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How to Deduct Materials and Supplies

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The IRS recently published guidance on deducting materials and supplies.  The issue is whether taxpayers can immediately deduct the purchase price of materials and supplies or must capitalize the purchase price of materials and supplies and deduct them over a period of years.

The treatment of materials and supplies depends on whether they are incidental or nonincidental.

Materials and supplies include the following items:

  • A unit of property that has an economic useful life of 12 months or less
  • A unit of property that costs $100 or less
  • A component purchased to maintain, repair, or improve a unit of property that is not acquired as part of any single unit of property
  • Fuels, lubricants, water, and similar items, that are reasonable expected to be consumed in 12 months or less, beginning when used in the taxpayer’s business operations.

Incidental Materials & Supplies:  These can be deducted in the year purchased (or incurred for accrual basis taxpayers).  Materials and supplies are incidental if they are carried on hand and no record of consumption is kept or written inventories of these items are not maintained.

Nonincidental Materials & Supplies:  These are deducted in the year they are used or consumed in the taxpayer’s business operations.

Example of Incidental Materials & Supplies

ABC Corp buys 20 bottles of window cleaner at $2 each, 50 pens at $1 each, and 10 printer toners at $60 each.  ABC Corp does not inventory these items or otherwise maintain a record of these items.  Once each item is used, its expected life is less than 12 months.  These items are considered materials and supplies because each unit of property costs $100 or less, and their expected useful life is 12 months or less.  These items are incidental materials and supplies because there is no record of consumption and no inventories are maintained.  ABC Corp may deduct the purchase price of these items in the year they are purchased.

Example of Nonincidental Materials & Supplies

Same facts as above example, except that ABC Corp keeps a written record of the printer toners on hand.  Since the printer toners are inventoried, they do not qualify as incidental materials and supplies.  They are nonincidental materials and supplies and must be deducted in the year they are used.  Thus, if ABC Corp uses 3 of the printer toners in 2011, 4 in 2012, and 3 in 2013, ABC Corp will deduct $180 in 2011 (3 toners used at $60 each), $240 in 2012, and $180 in 2013.  If ABC Corp did not maintain inventories or written consumption records, the full $600 toner purchase price would have been deducted in the year of purchase.  The window cleaner and pens may still be deducted in the year of purchase since these items were not inventoried.

Taxpayers may make two elections:

Election to Capitalize

Taxpayers may elect to capitalize the purchase price of materials and supplies and depreciate the purchase price over a number of years.  This election will be beneficial if the depreciable life is less than the number of years over which the materials will be consumed (e.g., materials can be depreciated over 3 years, but they will be consumed over 5 years)

De Minimis Election

A diminish election allows taxpayers to immediately deduct (up to a certain limit) the purchase price of both incidental and nonincidental materials and supplies.  However, most small businesses will not meet the requirements for the de minimis election.  The requirements are:

The business has an Applicable Financial Statement, which is

  • A financial statement filed with the SEC
  • An AUDITED financial statement
  • A financial statement required to be submitted to a federal or state governmental agency other than the IRS or SEC

The business has a written accounting policy in effect at the beginning of the year requiring it to expense items that cost no more than a specified dollar amount for book purposes and the policy is complied with.  Since the IRS published this guidance in December 2011, it is unlikely that taxpayers had a written policy in effect on January 1, 2012.

Surprising, but the IRS has received a lot of negative feedback about the complexity of these rules.  However, these rules are effective for 2012.

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230

 

Deducting Start-Up Costs (Investigation & Pre-Opening Costs)

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Before a business owner opens the doors for business, she typically has already paid a substantial amount of expenses.  The tax code refers to these expenses as start-up expenses.  Taxpayers can immediately deduct up to $5,000 of start-up expenses in the year that the taxpayer begins business operations.  The $5,000 allowable deduction is reduced dollar-for-dollar by the start-up expenses in excess of $50,000.  Start-up expenses that cannot be immediately deducted are deducted over 180 months (15 years).

Example:  John spends $4,000 in start-up expenses.  He can take a $4,000 deduction in the year his business begins operations. 

