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Thinking about Buying a Business? Your Opportunities for Tax Deductions Have Already Begun!

By Kim M. Larsen EA CTFS
Friday, February 20th, 2015

Are you aware of business start-up deductions? If you’re not, you should find out right away! You don’t want to miss out on these tax-deductible activities that are only valid when you’re starting a new business. In fact, you don’t have to start your own business; you can get these tax benefits from simply buying a business. Fortunately, this article deals you in on the details.

It Pays to Plan

Before you even purchase your new business, you can start keeping track of your deductible expenses. That’s right, you are eligible for deductions related to merely thinking about your soon-to-be business. Here’s an example. Let’s say you invite a friend to dinner because she purchased her business only a few years ago, and you’d like to find out more about what goes into starting a newly purchased company. That dinner is deductible because you have a business purpose for the expense—you are seeking necessary information for your venture. These expenses are called “start-up expenses”.

Whether you create or buy a business, you will by necessity go through an investigatory phase. If you don’t do this, you may want to reconsider going into business for yourself! However, the rules about how deductions work are a little different in each situation, so we’ll stay focused on the process for purchasing an existing company.

Basically, you are going to incur expenses while you analyze your options and make a decision about what kind of (and then which) business to buy. That is the extent of the investigatory phase. After that, start-up expenses stop, and you begin tracking business expenses.

Here’s a breakdown of the steps and what expenses you may be looking at:

  • Investigating Possible Businesses—First of all, let’s make clear that when we say “buy a business”, we are talking about actually purchasing an active business, not buying corporate stock. If during this period, you spend $41,000 to analyze and review your options, you can begin writing off those expenses the day the escrow closes on your purchase. You get a $5,000 write-off on the first day, and $200 each month after for the 180 months.[1]
  • Identifying Your Prospective Business—In order to take advantage of the expenses for your investigatory phase, you must identify the business you plan to purchase. If after investigating the possibilities, you do not identify a target business, you will not be eligible for any deductions. At the point when you identify your target business, your investigative expenses stop. In the event that you identify a target business but do not end up buying it, you are still eligible for acquisition and facilitative costs, but not the investigative costs.
  • Buying the Business—Once you have identified the business and move forward with purchase, any additional expenses are considered capitalization rather than start-up costs. These are costs that you cannot benefit from until you later sell or leave your business. The IRS has what is called a “bright-line rule” regarding the date your research of possible businesses ends and acquisition activities begin.[2] It is either 1) the date of your letter of intent (or similar documentation), or 2) the date that a binding written contract is executed between you and the target business (unless board approval is required, in which case it’s the date terms are approved by the board or its authorized committee). The IRS will go with whichever of these two dates is earlier.[3]

Take a look at that last bit about the bright-line rule. That means that if you hire an accounting firm, for instance, to investigate your target company, the firm may continue to provide services to you after you submit a letter of intent. The accounting firm will make a financial analysis in the investigatory phase, but it also could review the target company’s books and records after that point. Only the services provided before submission of your letter of intent count as start-up costs.[4] The additional services are capital costs.

Of course, the IRS never makes things easy, so there is an exception to the above bright-line rule. It wouldn’t be tax law if there weren’t, right? You see, some expenses are inherently facilitative, meaning they cannot be counted as investigatory expenses. What about the bright-line date, you may say. It doesn’t matter. Facilitative expenses are capital costs regardless of the date you incurred them. Here are some examples that are inherently facilitative to a purchase:[5]

  • Appraisal costs
  • The cost of a formal written evaluation of the transaction
  • The cost to have a purchase agreement prepared
  • Any costs necessary to obtain shareholder approval
  • Costs for negotiating the transaction
  • Costs for structuring the transaction
  • Any costs for conveying property, such as title registration or transfer taxes

When Corporations Are Involved

Things are always a little trickier when corporations are the entities making the transaction. You may find yourself in one or both of the following situations: you could be purchasing a corporation, and/or your corporation may be the buyer. Let’s look at a few scenarios.

