2

Qualifying for Your Home Office Deduction—Simplified

By Kim M. Larsen EA CTFS
Sunday, February 8th, 2015

You may know which expenses qualify for home office deductions, but are you savvy about the requirements for your office qualifying to take these deductions in the first place? In order to make home office deductions, your office must pass the “regular use” test. It’s just what it sounds like—a determination of whether you regularly do business from the office in your home.

What the IRS Says

The IRS states in its audit manual, “Regular use means that you use the exclusive business area on a continuing basis. The occasional or incidental business use of an area in your home does not meet the regular use test even if that part of your home is used for no other purpose.”[1] Obviously, setting up an area exclusive to your business, filling it with files, and never going in there will not cut it, but this definition does little to pinpoint exactly what does count.

According to the IRS, they consider your individual facts and circumstances when determining regular use.[2] Great, but that leaves things pretty vague when you’re trying to plan for your tax return. So, instead, we’ll take a look at court precedents to get a better idea of what exactly you need to do to get your deduction.

  • The Frankel Case—Max Frankel was the editor of The New York Times. In his case, he claimed that he used his home office to communicate by phone with prominent politicians at all levels of government, as well as community leaders and labor leaders. Records indicated that Frankel averaged a call per night, and Frankel stated that it may have taken several calls to complete a single discussion. The U.S. Tax Court decided in his favor, stating that the frequency was enough to qualify Frankel’s home office for regular use.[3]
  • The Green Case—Because of the circumstances of his work, and because many of his clients were unable to make calls during daytime hours, John Green took a large number of client phone calls at home after his regular work hours. This was a required condition of his employment. The calls averaged 2 ¼ hours per night, five nights per week. Again, the Tax Court decided the frequency met regular use requirements for a home office.[4]

Like any tax strategy, passing the regular use test requires one important item—sufficient evidence. Another court case, involving Anthony Cristo, illustrates this need. The court stated:[5]

“We do not suggest that the frequency or regularity of meetings or dealings must match the level we faced in Green in order to meet the requirements for regular use. However, in this case we have so little information that we cannot tell whether the facts, if we knew them, would satisfy any reasonable interpretation of regular use.”

What does this mean for you? It means that no matter how good a claim you have to regular use of the office in your home, you will lose out on those deductions if you can’t prove it with substantial evidence. The truth is you only need two pieces of evidence in order to prove regular use:

  1. A log recording how you spent your time, and
  2. Documents that support your log of time spent.

Your log can be as simple as keeping an appointment notebook or printed sheets from a calendar application. Note your schedule, including phone calls, meetings, opening mail/responding to business email, and any other business activities you complete at your home office. Next, you need something to corroborate with the log.

  • You say you responded to emails on this day at a certain time? Keep your sent emails. They’re time and date-stamped and prove that you were indeed responding to email.
  • You claim to have met a client at your home? You could keep a guest log and have the client sign in. Or, you could provide email correspondence of your client’s agreement to meet at that time.
  • You devoted 2 hours each evening to making and taking phone calls? This one is easy to prove. You simply need to provide your phone bill as documentation. Make sure you get a detailed copy.

Sure, keeping records is a pain in the butt. Just set up a routine now and stick with it. You can make it even easier by creating a checklist for yourself. Every day, go through the checklist and make sure you took care of logging and documenting your hours, that way you won’t forget anything. Once it becomes part of your routine, you’ll see that keeping emails or having people sign a guest log really isn’t all that hard—and your deductions may hinge upon it.

A Checklist to Get You Started

What do you need to do to comply with the IRS regular use rules?

  1. Use your home office more than 10 hours per week on average (this is a subjective number because the IRS has never given a specific amount of time required, but 10 hours seems to be a safe bet based on past cases).
  2. Build proof indicating that you actually did work for those 10 hours or more.

That’s it. It shouldn’t be too hard to find business activities you can do from your home office for just a couple of hours per day/night. This article already gives you a few easy ideas, as well as simple ways to document them. Start keeping good records now, and taking care of any tax issues that arise will be no problem.