Example 2: Joan spends $52,000 in start-up expenses.  Joan’s allowable start-up expenses are reduced dollar-for-dollar by the excess of her $52,000 start-up expenses over the $50,000 limit (a $2,000 reduction).  Joan can therefore deduct $3,000 in start-up expenses in the year her business begins operations.  She can deduct the remaining $49,000 in start-up expenses over 180 months beginning in the month her business begins operations.

What are Start-Up Expenses?

There are two categories of start-up expenses.  They are (1) Investigative Expenses and (2) Pre-Opening Expenses.

Investigative Expenses

These expenses include investigation expenses to determine what, if any, business to get into.  Investigation expenses are typically paid before the taxpayer has reached a decision to buy or create a specific business.  Examples of investigative expenses include expenses for analysis or survey of potential markets, products, labor supply; and viewing potential business locations and transportation facilities.

There is some uncertainty as to whether a taxpayer can deduct investigative expenses if the taxpayer never actually starts a business.  This gets a little tricky, but a deduction should be allowed if a taxpayer actually enters into a specific transaction for profit.  To meet this standard, the taxpayer must have gone beyond a general investigatory search for a new business or investment to focus on the acquisition of a specific business or investment.  However, expenses related to the general decision on whether to enter into a trade or business (and which business to enter) are nondeductible personal expenses.

Example:  Hildegard is considering opening a business.  She is considering a restaurant, a bakery, or a law firm.  She buys trade journals for each of the businesses, buys some business books, and takes a few business classes.  Hildegard decides not to open a business.  Since Hildegard never got beyond a general decision on which business to enter (if any at all), these investigative expenses are nondeductible personal expenses.

Example 2: Same as the last example, except Hildegard decides to open a law firm.  She hires a business broker.  She eventually starts negotiating a purchase of another lawyer’s firm.  She incurs expenses by hiring professionals to guide her in the purchase.  She also starts attending legal practice seminars and starts buying small office supplies.  The purchase agreement is never completed and Hildegard decides to keep her current job—she never starts her law practice. 

Once Hildegard has gone beyond general investigative expenses and started to focus on the acquisition of a specific business, her investigative expenses became deductible.  The deductible expenses include any expenses she paid to the broker, her professional fees, seminar fees, and small office supplies.  However, the expenses during the general investigative phase are still not deductible.

Pre-Opening Expenses

These costs are the normal operating expenses of a business, but are incurred after the taxpayer decides to establish or acquire a specific business, but before the business begins actual operations.  Examples of pre-opening expenses include advertising; training wages; travel expenses to line up distributors, suppliers or customers; and professional fees.

What Happens if the Business Closes before All the Start-Up Costs Have Been Deducted?

Start-up expenses in excess of $5,000 (or less if start-up expenses exceeded $50,000) are deducted over 180 months.  If the business closes before the 180 month period ends, the business may deduct any start-up costs that were not deducted.

Example:  Lucy pays $10,000 in start-up costs.  Her business begins July 1, 2012.  Her business shuts down on February 1, 2013.  Lucy can immediately deduct $5,000 in 2012.  The remaining $5,000 is deducted over 180 months.  Lucy deducts $166.68 of start-up costs in 2012 (for the six months between her July 1 opening date and the December 31 end of year).  Since Lucy’s business shuts down in 2013, she can deduct the remaining $4,833.32 of start-up expenses in 2013.

  Comments or questions about this post?  Please let us know through the comment area below!

If you found this article informative, subscribe to our Tax Newsletter.

Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230

Deductions for Conventions Outside the U.S. and on Cruise Ships

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This is the final post in a three part series that addressed tax issues of travel.  Prior posts included deducting domestic and foreign travel and deducting travel expenses of a spouse.  This post will focus on attending conventions outside the United States, including conventions on cruise ships.

To take a deduction, taxpayers must pass additional hurdles to show that the convention, seminar, or similar meeting outside North America or on a cruise ship directly relates to the conduct of their trade or business.  The North American area includes the U.S., its possessions, the Pacific Islands Trust Territory, Canada, Mexico, and certain Caribbean countries.

Conventions, Generally

To deduct expenses of a convention outside the North America, the taxpayer must establish that it is reasonable for the meeting to be held outside North America.  The reasonableness of the location includes factors such as:

  • The purpose and activities of the meeting
  • The sponsoring organization
  • The residences of the organization’s active members
  • The location of other meetings

In addition, the time spent in business meetings must be substantial when compared to the time spent sight-seeing and in other recreational activities; otherwise the trip will be considered a personal vacation and only the registration fees of the business meeting and other direct business expenses are deductible.