  • You Only Buy Common Stock—If you take over a corporation through common stock, any investigatory expenses are not deductible. This is because you have gained an investment rather than an actual business or trade interest.[6]
  • You Buy Stock Plus Assets—If stock purchase is included in the process to fully take over a corporation, that is a different matter. When you acquire a business’s assets, even when stock is also exchanged, you are eligible for start-up deductions and amortization.
  • Your Corporation Is the Acquirer—Unlike the sole proprietor, who claims start-up expenses on the Schedule C, an S or C corporation will claim these expenses on the corporate tax return. Always keep in mind that your corporation is a separate entity from you. Do not pay any of the costs incurred by your corporation. If you do, make sure the corporation reimburses you. Doing otherwise will cause headaches with your taxes.
  • You Form the New Business as Corporation—When you do this, you incur organization expenses for setting up your company’s entity structure. This can include fees paid to incorporate, legal services required to set up the corporation, accounting services, and expenses related to organizational meetings for directors or stockholders. These costs are separate from investigatory costs and capitalization costs.[7] The good news is that they can be amortized just like start-up expenses. You claim up to $5,000 in the first year and amortize the remainder over 180 months.[8]

Now you know what to do as far as acquiring your business, but what if the business fails or is sold before you finish seeing the full benefits of amortization? No worries. For sole proprietors, you deduct the remaining (unamortized) costs as a business loss.[9] For corporations, both the unamortized start-up and organization costs are deducted on the corporation’s final tax return.[10]

Tax law is not written to slow down businesses, despite the fact that it can get complicated. On the contrary, legislators know that the opening of new businesses benefits the whole economy. That’s why your able to write-off expenses like the ones discussed here. Take advantage of it! The benefits are available so that you and your business can succeed.

  1. IRC Section 195(b). ↑
  2. TD 9107. ↑
  3. Reg. Section 1.263(a)-5(e). ↑
  4. Reg. Section 1.263(a)-5(e) ↑
  5. Reg. Section 1.263(a)-4(e)(2). ↑
  6. H. R. Rep. No. 1278, 96th Cong., 2d Sess. 3, 9-13 (1980). ↑
  7. Reg. Section 1.248-1(b)(2). ↑
  8. Reg. Section 1.248-1T(a). ↑
  9. IRC Section 195(b)(2). ↑
  10. Liquidating Co., 33 BTA 1173. ↑
Categories : Business Expenses, Entertainment, Receipts, Records, Start Up, Tax Planning, Travel

How You Can Deduct Your S Corporation Board Meeting with Your Spouse

By Kim M. Larsen EA CTFS
Wednesday, February 18th, 2015

When it comes time to deduct business expenses on a tax return, most corporation include expenses for board meetings. After all, that’s undeniably a business expense, right? Well, sometimes it’s not so clear, like when the only two board members are a wife and husband. If you and your spouse jointly hold stock in your S corporation, how do you prove your right to a deduction? Can you go to a restaurant or take a business trip and still deduct the meeting?

Proving Your Business Purpose

When your board meeting consists of just your spouse and yourself, you have to be careful that the IRS has sufficient evidence documenting the business activities of the meeting. How do they know the event was a board meeting, and not just a pleasant lunch date? Husbands and wives have been conducting business together since before the birth of US tax law. You can study precedent cases to find out how the IRS is likely to view your situation.

Unfortunately, not many cases exist regarding this particular scenario, so you have to look at similar situations regarding deductible business expenses. In the case of Ben Heineman, the IRS questioned him for building an office at his vacation property, costing $1.4 million in today’s dollars (the office was built in 1969). Heineman stated that he could perform certain work (such as making business plans) better with his family and away from the distractions of the Chicago offices. Not exactly the same situation as a board meeting, but the same requirements for determining whether an expense is business or personal.

Heineman was the president and CEO of Northwest Industries, Inc., which had its principal offices in Chicago, IL. Not wanting to spend his summers in Chicago, he built the office at his vacation home in a resort area, Sister Bay, Wisconsin. During the period of the year when Mr. Heineman used this office (from about August until Labor Day), he worked at least 5 hours per day, six to seven days per week. He used this time to perform duties essential to the Chicago offices, including long-term business planning.

In the end, the courts ruled in favor of Mr. Heineman, stating it didn’t matter if it would have been less expensive for him to get a second office in Chicago. He had a necessary and ordinary business reason for the trip—he could concentrate better on his work at that location. Therefore, he was entitled to his deduction.

What the Heineman Case Means for You

Why is this case important for your board meeting scenario? The only deductions that Mr. Heineman claimed were depreciation on his office building and maintenance expenses for it. He did not claim traveling expenses for the trip between Chicago and Wisconsin. However, he did travel—to his vacation property. According to tax law travel regulations, you are able to deduct business expenses incurred on a trip that is otherwise personal, and that is why Mr. Heineman was able to deduct his second office expenses.

