What you can fully deduct? What is partially deductible? What can’t you deduct at all?

A lot of confusion exists on the issue of how much of a given food/meal expense is deductible. And rightfully so because some food/meals are fully deductible, some are only 50% deductible and some aren’t deductible at all.

Congress and the IRS have been legislating and regulating this issue for decades.  One has to remember that tax law does not necessarily have logic supporting it. Taxes are imposed in order to finance the operations of, and implement the policies of, the government. Having said that, the logic surrounding the deductibility of food/meals goes something like this:

You can fully deduct food /meals when the food or meal has an important business purpose, but the food/meal itself is not really intended to benefit the person whoconsumes the food as much as it benefits the business.  When there is really no business purpose or benefit to the meal, it isn’t deductible at all. When the food/meal starts to provide a direct benefit to those consuming it, yet still has a valid business purpose, you are likely getting into the area of partial deductibility. Got it? I didn’t think so.

So let’s just break this down into the categories. Here is what is fully deductible:

• Meals for which the business is reimbursed. If you charge your customers for meals you consume, for example while on a job site, you can fully deduct those meals. In truth, the charge and reimbursement likely offset each other rendering the event tax neutral.
• Food/meal costs for the company holiday party or picnic are considered immaterial employee benefits and are fully deductible.
• Meals provided on your premises for more than half of your employees that is for the convenience of the employer are 100% deductible. This would be in cases where a business keeps staff late or on weekends for specific business purposes.
• Food/meals made available to the public, usually for promotional or advertising purposes.
• Snacks and beverages provided to employees.Snacks, not steaks.

Here is what is 50% deductible:

• Meals with clients, customers and vendors that will benefit the business. This would mean the typical business lunch or dinner.
• Meals while on business travel including seminars, conventions and the like get the 50% treatment.
• Meals paid for in conjunction with office, stockholders, directors and employee meetings are half deductible.

Here are a couple of examples of food/meals expenses I would consider NON-deductible:

• A meal you consume while working through your lunch hour is not deductible.
• If you were joined at an otherwise deductible business meal by someone un-associated with the business, and has no business purpose for attending, I wouldn’t deduct the cost of that person’s meal.

As always, there are grey areas, but I encourage clients when in doubt to clearly document the business purpose of any meal or food expenditure. In truth, the IRS will be hard-pressed to debate you on business purpose if it is clearly stated and sounds legit. This is because the IRS has much greater success denying deductibility because a taxpayer just kept the receipt or included a vague statement to support the business purpose of the meal. “Lunch with Bob Smith “doesn’t cut it and the IRS knows this. If you take the extra 30 seconds to write down that business purpose, you increase your chance of getting the deduction under audit.  Omit that purpose and you will lose the deduction entirely.

Another tip: I encourage clients to keep 2 separate ledger accounts for meals and entertainment in their accounting records.  One to record the 100% deductible expenditures and one for the 50% deductible items. This will save you tax dollars to be sure.

If you have questions on this, by all means drop me a line and we’ll talk about it.

The IRS exists in part to collect taxes. Because they cannot audit, or look over the shoulders of every taxpayer, since their inception their behavior has been one that puts them at odds with taxpayers, in particular, business owners. The premise is simple: Scare folks into paying their taxes by pursuing and punishing as necessary those few whom they do audit who do not follow the law and/or pay the appropriate taxes. By making examples of them (yes the IRS specifically issues press releases when they get someone on tax fraud to scare the rest of us) the hope is that they get better compliance.

 A hot issue for the IRS is the issue of whether someone whom a business pays for services is an employee or an independent contractor. This is all about employment taxes. Independent contractors are just that, independent, and because of that those who pay them for their services aren’t required to withhold taxes from that pay, nor do they bear the burden of employer borne taxes (employer share of FICA, Medicare, unemployment taxes). Employees require the withholding taxes and employer taxes mentioned above and also generate other related costs such as worker’s compensation, safety and training, payroll processing costs, etc. This motivates employers to treat workers as independent contractors.Whether a given person who performs services for you is or isn’t your employee is not a choice you make, but a matter of law based on whether the level of oversight on a given person creates an employment relationship.

There are three areas the IRS looks at when making a determination about the status of a given worker and the business:

1. Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?

2. Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)

3. Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

It is important to note that the IRS does not require a preponderance of evidence pointing to one status, if it finds even one aspect of the relationship that implies employment; they may pursue the business for the employment taxes due. This can be costly which is why it is important to seriously consider the risks when paying folks for their services. I could fill pages with examples, IRS regulations and court cases. Rather than do that, I ask that if you have some folks you treat as independent contractors and have any concern they may be employees, call me and let’s talk about that relationship and make sure it is being handled properly. This issue is front and center for the IRS. If you are audited this issue will definitely be addressed. If your tax returns indicate that you may be improperly classifying workers as independent contractors, that issue may create an audit. It is truly best to toe the line on this one.