Example:  Jethro, who lives in Michigan, is considering opening a business in Italy.  He attends a 3 day seminar in Italy, organized by Italian accountants and attorneys, that explains the nuts and bolts of conducting business in Italy.  Since the seminar’s purpose is to explain how to conduct business in Italy, and the seminar is sponsored by Italian business and legal professionals, it is reasonable for the seminar to be held outside North America.  John can deduct his travel expenses to Italy, his lodging and meals, and incidentals.  However, the time spent in the seminars must be substantial compared to his recreational activities in Italy or the travel expenses (with the exception of the seminar fees) will be nondeductible.

Example 2: Elly May is a successful attorney in Michigan.  Her local bar association holds a convention in Paris that addresses legal practice in Michigan.  It is probably not reasonable for a convention addressing Michigan law to be held in Paris.  Therefore, her travel costs to Paris will not be deductible.  However, she may take a deduction for the convention’s registration fees.

Conventions on Cruise Ships

Deductions for conventions on cruise ships are limited to $2,000 per person per year.

 

Additionally, deductions are allowed only if the ship is a U.S. registered vessel, and all of its ports of call are in the U.S. or its possessions.  A taxpayer must also attach the following written information to her return for the year the deduction is claimed:

  • A statement signed by the taxpayer showing the number of days of the trip, the number of hours each day spent attending scheduled business activities, and the program of the convention’s scheduled business activities
  • A statement signed by an officer of the sponsoring organization that includes a schedule of each day’s business activities and the number of hours the taxpayer attended those meetings

Guess what?  The IRS doesn’t like conventions on cruise ships!

 

 Comments or questions about this post?  Please let us know through the comment area below!

If you found this article informative, subscribe to our Tax Newsletter.

Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230

 

 

Deduct Travel Expenses of a Spouse

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A past blog post explained the rules for deducting domestic and foreign travel.  This post will focus on claiming deductions for travel expenses of a spouse who accompanies the business owner on travel.  The IRS is very skeptical of allowing travel expenses of an accompanying spouse because it believes the spouse’s travel isn’t really for business purposes.  The IRS believes the spouse tags along for personal reasons such as offering the business owner companionship or it is a chance for the spouse to take a vacation.

The IRS disallows deductions for amounts paid with respect to a spouse, dependent, or other person accompanying a business owner on business travel unless:

  • The accompanying person is an employee of the taxpayer
  • The travel of the accompanying person is for a bona fide business purpose
  • The travel expenses would otherwise be deductible by the accompanying person (see post on domestic and foreign travel)

The term other persons would include friends and other family members.  The term other person does not include a business associate whose travel expenses are for a bona fide purpose.  Examples would include customers, suppliers, partners, professional advisors, etc.

The first requirement is fairly straight forward.  The spouse must be employed by the taxpayer.  The spouse must receive a W-2, payroll taxes should be paid, and payroll records should be kept.

The challenge lies in the second requirement—bona fide business purpose.  The presence of the spouse must be necessary, not merely helpful, for a business purpose.

Examples of a bona fide business purpose where a strong argument that the spouse’s work is necessary include:

  • The spouse acts as a translator for foreign speaking meeting participants
  • The spouse acts as a professional advisor (CPA or attorney) for the business owner
  • The meeting is held with participants with whom the spouse has had business dealings and the spouse can help the business owner negotiate with them

In a few court cases, the courts have allowed deductions when the spouse’s presence was required by the business, and it helped promote the company’s public image, enhance the morale of company representatives, and improved business relationships.

Examples where the IRS held that a bona fide business purpose did NOT exist include:

The spouse:

  • hosting a reception
  • socializing with business associates
  • performing light clerical duties

Even if the spouse’s travel expenses don’t qualify as deductions, the business owner is allowed to deduct the travel expenses she would have incurred had she traveled alone.  The allowable deductions generally are more than half of the total travel expenses for both people.

