Archive for Deductible Expense
May 17, 2012
John R. Dundon II
Business Expense, Deductible Expense, Disallowed Expenses, Employee Business Expense, Employment Tax, IRS Enforcement, IRS Examination, Tax Abuse, Tax Deductible Expenses, Tax Guidance & Preparation, Trust Fund Recovery Penalty
Tool and Equipment Plans generally require employees to provide their own tools. Some plans purport to receive tax-favored treatment as “accountable plans” under the definition of adjusted gross income in Internal Revenue Code § 62(c). If you are expected to use your own tools and equipment on the job and get reimbursed be very careful in understanding the definition of an “accountable plan” because the Internal Revenue Service has established a compliance team to address significant concerns with certain Employee Tool and Equipment Plans that purport to receive tax-favored treatment as accountable plans. It’s all spelled out in the Alert. Here’s the facts as I understand.
1. According to ILM 201120021 a reimbursement or other expense allowance arrangement that pays an amount regardless of whether an expense is paid or incurred or reasonably expected to be paid or incurred by the employee in performing services for the employer violates the business connection requirement of an accountable plan under Treas. Reg. § 1.62-2(d)(3)(i). Accordingly, payments made under the arrangement are treated as made under a nonaccountable plan. Amounts treated as paid under a nonaccountable plan must be included in the employee’s gross income for the taxable year, are subject to withholding and payment of employment taxes, and must be reported as wages or other compensation on the employee’s Form W-2.
2. The IRS’ Chief Counsel issued the following Advice – ILM 200745018 concluding that an employer’s tool reimbursement plan does not satisfy the requirements of an accountable plan.
3. IRS Revenue Ruling 2005-52 holds that tool allowances paid to employees are not paid under an accountable plan because the substantiation and return of excess requirements are not met.
4. A Coordinated Issue Paper Revised on July 2,2008 concludes that Employee Tool and Equipment Plans under which amounts are paid to employees for the use of their tools and equipment, do not meet the accountable plan requirements.
5. An IRS Private Letter Ruling (200930029) states that an employer’s expense reimbursement plan satisfies the business connection, substantiation, and return of excess requirements of an accountable plan. Payments made under the Plan were allowed exclusion from the Technician’s income and not considered wages subject to the withholding and payment of employment taxes because the Plan only reimbursed covered costs that the Technician substantiated.
If you are an employer that requires your employees to provide their own tools you may want to review and understand this private letter ruling and only provide reimbursement for tool expense upon written substantiation (aka receipt). It is best practice to understand the nuances of accountable and nonaccountable tool and equipment plans. A blanket payment made to an employee on a regular and consistent basis is usually considered income subject to employment tax regardless of what it is called.
With mortgage rates at levels not seen in generations and the banks finally starting to lend again many people have been calling with questions about the tax implications of refinancing. It can be a little confusing and this is my best attempt at explaining it in general terms without hitting line item detail of a HUD statement.
Mortgage interest is treated separately and distinctly from mortgage fees, charges and taxes. When loan proceeds are used for business or investment the charges are generally deductible over the life of the loan under Internal Revenue Code §162(a) or §212 and include among other items:
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Overnight/courier fees
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Underwriting fees
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Credit report fees
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Appraisal fees
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Notary fees
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Escrow fees
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Title insurance fees
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Document preparation fees
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Flood certificate fees
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Modification endorsement fees
Balances not amortized are deducted when the loan is paid off.
Items such as transfer, recording, and conveyance fees are treated as the cost of acquiring the property and included in the property’s basis under §263(a)(1).
If the loan proceeds were used for personal purposes, like your primary residence, taxes and points are generally deductible on Schedule A while most fees and charges are not.
If you are an employer you can appreciate the fact that everyone working for you it seems wants to be an independent contractor until they get injured on the job or get pissed off at you and seek relief outside of your organization. Employees and the subsequent employment tax liability they bring can be a real kick in the pants. If you have taken the risk of actually having employees then you may be keenly aware that it has become practically impossible to compete for prospective business if the competition is using improperly classified workers as independent contractors and subsequently avoiding payroll tax liabilities. It seems these days that operating margins across all industry groups are razor thin and getting undercut on bids by a competitor who is not paying employment tax creates an uneven playing field. Many, many times the difference between staying viable as a small business owner and closing up shop distills down to the employment tax liability and whether or not that liability can be paid in a timely fashion.