The question at tax time I hear the most starts off “Can I deduct…..? I have to admit that more often than not the answer is ‘no.’ But that doesn’t mean there aren’t a lot of rarely used tax deductions out there that are often missed, largely because people don’t even know that the deduction exists. Here are examples of 5 that I find more often than not get overlooked:

• Mileage deduction incurred while working on behalf of a qualified charity. A taxpayer cannot deduct the value of their time contributed to a charity. They can however deduct the mileage they incur driving their vehicle on behalf of that charity at the rate of 14 cents/mile. Those miles can add up if the commitment is an ongoing to such things as church youth groups, elder care, etc.
• Last year’s state income tax bill paid in the current year.  The focus when pulling together tax information usually involves deducting payments specific to that tax year. Often forgotten is the fact that if you paid state income tax when your tax return was due, you can deduct that tax payment in the current year even though it relates to the prior year’s tax. This is because most individuals are “cash basis” which means expenditures are deducted in the year they are paid. If, in April 2012 you paid $500 due when you filed your 2011 tax return, you can deduct that payment in 2012. Another related and often missed deduction is the 4th quarter estimated tax payment made to a state which is due and thus paid in January of the following year. When looking at any deduction, taxpayers should think in terms of when the deduction was paid, not so much what year or period it was related to. For a charitable deduction, making a pledge to contribute isn’t deductible when you pledge, it becomes deductible when you actually write and send the check.
• Deductible expenses paid when closing on or refinancing you principal residence. When a taxpayer closes on their new home, or when they refinance, often a number of expenses are paid that get missed when it comes time to file their tax return. The most common missed expense is property taxes. At closing property taxes are often charged to both the buyer and seller for the taxes that are either unpaid at that time or represent the share of taxes they are responsible as of closing. These do not show up on any IRS form provided to the taxpayer. You should keep a copy of the reconciliation of monies (Often called the “HUD Statement”) paid and received at closing and provide it to your tax preparer. There also may be points or other deductible assessments.
• Long-term care insurance. As the cost of health care becomes a real concern for people, more are turning to purchasing long-term care policies to protect them from these potentially disastrous costs, particularly when they are older. The premiums for these policies are deductible, subject to limitations based on age when paid. These expenditures are considered medical expenses and thus subject to the 7.5% AGI floor for most. However, self-employed folks can fully deduct these payments like they do their health insurance premiums.
• Reinvested dividends. This is not so much a tax deduction but a tax adjustment that many taxpayers miss.  When you buy a mutual fund, usually the dividends of that mutual fund are reinvested in more shares. You still pay tax on those dividends even though you don’t get the money. What gets missed is those reinvested dividends become part of the cost of those shares when figuring the gain if you sell, thus reducing your tax. For example if you invest in a mutual fund with $5,000 and over the next 3 years receive $200 in dividends you reinvest in more shares, if you sell those shares your cost basis is $5,200. Being sure to account for those reinvestments can save a lot of money!

If an individual, partnership, estate, trust, or an S corporation engages in an activity that
is not conducted as a for-profit business, deductions are limited to the amount of income
from the activity. If an activity is considered a for-profit business, deductions can exceed
income, allowing the resulting loss to offset other income. Regulations contain a list of
factors to be considered in determining whether an activity is engaged in for profit. The
factors include:

 
(1) The manner in which the taxpayer carries on the activity,
(2) The expertise of the taxpayer or his advisers,
(3) The time and effort expended by the taxpayer in carrying on the activity,
(4) The expectation that assets used in the activity may appreciate in value,
(5) The success of the taxpayer in carrying on other similar or dissimilar activities,
(6) The taxpayer’s history of income or losses with respect to the activity,
(7) The amount of occasional profits, if any, which are earned,
(8) The financial status of the taxpayer, and
(9) Whether elements of personal pleasure or recreation are involved.

 
No single factor is determinative. Note that in item (6) above, there are no specifics on how many years of loss need be incurred to be considered/determined a hobby. There is a sort of wives tale that you would be presumed to have a hobby if you incur lossses in 3 consecutive years. No such law/rule/regulation exists.

Court Case: The taxpayers became interested in Welsh ponies and cobs in 1995 when
their daughter began riding lessons on a Welsh pony. They purchased a second horse
in 1998. By 2003, they owned 10 horses. Their business plan was to acquire, breed, and
train high-quality Welsh ponies and cobs and sell them. They began reporting their horse
activity as a Schedule C business in 1998. After sustaining substantial losses in the activity
over the next several years, the IRS disallowed the losses, claiming the activity was a
hobby rather than a for-profit business. The court looked to the nine factors listed in IRS
regulations to determine whether the taxpayers were engaged in a hobby or a for-profit
business. For the following reasons, the court determined the manner in which the taxpayers
carried on their activity, and their history of losses indicated it was not for profit.
At first, the taxpayers paid to board their horses with third-party providers. In 1999, the
taxpayers concluded the horse activity could be profitable only if they purchased land
and facilities where they could board their horses and generate income by providing
boarding and training services to others. However, they did not begin this search until
2001, and did not actually purchase the land until 2005, on which they did not begin construction
until 2006. The taxpayers continued to acquire horses in the years after 1999, increasing
their stock from two horses to 10 even though they had not yet acquired land for
a facility. The court concluded that an actual and honest profit motive would have halted
the purchase of new horses until after obtaining the new facility to board the horses.