Example:  Wilma is a business owner.  Fred accompanies her on travel.  Although Fred is there for a bona fide business purpose, his travel expenses are not deductible because he is not employed by Wilma—remember the spouse has to be an employee.  They have the following expenses:

  • lodging is $150 per night for a double room for four nights (assume a single rate room is $100 per night)
  • transportation expenses for the 1,000 mile trip at 55.5 cents per mile is $550
  • meals cost $800 (assume meal costs would be $500 if Wilma traveled alone)

Wilma’s deductible expenses are:

  • $400 for lodging (the single rate room times four nights)
  • The full $550 for transportation (since she would incur this same expense even if Fred didn’t tag along)
  • $500 for meals (reduced by 50% disallowance rule)

The deductible expenses of $1,450 (before 50% meal disallowance) is more than 50% of the total travel expenses of $1,950. 

 Comments or questions about this post?  Please let us know through the comment area below!

If you found this article informative, subscribe to our Tax Newsletter.

Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230

How to Deduct Travel Expenses

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Travel expenses include transportation, lodging, meals, and related incidentals.  Business travel expenses are fully deductible (except for meal expenses, which are 50% deductible).  The travel expenses must be properly substantiated.

There are different rules for domestic and foreign travel.  There are also different rules depending on whether the travel is exclusively for business, primarily for business, or primarily for personal reasons.

Domestic Travel

Exclusively for Business:  If a taxpayer’s trip is solely for business reasons, all reasonable and necessary travel expenses (travel fares, lodging, transportation, meals, and incidentals) are fully deductible (except that meals are 50% deductible).

Primarily for Business:  the deductible travel expenses include the costs of getting to and from the business destination and any business related expenses while at the business destination.  Personal expenses incurred while at the destination are not deductible.

Primarily for Personal Reasons:  the costs of getting to and from the destination are not deductible because they are considered personal expenses.  However, any business costs the taxpayer pays at the destination will be deductible.

Whether the trip is primarily for business or personal reasons depends on the facts and circumstances of the travel.  The IRS tends to focus on the amount of time spent on business and personal activities.  The primary purpose of the trip is determined based on which purpose (business or personal) exceeds 50% of the time spent on the trip.

Example 1:  Joan has a business in Detroit.  She travels to L.A. for meetings that span four days.  Joan arrives in L.A., spends four days in meetings, and immediately returns home to Detroit.  She spent $500 in airfare, $800 in lodging, and $500 in food.  Since, Joan’s trip is exclusively for business, Joan can claim travel expenses of $1,550 ($500 airfare, $800 lodging, and 50% of $500 food).

Example 2: Same facts as above except Joan spends three days site seeing throughout California.  She spends $600 in lodging, $250 in meals, and $150 in auto expenses while site seeing.  Since the primary purpose of her trip was business (based on 4 days of business versus 3 days personal), she may still deduct the $1,550 travel expenses from Example 1.  However, the expenses for lodging ($600), meals ($250), and auto expenses ($150) she spent while site seeing are nondeductible personal expenses.

Example: Same facts as example 2 except Joan spends 6 days site seeing.  Since the purpose of her trip is now considered personal (based on 4 days of business versus 6 days personal), the costs of getting to and from the destination are nondeductible.  Thus, the $500 airfare to L.A. is no longer deductible.  Her site seeing expenses are also not deductible.  However, Joan may still deduct her business expenses while in L.A. ($800 in lodging and 50% of her $500 food expenses from example 1).

Foreign Travel

Exclusively for Business:  If a taxpayer’s trip is solely for business reasons, all reasonable and necessary travel expenses (travel fares, lodging, transportation, meals, and incidentals) are fully deductible (except that meals are 50% deductible).

Majority of Time on Business:  ALL travel expenses are allocated between deductible business expenses and nondeductible personal expenses.  The expenses should be allocated to deductible and nondeductible categories using a day-to-day allocation method based on business days and personal days.  There are two things to take note of:

  • This differs from the domestic travel rules where the costs of getting to and from and destination are fully deductible if the trip is primarily for business.  For foreign travel, the costs of getting to and from the destination must be allocated if the trip is not exclusively for business, even though the majority of time is spent on business
  • ALL travel expenses (not just getting to and from the destination) must be allocated

Majority of Time for Personal Reasons:  ALL travel expenses (costs of getting to and from the destination, lodging, meals, etc.) are not deductible because they are considered personal expenses.  However, any expenses that the taxpayer pays at the destination will be deductible if they are directly related to business.