On the other hand if you are running fast and loose with your worker classifications and improperly classify workers as independent contractors when indeed they should be classified as employees the tax ramifications can be devastating for the responsible party. If you mis-classify workers and get audited by the IRS you can be found liable for trust fund employment taxes and the trust fund recovery penalty. These assessments are not discharged in bankruptcy and can subsequently destroy lives. I’ve seen it happen on many different occasions. The fallout is tragic particularly when good people are involved.
Now, finally, to provide relief the Internal Revenue Service is offering a new program that will allow many employers the opportunity to resolve past worker classification issues. You apply for the program by filing IRS Form 8952, Application for Voluntary Classification Settlement Program, at least 60 days before treating the workers as employees.
Employers accepted into the program will pay an amount approximately equal to just over one percent of the wages paid to the reclassified workers for the past year. No interest or penalties will be due, and the employers will not be audited on payroll taxes related to these workers for prior years. On the down side if it can be called that participating employers will, for the first three years under the program, be subject to a special six-year statute of limitations, rather than the usual three years that generally applies to payroll taxes.
Under this new Voluntary Classification Settlement Program (VCSP), eligible employers can obtain substantial relief from federal payroll taxes they may have owed for the past, if they prospectively treat workers as employees. The VCSP is available to most for profit businesses, tax-exempt organizations and government entities that have up until now improperly classified their workers as independent contractors, and now want to correctly treat these workers as employees. To be eligible employers must:
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Consistently have treated the workers in the past as non-employees,
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Have filed all required Forms 1099 for the workers for the previous three years
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Not currently be under audit by the IRS
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Not currently be under audit by the Department of Labor or a state agency concerning the classification of these workers
For more information be sure to check out IRS Announcement 2011-64.
If you are in the business of dispensing marijuana according to the United States Office of Homeland Security you are selling an illegal drug not a medicine like many individual states believe. Nevertheless Internal Revenue Code IRC 280(E) states that the expenses associated with selling illegal drugs are not deductible from revenue when calculating federal income for federal income tax purposes. This means that the usual and customary business expenses associated with your business model cannot be deducted on your federal income tax return, be it a 1040 Schedule C, 1120, 1120S, or 1065 form, etc.
IRC 280(E) clear stipulates, “No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”
As I write this one large California dispensary has been issued a Statutory Notices of Deficiency from the IRS in excess of one million dollars. Others are sure to follow and perhaps bankruptcy to ensue. Here in Colorado or any state in which marijuana is considered a medicine if you are capable of staying compliant with the state statutes regarding the matter and wish to stay compliant with the IRS it is my personal opinion that you should report all revenue derived from selling marijuana to the IRS as income and pay federal income tax on all revenue. Also be sure to pay federal employment tax for your employees (IRS Forms 941, 940, 945) but do NOT deduct the employment tax liability as an expense at the federal level. It too is not a deductible expense. Report NO EXPENSES WHATSOEVER $0.00.
It is widely believed, perhaps wrongly so, that legitimate dispensaries should be safe passing costs on to customers provided local authorities are successful in weeding out (as it were) non-compliant dispensaries and creating a level playing field in the local communities. In the states where marijuana dispensing is a legal activity at the state level I am currently of the opinion, perhaps wrongly so, that business expenses associated with selling marijuana would be deductible on the state income tax return for the states in which the business operates. This is relatively new territory though so anyone with more insight is welcome to accordingly respond. If I were to sign a tax return of this nature I would start by asking the state department of revenue in which the business operates to provide direction on the matter from their perspective.
What I do know as a matter of fact is that engaging a strategy of cost segregation specifically separating out the peripheral or indirect costs of selling marijuana from the direct costs of selling marijuana and claiming those indirect costs to be deductible at the federal level is a violation of IRC 280(E). Don’t do it.
