Monthly Archives: August 2012
Rules for Deducting Rental Losses
Rental losses may not be deductible because of the passive activity loss rules. The passive loss rules apply to activities in which taxpayers do not materially participate. Taxpayers usually satisfy the material participation standard by being involved in a business for 500 hours per year (although there are several other ways of materially participating). Passive losses can only be deducted against passive income. Passive losses will also be allowed when the activity is disposed of in a taxable transaction (e.g., the activity is sold). Congress created the passive loss rules in 1986 to curb tax shelter abuses. Unfortunately, these rules also affect many legitimate activities.
Unfortunately, rental activities will be classified as passive activities even if the taxpayer materially participates in the rental. Therefore, rental losses will not be deductible against other income until the rental activity is disposed of in a taxable transaction (e.g., the rental property is sold).
Fortunately, there are three ways rental losses may be deductible:
- If the taxpayer actively participates in the rental activity, rental losses of up to $25,000 per year may be deductible
- If the taxpayer meets the requirements to be classified as a real estate professional
- If the activity is not treated as a rental by the tax law
Actively Participating in the Rental Activity
Taxpayers who actively participate in a rental activity can deduct up to $25,000 of rental losses per year. Taxpayers actively participate in a rental activity through managerial functions such as deciding on rental terms, approving tenants, and approving capital expenditures. Taxpayers must own at least 10% of the value of the rental activity to meet the active participation standard. Finally, the $25,000 loss is reduced by 50% of the excess of the taxpayer’s adjusted gross income over $100,000.
Example: Wilma owns a rental property. She negotiates lease terms with potential tenants, approves tenants, and decides what improvements (repairs, carpeting, etc.) will be made to the property before leasing it out. Wilma’s adjusted gross income is $90,000. Since Wilma decides on rental terms, approves tenants, and approves capital expenditures, she actively participates in the rental. Her income is below the phaseout threshold so she can deduct up to $25,000 of rental losses.
Real Estate Professionals
Real estate professionals may fully deduct rental losses. A Taxpayer must meet the following three requirements to be classified as a real estate professional:
- She must spend more than 750 hours per year in real property trades or businesses in which she materially participates (e.g., spends more than 500 hours in the activity) AND
- She spends more than 50% of her time in real property trades or businesses in which she materially participates
- She must materially participate in the rental activity for which she is trying to claim a loss
The term real property trade or business means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
Example: Barney is a real estate broker. He spends 1,000 hours per year working as a broker. He also spends 1,000 hours per year managing an apartment building that he owns. The apartment building will suffer a $100,000 rental loss this year. These are Barney’s only activities. Since Barney spends 2,000 hours per year on real estate businesses and 100% of his time is spent on real estate businesses, he is a real estate professional. Since Barney spends more than 500 hours in the apartment building activity, he materially participates in the apartment building activity. Barney meets the requirements of the real estate professional exception and may fully deduct the $100,000 loss.
Activities Not Treated as Rentals by the Taw Law
Rental activities of a very short duration or that require substantial services along with the rental property may be classified as business activities rather than rental activities. This is due to the increased involvement of the taxpayer in such activities. If a rental activity is classified as a business activity, taxpayers may be able to deduct losses if they materially participate. Normally, rental losses are not deductible even if taxpayers materially participate (unless the active participation or real estate professional exceptions apply).
The following rental activities are treated as non-rental activities:
- The property is rented by each customer for an average of seven days or less (e.g., hotel rooms or cars)
- Significant personal services are provided, and each customer rents the property for an average of more than seven, but no more than 30 days (e.g., a dude ranch or resort).
- Extraordinary personal services are provided, regardless of the average period of customer rental (e.g., nursing home).
- The rental is incidental to the taxpayer’s nonrental activity, (e.g., the rental of a parking lot for a special event). If the gross rental income in those situations is less than 2% of the lesser of the property’s unadjusted basis or its fair market value, the rental of the property is considered incidental to a nonrental activity.
- The property is made available by the taxpayer during defined business hours for nonexclusive use by various customers (e.g., a golf course that has both daily customers and customers who purchase long-term passes).