While the foreign travel rules require an allocation of expenses if business travel is combined with personal travel, there is a safe harbor.  If the primary purpose of the trip was business AND any of the following exceptions is met, allocation of travel expenses is not required–the trip is treated as being exclusively for business (and 100% of the travel costs are deductible):

  • No more than seven consecutive days are spent outside the U.S.
  • Less than 25% of the total time on the trip is devoted to nonbusiness activities
  • The taxpayer has no substantial control over arranging the trip—a self employed taxpayer is generally considered to have substantial control over his travel and won’t qualify under this exception.  Employees may qualify under this exception.
  • The taxpayer establishes through a facts and circumstances analysis that personal vacation was not a major consideration.
This is just an overview of the travel deduction rules.  They get more complicated.  If you have any questions on how this applies to you, just give us a call.

Comments or questions about this post?  Please let us know through the comment area below!

If you found this article informative, subscribe to our Tax Newsletter.

Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230

 

 

The Right Way and The Wrong Way to Reimburse Employees

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When a business reimburses an employee for incurring business expenses, there is a right way and a wrong way to do so.  The right way is through what is known as an accountable plan.  The wrong way is through…wait for it…a nonaccountable plan.

The Wrong Way

If the employer has a nonaccountable plan, when the employer reimburses an employee for business expenses the employer takes a deduction in the amount of the reimbursements.  The deduction is treated as a compensation deduction and the reimbursement is included in the employee’s income.  Payroll taxes on this amount are due.  If the employee has substantiation for the expenses, she can deduct them as an itemized deduction on her personal tax return.  These expenses are reported on Form 2106, and are subject to the 2% of AGI floor.  Additionally, if the employee had meal expenses, she can only deduct 50% of them.

Example:  JoJo Corp employs John and JoJo Corp does not have an accountable plan.  John incurs business expenses of $1,000 for travel and supplies and $500 for meals.  JoJo Corp reimburses $1,500 of John’s expenses.  JoJo Corp takes a $1,500 deduction (JoJo Corp’s deduction for meals is not reduced by 50%).  JoJo Corp pays FICA, FUTA, and state unemployment tax on this $1,500 compensation deduction.  John’s W-2 is increased by the $1,500 reimbursement.  John will also pay his share of FICA tax.  John can take an itemized deduction for $1,000 of the travel and supplies expenses and an itemized deduction of $250 for the deductible 50% of meal expenses.  However, these expenses are reduced by 2% of Jon’s AGI.  If John has AGI of $100,000, the $1,250 deduction is reduced by $2,000 (2% of $100,000 AGI).  Since the deductions are less than 2% of AGI, John cannot take a deduction.

The Right Way

If the employer has an accountable plan, expense reimbursements are deductible by the employer as business expenses rather than as compensation.  The 50% meal limitation now applies to the employer.  The reimbursements are excluded from the employee’s income and are exempt from payroll tax.

Example:  Same facts as above, except JoJo Corp has an accountable plan.  JoJo Corp will have a business deduction of $1,250 ($1,000 for travel and supplies plus 50% of the $500 meal expense).  John will not have to report the amount of the reimbursement as income.  Neither JoJo Corp nor John will owe any payroll taxes on the reimbursement.  Since JoJo Corp takes the deduction for the business expenses, the 2% of AGI floor is irrelevant.

There are three requirements of an accountable plan:

PROVING A BUSINESS CONNECTION

The plan pays reimbursement and allowances only for otherwise deductible business expenses (such as travel, lodging, or meal expenses)

MAINTAINING ADEQUATE SUBSTANTIATION

The employee accounts for the business expenses by submitting to the company a detailed written record substantiating the expense’s time, place, amount, and business purpose.

REQUIRING EMPLOYEES TO RETURN EXCESS ADVANCES

This mainly applies when an employer advances funds to the employee to pay business expenses.  Advances in excess of business expenses must be returned to the employer.

A few years back, the IRS had an audit initiative focused on executive compensation, fringe benefits, and employee reimbursement plans.  IRS found a great deal of noncompliance and, in future audits will spend more time auditing these items.  It is very important to properly comply with the three requirements of accountable plans if you want to take advantage of the benefits they offer.

Comments or questions about this post?  Please let us know through the comment area below!

 If you found this article informative, subscribe to our Tax Newsletter.

Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230