I’ve been getting asked this question quite a bit so I put it directly to the IRS. My guess is that I wasn’t the only one who asked because today the Internal Revenue Service issued guidance designed to clarify the tax treatment of cell phones.
The guidance relates to a provision in the Small Business Jobs Act of 2010, enacted last fall, that removed cell phones from the definition of listed property, a category under tax law that normally requires additional recordkeeping by taxpayers.
The Notice provides guidance on the treatment of employer- provided cell phones as an excludible fringe benefit. When an employer provides an employee with a cell phone primarily for noncompensatory business reasons, the business and personal use of the cell phone is generally nontaxable to the employee. The IRS will not require record keeping of business use in order to receive this tax-free treatment.
The IRS additionally announced in a memo to its examiners a similar administrative approach that applies with respect to arrangements common to small businesses that provide cash allowances and reimbursements for work-related use of personally-owned cell phones. Under this approach, employers that require employees, primarily for noncompensatory business reasons, to use their personal cell phones for business purposes may treat reimbursements of the employees’ expenses for reasonable cell phone coverage as nontaxable. This treatment does not apply to reimbursements of unusual or excessive expenses or to reimbursements made as a substitute for a portion of the employee’s regular wages.
Under the guidance, when employers provide cell phones to their employees or where employers reimburse employees for business use of their personal cell phones, tax-free treatment is available without burdensome record keeping requirements. The guidance does not apply to the provision of cell phones or reimbursement for cell-phone use that is not primarily business related, as such arrangements are generally taxable. Details are in the memo and in Notice 2011-72
If you think you have a viable ongoing business with a profit motive be sure to maintain adequate financial records on a computer that you back up off site on a regular and consistent basis. Also be aware that in the tax court case of Chandler v. Commissioner (TC Memo 2010-92) the significance of inadequate hand kept records was a major determining factor in ruling that the tax payer’s horse breeding business was actually a hobby and not a business.
Even though the tax code states that handwritten records are an acceptable method for maintaining the accounting books as long as the records are accurate and provide substantial information for the taxpayer to prepare the tax return [Reg. §1.446-1(a)(4)], the tax court’s determination as drafted in TC Memo 2010-92 compels me to ALWAYS recommend the use of bookkeeping software.
In this case the IRS issued a deficiency notice citing lack of profit motive under §183 for horse breeding, training and racing activities. The IRS also determined Jo Anne, the tax payer, was liable for a §6662(a) accuracy related penalty in regard to maintaining adequate books and records for her horse breeding and training business.
The Tax Court determined the handwritten records Jo Anne kept
did not prove to be accurate or substantial. The Court also found
Jo Anne was able to reduce taxable income by approximately 40 percent for the years in question by claiming losses on her Schedule F relating to the horse breeding and training activities. Because the taxpayer did not provide the Court with adequate records and was unable to prove she was engaged in these activities for a profit otherwise, the dis-allowance of the deductions under §183(a) increased Jo Anne’s tax liability and she was held liable for the tax along with interest and penalties for the years under review.
July 8, 2011
John R. Dundon II
Business Expense, Cost Basis, Deductible Expense, Home Office, Self Employ, Small Business, Sole Proprietor, Sub-chapter S, Tax Abuse, Tax Guidance & Preparation
Okay I’m taking another case to IRS appeals regarding the home office deduction. In preparation I reviewed IRS Publication 587: Business Use of Your Home and I pulled some relevant quotes.
“You can have more than one business location, including your home, for a single trade or business. To qualify to deduct the expenses for the business use of your home under the principal place of business test, your home must be your principal place of business for that trade or business. To determine whether your home is your principal place of business, you must consider: the relative importance of the activities performed at each place where you conduct business, and the amount of time spent at each place where you conduct business.”
Your home office will qualify as your principal place of business if you use it exclusively and regularly for administrative or management activities of your trade or business. And you have no other fixed location where you conduct substantial administrative or management activities of your trade or business.
The publication is clear that the two prong test which must be satisfied in addition to the “regular and exclusive test” are 1) the relative importance of the work being performed and the allocation of time spent between the two locations and 2) conduct of “Substantial” management activities.
Examples 2, 3 and 4 of IRS Publication 587 all discuss a very important point: the availability of a “Fixed Location” from which to conduct managerial or administrative functions.