If the taxpayer conducts one of these activities, she will be able to deduct losses as long as she materially participates in the activity.
Comments or questions about this post? Please let us know through the comment area below!
If you need help with small business taxes,
sign up for a FREE tax consultation.
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 Materials and Supplies
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.
Comments or questions about this post? Please let us know through the comment area below!
If you need help with small business taxes,
sign up for a FREE tax consultation.
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 Tax Implications of a Company Car
When an employer provides a company vehicle to an employee, the employee must generally include the market value 
of her personal use of the vehicle in her income. The employer can generally take a payroll deduction for the actual costs, including depreciation, of providing the vehicle to the employee.
If the personal use of the vehicle is de minimis (of such small value that accounting for it would be impractical), the employee will not have to include the value of her personal use in income. However, personal use of more than one day per month is not considered de minimis, so this exception is of little value.
Determining How Much to Include in the Employee’s Income
Under the general valuation rule, the value of the company vehicle that is included in the employee’s income is what it would cost the employee to lease a comparable vehicle for the same period the vehicle is available to her. Generally, a cents-per-mile value cannot be used unless a comparable vehicle is available for lease to the employee on a cents-per-mile basis.
There are also three special valuation rules (each having different requirements).
- The Annual Lease Value Method
- The Commuting Value Method
- The Cents-per-Mile Method
The Annual Lease Value Method (ALV)
The ALV is based on IRS tables and is based on the market value of the vehicle on the first date it is available to the employee. The vehicle’s purchase price can be used as the market value if the vehicle was purchased in an arm’s length transaction. If the employer leases the vehicle, the employer can use the MSRP plus sales tax less 8% of this sum as the market value.
Example: ABC Corp leases a Ford Focus. The MSRP for the car is $23,000. After sales tax, the cost is $24,380. ABC Corp can reduce this sum by 8% to determine a market value of $22,429 to look up in the ALV tables. Based on the ALV tables, the employee will have to include $6,100 as income for her personal use of the car with a market value of $22,429.
The ALV includes maintenance and insurance, but does not include gas. If the employer pays for gas, the value of the gas will have to be included in income in addition to the ALV amount.
The Commuting Value Method
This method may be used if four requirements are met:
- The auto must be owned or leased by the employer and provided to the employee to use in the employer’s business
- The employer requires, because of business reasons, the employee to commute in the vehicle (e.g., the employee is on 24 hour call)
- The employer must have a written policy that forbids the employee (or certain family members) from using the vehicle for personal reasons other than commuting or de minimis personal use
- The employee required to use the vehicle must not be a controlling owner of the employer
If these requirements are met, the personal use value of the company car will be $3 per round trip ($1.50 per one way commute).
The Cents-Per-Mile Method
This method may be limited because it cannot be used when the value of the vehicle when it first becomes available to the employee exceeds $15,900 for a passenger vehicle and $16,700 for a truck or van. In addition, this rule may be used only for vehicles that are expected to be used in the employer’s business throughout the year, or for vehicles that are actually driven at least 10,000 miles in that year and used primarily for business by employees. If the vehicle qualifies under this method, the standard mileage rate (55.5 cents in 2012) may be used to determine the personal use value of the vehicle.
Requirements of All Special Use Valuation Methods
To use any of the three special valuation rules, one of the following conditions must exist:
- The employer treats the value of the vehicle as wages for reporting purposes before the extended due date of its tax return for the year the benefit is provided
- The employee includes the value of the benefit in income before the extended due date of her tax return for the year the benefit is provided
- The employee is not in control of the employer
- The employer demonstrates a good faith effort to treat the benefit correctly
Payroll Tax Implications
The employer must report and withhold income and employment taxes on the value of personal use of a company car. However, there are two elections available to the employer:
- The employer can elect to treat the personal use value as paid at any time during the year. Thus, the employer can treat the entire personal use value as being provided on December 31 of each year to delay the due dates of the income withholding and payroll taxes
- An employer can elect not to withholding income taxes (the employee will have to pay income tax estimates on her own). However, the employer is still responsible for employment taxes.