  1. Internal Revenue Manual Exhibit 4.10.10-3 — Standard Explanation Paragraph 4814 Test for Home Office (Last Revised: 01-11-2011). ↑
  2. Prop. Reg. Section 1.280A-2(h). ↑
  3. Max Frankel v Commr., 82 TC 318. ↑
  4. John W. Green v Commr., 78 TC 428; Rev on another issue, 52 AFTR 2d 83-5130, 707 F2d 404 (CA9, 5/31/1983). ↑
  5. Anthony B. Cristo v Commr., TC Memo 1982-514. ↑
Categories : Business Expenses, Home Office, Receipts, Records, Tax Planning

Considering a Historic Building for Your Business? These Tax Credits are Good News

By Kim M. Larsen EA CTFS
Sunday, February 8th, 2015

Historic buildings make a beautiful location for doing business. Unfortunately, many of them may seem out of the price range of small business owners. But, that’s not necessarily the case. The state and federal governments have an interest in preserving these properties, and they are willing to give you tax credits for buying and restoring a historic building. The credits reimburse a large proportion of your restoration costs.

This really is a great incentive to go for a building that will give your company a unique and professional feel. You see, unlike deductions, tax credits reduce your taxes dollar-for-dollar. For example, when you spend $20,000 and get a 50 percent tax credit, you save $10,000 on your tax bill. It’s that simple. It depends which state you live in, but tax credits could save you up to 70 percent on the restoration costs, making a historic building a much more reasonable option.

Federal and State Credits

You have two separate tax credit options available to you from the federal government.[1] The first is a 20 percent credit for rehabilitating an income-producing building that has been deemed a certified historic structure by the Secretary of Interior, through the National Park Service. The other is for rehabilitating non-historic buildings that were put into service prior to 1936, and the credit is for 10 percent of the rehab cost.

You can also get an additional credit from most states, and it’s perfectly legal to take advantage of both the state and federal credits. Tax credits at the state level can be anywhere from 0 to 50 percent. You can check the laws for your state at the National Trust for Historic Preservation . If you’re fortunate enough to live in a state that provides a 50 percent credit, you’ll get up to 70 percent off the rehab costs when combined with the federal credit.

Other Credits

A few other credits also exist that may help you with the purchase of a building. Here a few you might consider:

  • If you’re buying in a low-income area, you could qualify for the new markets tax credit for loans and investments in such locales.[2]
  • The low-income housing tax credit is available for real estate investments in affordable housing.[3]
  • Another option is available that is not a credit but is still a good option to keep in mind regarding your business property. You can donate your historic building to a qualified 501(c)(3) organization.

Making Sure You Qualify

In order to get the tax credits for your historic building, you must use it for the purpose of producing income. Some qualifying examples include:

  • Apartments
  • Single-family rentals
  • Industrial buildings
  • Commercial buildings
  • Agricultural buildings

Although some forms of residential real estate are included in the list, you may not claim the historic tax credit for your personal home. However, if you own a property that you use for both your home and an office space or rental unit, it’s possible for you to qualify on just the part of the building you don’t use for your residence.

Important tip: If you don’t plan on keeping the property for more than five years, you will have to repay some of the federal tax credit at the time of sale. This is because the federal government has a five year recapture period for this purpose. On the other hand, if you do keep the property for more than five years, you don’t pay any recapture and benefit from 100 percent of the building’s increased value.[4]

You’ll also need to check the recapture rules for your state, which are separate from the federal recapture period.

Additional Guidance

Now know just how substantial the available historic tax credits are, but you’ll also need some advice on how to get the whole process started:

  1. Use the National Park Service website to search for historic places.
  2. Find contact information for the historic preservation office in your state. They’ll be able to help you with state-specific information throughout the process.
  3. Look for an architect with experience in historic preservation. This is not only important to maintaining your building, but also to your taxes. That’s because the Secretary of Interior has to certify your historic restoration as authentic.[5] Here are some of the regulations:[6]
  • Justification for window removal
  • Justification for alterations to the storefront
  • Ensuring that replacement sash matches with the original size, color, trim details, pane configuration, and reflective qualities (you can see that the requirements are pretty specific)
  1. Make sure you know the specifics for the tax credits available to you in your area. Before you make a purchase, you should consult your tax advisor and the state preservation office.
  2. This should go without saying, but just so we’re clear, be certain that you will make a profit. Calculate the numbers with the after-tax adjusted rate-of-return formula. This is also called the managed internal rate of return (MIRR).

What Do the Credits Cover?

