Archive for Disallowed Expenses
A taxpayer came to me today for verification on dependent care expenses. Their basic profile may be similar to yours. A husband and wife with two children in day care. The wife is a full time student that does not work outside of the house. The husband was laid off from his former job and has been regularly seeking gainful employment throughout the duration of the tax year in question.
These good people were told by a cog in a tax preparation franchise that they did not qualify for dependent care expenses because neither had employment income. Of course I got pissed off because I’m just so sick and tired of tax practitioner ineptitude and deceit that I felt compelled to throw down this post at the end of a long day which is basically a brief overview of IRS Publication 503, Child and Dependent Care Expenses reported on IRS Form 2441.
This can be a hard topic to understand. Here’s the basic deal on dependent care – expenses paid while either working, seeking employment or attending school are qualified dependent care expenses under IRC [§21(e)(7); Reg. §1.21-1(a)(3)]. As long as the husband/wife file a joint return, the expenses paid while the wife attends school full-time for at least five months of the year and the expenses paid while the husband actively seeks employment are qualifying dependent care expenses.
A taxpayer who is a student is deemed to have earned $250 per month thus meeting the earned income requirement of §21. This is what tripped up the neophyte tax practitioner.
Regarding the Child and Dependent Care Tax Credit, according to IRS Tax Topic 602 this tax credit is “generally a percentage of the amount of work-related child and dependent care expenses you paid to a care provider. The percentage depends on your adjusted gross income. Work-related child and dependent care expenses qualifying for the credit are those paid for the care of a qualifying individual to enable you to work or actively look for work for any period when you had one or more qualifying individuals. Expenses are paid for the care of a qualifying individual if the primary function is to assure the individual’s well being and protection.”
Three points that tend to trip taxpayers up are:
1. In general. amounts paid for services outside your household qualify for the credit if the care was provided for a qualifying individual who (i) was your qualifying child under age 13 or (ii) regularly spent at least 8 hours each day in your household.
2. The expenses qualifying for the credit must be reduced by the amount of any dependent care benefits provided by your employer that you excluded from gross income.
3. The total expenses qualifying for the credit are capped at $3,000 (if you had one qualifying individual) or at $6,000 (if you had two or more qualifying individuals), and may not exceed the lesser of your and your spouses earned incomes.
A qualifying individual is:
1. Your dependent who was under age 13 when the care was provided and was your qualifying child
2. Your dependent who was physically or mentally incapable of self-care and who had the same principal place of abode as you for more than half of the year, or
3. An individual who was physically or mentally incapable of self-care, had the same principal place of abode as you for more than half of the year, and was your dependent. For this purpose, whether the individual was your dependent is determined without regard to the individual’s gross income, whether the individual filed a joint return with the individual’s spouse, or whether you or your spouse could be claimed as a dependent on someone else’s return.
According to IRS administrative guidelines to its examiners concerning Rev. Rul. 2012-18, published in the 2012-26 Internal Revenue Bulletin, when performing a tip examination (aka audit), IRS examiners must ensure that service fees or charges are properly characterized as wages and not tips. If the payment is not a tip then it is a service charge and reported as wages.
Whether payments should be reported as tips or service charges basically distills down to whether the following factors were present:
(1) The payment was made free from compulsion;
(2) The customer had the unrestricted right to determine amount;
(3) The payment was not be the subject of negotiation or dictated by employer policy; and
(4) The customer determined who receives the payment.
Automatic gratuities (for parties of a certain size for example) should according to this directive to examiners be reported as service charges and not tips in my humble opinion. Comments on the interim guidance may be submitted either electronically at TIP.Program@irs.gov or in writing to:
Internal Revenue Service
National Tip Reporting Compliance
3251 North Evergreen Dr. NE
Grand Rapids, MI 49525
Also I learned that the IRS intends to solicit public comments on proposed changes to it’s existing voluntary tip compliance agreements. Specifically, the Tip Reporting Alternative Commitment (TRAC) program and other variations of TRAC agreements.
The principal author of this revenue ruling is Linda L. Conway-Hataloski of the Office of Division Counsel/Associate Chief Counsel (Tax Exempt & Government Entities). For further information regarding this revenue ruling, contact Linda L. Conway-Hataloski at 202-622-0047.
You are allowed deductions for ordinary and necessary expenses incurred in the course of business under §162, but you must also keep adequate records to substantiate expenses which can at times seem esoteric if not convoluted. Deductible travel expenses for example under §274(d) are based on whether or not the travel relates to a business activity or is for pleasure, while §162(a)(2) specifically states the amounts cannot be lavish or extravagant under the circumstances.
No single factor or set of factors can determine if you are engaged in a business activity for profit, but all facts and circumstances must be taken into account §183-2(b). Three common questions are considered when determining whether or not the activity is for profit or a hobby subject to the hobby loss rules under §183.
• Did you conduct the activity in a manner similar to comparable activities that are profitable?
• Did you maintain complete and accurate books and records for the activity?
• Did you change operating procedures, adopt new techniques or abandon unprofitable methods to ensure profitability of the activity?