IRC Sec 280A (c) (1) (c) commentary states, “For purposes of subparagraph (A) , the term “principal place of business” includes a place of business which is used by the taxpayer for the administrative or management activities of any trade or business of the taxpayer if there is no other fixed location of such trade or business where the taxpayer conducts substantial administrative or management activities of such trade or business.” Sub paragraph A identifies the principle place of business as a condition allowing the deduction for allocating costs connected with the business use of home.
However the conference report for P.L 105-34 (1997) (the law that reversed Soliman) supports the conclusion that an office in home deduction is possible even when the taxpayer has another fixed office at which (s)he also performs INSUBSTANTIAL administrative and management activities. The key for the home office deduction to be considered when another professional office is available is that the administrative and management activities performed at the taxpayer’s professional office must be INSUBSTANTIAL.
On a personal note I have conflicting thoughts about the Home Office Deduction. I don’t take one for myself mostly because it is such a pain in the proverbial hinder to tabulate and report. For my client’s that are entitled to it I usually encourage them to leave out depreciation expenses mostly because it requires precise bookkeeping to accurately recapture depreciation when the property is disposed. Also through people I communicate with at the IRS excessive home office deduction expenses are flagged in the Automated Collection System for an Automated Under Reporter Correspondence Audit.
July 5, 2011
John R. Dundon II
Appeals & Audit Resolution, Audit Reconsideration, Business Expense, Correspondence Audit, Deductible Expense, Disallowed Expenses, Entity Classification, IRS Audit, IRS Examination, Tax Deductible Expenses
The IRS has developed a rule of thumb for analyzing business losses called the Hobby Loss Rule of Thumb that basically says if a business reports a net profit in 3 out of the last 5 years it is presumed to be a for-profit business. Similarly if a business reports a net loss in more than 2 out of the last 5 years it is presumed to be a not-for-profit hobby. Whether you have a business or a hobby is important to the IRS because your hobby expenses are only deductible up to hobby revenue each year and additional losses cannot be carried to another tax year to offset gains like they could if you had a business.
In that most new businesses often incur losses at first, it is quite common for a business to have a year or two of losses before becoming profitable. In fact I have seen MANY businesses with several years of losses before ever making a profit. Generally speaking the burden of proof as to whether you are in a business or just have an expensive hobby is on you the tax payer. So be sure to document everything that can help demonstrate your profit motive. You can also prove your profit motive using the following nine factors listed in IRS Publication 535 Business Expenses:
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You carry on the activity in a businesslike manner. To determine this ask yourself questions like, do you have customers? Do you have suppliers? Do you make anything? What do you sell? Do you have letterhead and a business card? How do you keep and reconcile your financial records? Do you have an Taxpayer Identification Number? How are you structured organizationally?
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The time and effort you put into the activity indicate you intend to make it profitable. How much personal time and energy do you spend on the venture? What personal sacrifices are you making to the betterment of the venture?
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You depend on income from the activity for your livelihood.
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Your losses are due to circumstances beyond your control or are normal in the start-up phase of your business.
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You change your methods of operation in an attempt to improve profitability. How do you document operational procedures?
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You, or your advisers, have the knowledge needed to carry on the activity as a successful business.
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You were successful in making a profit in similar activities in the past.
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The activity makes a profit in some years, and how much profit it makes, and
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You can expect to make a future profit from the appreciation of the assets used in the activity.
An audit to defend your business losses involves a relatively detailed review of your income and your expenses for your business. The IRS Examiner will examine your accounting records, receipts, invoices and bank statements looking for income that might be unreported or deductions that might be overstated. The IRS may also question whether certain expenses are directly related to your business. Demonstrate that you are in business for yourself, and you will succeed in defending your business losses against an IRS examination.
I think the bottom line is that if you really have a business you are best served to have a separate and distinct taxpayer identification number with the IRS regardless of your business structure. For whatever it is worth as of today I have not encountered a single situation where the IRS believed that an entity structured as a corporation was actually a hobby so in addition to getting the taxpayer ID number, consider incorporating as a sub-chapter S corporation.