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
Deducting Start-Up Costs (Investigation & Pre-Opening Costs)
){kind=link}
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
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
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
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.
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
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
Getting Schooled—Providing Employee Educational Assistance
There are two primary methods for business owners to provide tax-free educational assistance to themselves and to their employees. The methods are:
- Working Condition Fringe Benefit
- Section 127 Plan
Working Condition Fringe Benefit
Educational expenses paid under this method are deductible by the employer and are tax free to the employee. The educational expenses are also excluded from payroll taxes such as FICA and FUTA. There is no limit on the amount of educational expenses that qualify; however, the educational expenses must be ordinary and necessary business expenses.
To qualify as a working condition fringe benefit, the educational program must relate to maintaining or improving the skills required by the employee’s job. The education itself must NOT lead to the student qualifying for a new trade or business. Education required to meet the minimum skill level required for the job does NOT qualify. Job related education may be furnished directly by the employer or through a third party such as an educational institution or seminar organization. The educational expenses of the business owner also qualify.
Example: ABC Corp employees Joan as an engineer. Joan is climbing the corporate ladder and believes an MBA will help her develop management skills to help her advance her career. ABC Corp pays for her MBA. Since the MBA will improve her skills, the educational expenses paid by ABC Corp will not be taxable to her. In addition, ABC Corp can take a deduction for the educational expenses.
Example 2: John is a law student working in a law firm as a legal assistant. The law firm offers to pay John’s law school tuition. These expenses will NOT qualify as a working condition fringe benefit because the law degree is required for John to meet the minimum requirements for his job as an attorney. However, the tuition may qualify for exclusion as a Section 127 plan.
Section 127 Plan
A Section 127 plan is a qualified education assistance program. The first $5,250 of qualified educational assistance provided during the year is exempt from tax, including FICA and FUTA.
To qualify under Section 127, a plan is required. The plan must:
- Be in writing
- Provide educational assistance exclusively to employees (possibly including owners)
- Not provide employees with a choice of education assistance and taxable compensation
- Provide reasonable notice of the availability and terms of the program
- Not discriminate in favor of highly compensated employees or their dependents
- Not pay more than 5% of the benefits to more-than-5% owners or their spouses or dependents
Children of owners can participate in a Section 127 plan if they are at least 21 years of age, are legitimate employees, are not more than 5% owners, and are not dependents of the owner. Children under age 21 can still participate in Section 127 plans, but their educational expenses are subject to the nondiscrimination rules (which could disqualify the plan).
Example: ABC Corp is owned by John. ABC Corp has three employees—Adam (John’s son) and two unrelated employees. All employees are 22 years old. John does not claim Adam as a dependent. ABC Corp pays $5,000 towards each employee’s tuition. Since Adam is at least 21 years old, is a legitimate employee, is not a dependent, and is not a more-than-5% owner, the tuition paid on his behalf is not counted as being for a highly compensated employee or a more than 5% owner. All employees may exclude the $5,000 tuition payment from their incomes.
Example 2: Same facts as above except that Adam (John’s son) is 20 years old. Since Adam is under age 21, he is attributed ownership from his father (i.e., Adam is considered a 100% owner). Since 33% of the benefits ($5,000 tuition for Adam divided by $15,000 total tuition paid) are paid for a more-than-5% owner, EACH employee must report the $5,000 tuition payment as income.
Key Difference between a Working Condition Fringe Benefit and Section 127 Plans:
- A $5,250 cap applies to Section 127 Plans, but not working condition fringe benefits
- If over $5,250 is spent on educational expenses under a Section 127 plan, the excess may qualify as a working condition fringe benefit
- The cost of travel, meals, and lodging may qualify as a working condition fringe benefit but not under a Section 127 plan
- The working condition fringe benefit is not subject to nondiscrimination rules
- The limitation on expenses that qualify a student for a new job or to meet minimum eligibility requirements will not qualify as a working condition fringe benefit, but may qualify under a Section 127 plan.
These rules are fairly complex. If you need help navigating through these rules, give us a call and we’ll be happy to help.
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