According to Douglas Rundlett, et ux. v. Commissioner TC Memo 2011-22, even though you may conducted an activity in a businesslike manner you should also demonstrate that you adopt new techniques or strategies to limit future losses or risk being viewed as being engaged in a not for profit activity or hobby.
If you incur interest expense on loans you should use the tracing rules of Reg. §1.163-8T to determine whether the interest expense is for:
3. passive activities. or is
4. personal in nature
The regulation focuses on the use of the loan proceeds, not the item or items used as collateral for the loan.
Reg. §1.163-8T(c)(1) even sets forth an example of a taxpayer pledging his corporate stock as security for a car loan. In the example, the conclusion is that the loan interest is personal based on its use to purchase a personal use vehicle. In order to properly deduct the interest, it is essential to determine and document the use of the loan proceeds received as evidenced in James Ellington, et ux. v. Commissioner TC Memo 2011-193.
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.
Recently the IRS’ Outreach Corner published an article stating that if you’re searching for a job, “you may be able to deduct some of your expenses, such as attending career fairs, moving expenses and submitting resumes, on your tax return as long as you are looking for a new job in your current occupation.”
This is a true statement of fact however I worry for taxpayers because particular care needs to be had in understanding, substantiating as well as representing how long it has been since your last ‘job’ as well as whether the new ‘job’ in question is in the same ‘occupation’ as your previous ‘job’ and ultimately what the definition of a ‘job’ really is. These are the questions I am regularly faced with in IRS audits when job search expenses are being scrutinized and in Appeals if job search expenses have been disallowed.
For more information about job search expenses check out:
• Job search expenses fall into the category of miscellaneous itemized deductions on Schedule A, Itemized Deductions. If your total itemized deductions are higher than the standard deduction, it’s generally better to choose to include your itemized deductions. Also, in most cases, these expenses must exceed your adjusted gross income by two percent to provide a tax benefit.
• Expenses incurred while searching for a job in your current occupation can be deductible. However, you may not deduct expenses incurred while looking for a job in a new occupation.
• Fees paid to employment and outplacement agencies are deductible. However, if your employer reimburses you for these fees in a later year, you must include the amount in your gross income up to the amount of your tax benefit in the earlier year.
• Costs for resume preparation and postage for mailing your resume to prospective employers is deductible.
• Travel expenses may be deductible if the primary purpose for the trip is to look for a new job. The amount of time you spend on personal activity compared to the amount of time you spend looking for work is important in determining whether or not the trip is primarily personal or primarily to look for a new job.
• Moving costs to a new job location may be deductible. However, you must meet certain criteria relating to distance moved and timing of the move. See IRS Publication 521, Moving Expenses.
• Job search expenses cannot be deducted if there was a substantial break between the end of your last job and the time you began looking for a new one.
• You cannot deduct job search expenses if you are looking for a job for the first time.
Taxpayers who own shares in an S corporation are allowed pass-through losses to the extent of their basis (also commonly referred to as investment) under §1366(d) in their entity. Shareholders can obtain basis in a variety of ways such as direct investment, loaning the corporation money, contributing capital etc. However sharholders of S Corporations do not gain basis by personally guaranteeing debts of the corporation.
In Spencer v. Commissioner, 110 TC 62, TC Memo 2010-55, the Court ruled that mere shareholder guaranties of S corporation indebtedness generally fail to satisfy the requirements of §1366(d)(1)(B) because there is no economic outlay or direct indebtedness between the corporation and its shareholders. In other words no form of indirect borrowing, including personal guaranties, gives rise to indebtedness from the corporation to the shareholder unless the shareholder pays part or all of the obligation. As such there is no increase in basis by personally guaranteeing a debt for the Sub-chapter S Corporation that you own, if you own one.
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.
The Internal Revenue Service announced that it reached an agreement with the Millennium Multiple Employer Welfare Benefit Plan (Millennium Plan) which is presently the subject of a bankruptcy proceeding filed on June 9, 2010, in the U.S. Bankruptcy Court for the Western District of Oklahoma (Case No. 10-13528). Those disrespecting the Code have been brought down. Kudos to the IRS!
Under the agreement the terms of the Order Confirming Modified Plan dated June 16, 2011, the Millennium Plan will terminate its operations, liquidate its assets and distribute approximately $80 million in assets to individual participants. The agreement with the IRS resolves certain issues relating to an IRS investigation into the design, marketing, operation and management of the Millennium Plan. In my opinion this is a case of morally bankrupt people engaging in suspect behavior to pad their pockets with ill-gotten gains. They make me sick to my stomach. The agreement with the IRS also provides a procedure for resolving hundreds of income tax and penalty examinations of employers and employees who participated in the Millennium Plan. Finally, the agreement with the IRS addresses tax issues relating to the liquidation of the Millennium Plan, including information reporting and income tax withholding requirements.
Section 6103 of the Internal Revenue Code strictly controls the disclosure of tax information. In connection with this agreement, the Millennium Plan consented to the IRS issuance of the IRS news release announcing the settlement on the hopes I suspect that no one is surprised in 2012.