Basically, any costs that are part of renovation, restoration, rehab, or reconstruction of a historic building qualify for tax credits, and a variety of business structures are eligible, including S corporations, partnerships, personal service corporations, closely held corporations, and individuals. The lessee of a historic building also qualifies for credits on the expenses for renovating or rehabilitating a qualifying building. Expenses that do not qualify include:

  • Costs for acquiring the building[7]
  • The price of the land or other features like sidewalks, landscaping, or parking lots[8]
  • New construction[9]
  • Personal property[10]
  • Expanding the volume of the building[11]

There is a caveat that could prevent you from gaining the full benefit of these tax credits if you’re a high income earner—the AMT (alternative minimum tax). The AMT is calculated separately from your regular taxes and works to eliminate some of the deductions you would normally be entitled to. At tax return time, you’ll pay either the AMT or regular taxes, whichever is higher.

Because the highest earners often have the most deductions, the AMT was created as a way to cap that lost tax revenue. You can’t use the historic renovation credit if you’re paying the AMT in a particular year, but you may carry the denied credits back one year and forward 20 years.[12] Just keep track of your credits and rehab expenses, and don’t forget to claim the benefit in a year when you don’t pay the AMT.

It’s important to make sure you check all the details with your tax advisor and document your strategy. If you’re going to go to the work and expense of renovating a historic building for your business, you want to make sure you get the tax advantage you’re expecting. Otherwise, you can find your business with a heavy and unexpected financial burden. With the right plan in place, a renovated building can establish your business as being committed to the local community, its culture, and its history.

  1. IRC Section 47. ↑
  2. IRC Section 45B. ↑
  3. IRC Section 42. ↑
  4. IRC Section 50(a). ↑
  5. IRC Section 47(c)(2)(C). ↑
  6. Federal Taxes Affecting Real Estate (6th Edition), Thom V. Glynn, Esq., Release No. 33, May 2005, Section 5.03[4][b]. ↑
  7. Reg. Section 1.48-12(c)(9). ↑
  8. Reg. Section 1.48-12(c)(5). ↑
  9. Reg. Section 1.48-12(b)(2)(iv). ↑
  10. IRC Section 47(c)(2). ↑
  11. Reg. Section 1.48-12(c)(10). ↑
  12. Tax Aspects of Historic Preservation, Mark Primoli, IRS, October 2000, p. 11. ↑
Categories : Business Expenses, Investments, Tax Planning

Make Your Records Rock Solid to Avoid Audit

By Kim M. Larsen EA CTFS
Sunday, February 8th, 2015

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. ↑
Categories : Audits, Business Expenses, Cars, Trucks & SUVs, Depreciation, Entertainment, Receipts, Records, Tax Planning, Travel

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

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

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

Remember Who You’re Dealing With

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

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

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

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

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

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

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

Here are some specific examples of good authority documents:

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

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

Strategy for Talking to the IRS

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

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

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

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

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

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

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

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

What If Your Case Goes to Court?

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

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

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

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

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

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

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

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

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

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

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

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

Doing Business in Luxury

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

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

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

Types of Deductions

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

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

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

Getting Business Travel Right

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

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

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

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

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

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

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

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

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

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

Your Guide to Tax Deductions on Business Entertainment

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

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

Entertaining in a Business Setting

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

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

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

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

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

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

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

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

Entertaining in a Non-Business Setting

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

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

Putting the Rules in Practice

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

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

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

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

Recording Your Proof

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

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

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

Maximize Your Tax Deductions on Business Repairs

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

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

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

Now, which would you prefer?

Boosting Your Net Worth with the Right Fixes

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

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

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

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

Defining a Repair

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

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

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

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

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

Tips on Making a Case for Repairs

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

Here are some additional tips:

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

What’s the Main Concern?

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

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

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

You Can Get Big Tax Deductions from Your Home Office

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

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

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

Let’s Find the Deductions

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

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

What Are the Rules?

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

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

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

The Minimalist Home Office

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

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

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

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

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

You Can Make the Most of Tax Deductions on Employee Parties

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

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

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

50 Percent Deductible Entertainment

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

The Employee Party and 100 Percent Deductible Entertainment

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

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

How Does This Fit into Your Business?

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

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

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

Exceptions to Watch Out For

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

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

Keeping Records

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

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

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

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

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

How to 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
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