The same travel regulations would apply to you if you take your spouses-only board meeting to an out-of-town location. So, what you need to show the IRS (with accepted documentation) is:

  1. Business was the primary purpose of the trip, and
  2. Business actually took place during the trip.

All you have to do to establish business as the trip’s primary purpose is to ensure that you conduct business on more days than you partake in personal activities. Fulfilling the requirement that the trip was necessary for business is tougher. How do you show that it was necessary to go out of town? Again, look at Heineman. You could have some very good reasons for going out of town to conduct business: get away from ringing phones, find peace and quiet to concentrate, or not to be distracted by email or employees.

As for proving that you conducted business, you simply keep records of evidence that you did work. These could include:

  • Documents generated on this trip (such as a business plan)
  • A recording of business conversations that took place
  • Evidence that you were in a business setting
  • A print log showing you physically printed business documents to be discussed and reviewed

The out-of-town board meeting can be a bit of hassle to document, so if you’re banking on the deductions making the cost of the trip worthwhile, you’d better make sure you plan efficiently and can back up your claim to the business purpose of the trip. The funny thing, however, is that an in-town board of directors meeting for a wife and husband is even more difficult to prove.

You see, tax law specifies that you cannot deduct personal, family, or living expenses. That means deducting a meal at a restaurant as a business expense is going to be awfully difficult to justify to the IRS, particularly when no one else is participating other than you and your spouse. You’ll see why with an example of a couple who was not allowed to deduct their board meeting expenses.

Mr. and Mrs. Duquette were the sole board members of Norman E. Duquette, Inc. and attempted to deduct expensive meals at two separate restaurants on January 1 and February 1. At the meals, they discussed items such as approval of payment for trips and determining whether to move the business to Naples, Florida. Unfortunately for the Duquettes, the court decided that the couple had no evidence that the issues required significant discussion.

The Duquettes had no employees, and the couple both lived and worked together. The court found no proof that could justify a husband and wife having an expensive dinner in this situation, when they could have just as easily had the discussions elsewhere without the expense. Here is the IRS’s standard stance on the matter (from the Internal Revenue Manual): “Board meetings between husband and wife are not ordinary and necessary business expenses, but personal entertainment expenses, and are therefore not deductible” (Treas. Reg. Section 1.162).[1]

The takeaway from this is that fine dining expenses are not deductible as a wife-and-husband board meeting under official IRS policy. That does not necessarily mean you cannot deduct such expenses, but you’d better be prepared to have a rock-solid justification for it (i.e. a well-documented business reason). Unlike the Heineman case, the Duquette case does not set a precedent (and neither does the IRS audit manual).

Applying the Cases to Your Situation

If your spouse-only board meeting needs to be away from home, either in-town or out, you need to be able to answer the question “Why?” Heineman had something concrete to show the IRS and the court—a business plan that he developed because he was able to concentrate and focus better at the second office. The Duquettes, in contrast, failed to produce any evidence of work effort during the meetings.

To take advantage of deductions for a spouses-only board meeting for your S corporation, you should be confident that you have at least a 50-50 shot at your reasons being accepted, and whoever prepares your taxes has to back up that assertion. Your tax preparer is at risk of severe penalties for filing a return that doesn’t have a justifiable 50-50 chance. When using this strategy, show the Heineman case to whoever prepares your taxes. But, remember that you are highly unlikely to be able to deduct the in-town, husband-and-wife meeting at a restaurant.

Still want to conduct a meeting during a meal? If it’s an issue that requires a third party, such as your attorney, then go ahead! It’s only when spouses dine together exclusively that the deduction becomes difficult. But, when the two of you are meeting to discuss business matters with someone else who is necessary to the discussion, it makes sense that you must find a location to meet (just be sure to document the business purpose!).

  1. Internal Revenue Manual 4.10.10, Paragraph 9707. ↑
Categories : Business Expenses, Corporations, Entertainment, Tax Planning, Travel

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

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

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 Commissioned Employees Have Vanquished the AMT and You Can, Too

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

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

What You Need to Know about the AMT

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

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

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

What Employees Can Do about It

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

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

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

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

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

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

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

Going Forward

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

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

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

Other Cases

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

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

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

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

AMT Tax Savings

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

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

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

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

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

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