The taxpayers argued that they had unforeseen difficulties in acquiring property and
constructing a facility to board their horses. The court noted that IRS regulations list
drought, disease, fire, theft, weather damage, and depressed market conditions as examples
of acceptable loss-causing circumstances. The taxpayers’ failure to locate and acquire
property for six years was not attributable to circumstances beyond their control.
They did not begin their search until more than a year after the time they claimed such a
facility was essential to make a profit. They also only made offers on two properties in the
first four years of their search. The court concluded that the six-year delay in acquiring
the necessary land indicated that making a profit was not the taxpayers’ priority.

It is necessary in all cases in which a hobby determination is at least possible, that the activities of the business are reviewed in context with the 9 factors in the Regulations.

As we approach the end of the year it is common for folks to start thinking about how they can reduce their tax bill. If you have recognized some capital gains this year, or are just looking to take advantage of the $3,000 capital loss deduction, you may be considering selling some stock you hold at a loss before the end of the year. Before doing so, make sure you understand the ramifications of the wash sale rules.

Under these rules if you sell stock or securities for a loss and buy substantially identical stock or securities back within the 30-day period  before or after the sale date, the loss cannot be claimed for tax purposes. This rule is  designed to prevent taxpayers from using the tax benefit of a loss without parting with ownership in any significant way. Note that the rule applies to a 30-day  period before or  after the sale date to prevent “buying the stock back” before it’s even  sold. (If you participate in any dividend reinvestment plans, the wash sale rules may be inadvertently triggered when dividends are reinvested under the plan, if you have separately sold some of the same  stock at a loss within the 30-day periods.)

Although the loss cannot be claimed on a wash sale, the disallowed amount is added  to the cost of the new stock. Thus, the disallowed amount can be claimed when the new stock is finally disposed of (other  than in a wash sale).

Example. Henry buys 500 shares of ABC Corp. for $10,000 and sells them on June 5  for $3,000. On June 30, he buys 500 shares of ABC again for $3,200. Since the stock was “bought back” within 30 days of sale, the wash sale rules apply. Henry cannot claim his  $7,000 loss. His basis in his “new” 500 shares is $10,200: the actual cost plus the $7,000  disallowed loss.

If only a portion of the stock sold is bought back, then only that portion of the loss is  disallowed. Thus, in the above example, if Henry had only bought back 300 of the 500  shares (60%), he would be able to claim 40% of the loss on the sale ($2,800 under the  facts involved). The remaining $4,200 of loss disallowed under the wash sale rules would  be added to Henry’s cost of the 300 shares.

Note that while wash sale losses cannot be claimed, gains cannot be avoided. That is,  if you sell stock for a gain and buy it right back, you must still report the gain—no  special rule applies.  

Please let me know if you have any questions on this topic or would like my help in  planning future stock transactions.

-Larry

Year-end tax planning is especially challenging this year
because of uncertainty over whether Congress will enact sweeping tax reform
that could have a major impact in 2012 and beyond. And even if there’s no major
tax legislation in the immediate future, Congress next year still will have to
grapple with a host of thorny issues, such as whether to once again “patch” the
alternative minimum tax (e.g., to avoid a drastic drop in post-2011 exemption
amounts), and what to do about the post-2012 expiration of the Bush-era income
tax cuts (including the current rate schedules, and low tax rates for long-term
capital gains and qualified dividends), and the expiration of favorable estate
and gift rules for estates of decedents dying, gifts made, or generation-skipping
transfers made after Dec. 31, 2012.

Here are some things to contemplate if you are a business owner:

•Businesses should consider making expenditures that qualify for
the business property expensing option. For tax years beginning in 2011, the
expensing limit is $500,000 and the investment ceiling limit is $2,000,000. And
a limited amount of expensing may be claimed for qualified real property.
However, unless Congress changes the rules, for tax years beginning in 2012,
the dollar limit will drop to $139,000, the beginning-of-phaseout amount will
drop to $560,000, and expensing won’t be available for qualified real property.
The generous dollar ceilings that apply this year mean that many small and
medium sized businesses that make timely purchases will be able to currently
deduct most if not all their outlays for machinery and equipment. What’s more,
the expensing deduction is not prorated for the time that the asset is in
service during the year. This opens up significant year-end planning
opportunities.

•Businesses also should consider making expenditures that
qualify for 100% bonus first year depreciation if bought and placed in service
this year. This 100% first-year writeoff generally won’t be available next year
unless Congress acts to extend it. Thus, enterprises planning to purchase new
depreciable property this year or the next should try to accelerate their
buying plans, if doing so makes sound business sense.

•Nail down a work opportunity tax credit (WOTC) by hiring
qualifying workers (such as certain veterans) before the end of 2011. Under
current law, the WOTC won’t be available for workers hired after this year.

•Make qualified research expenses before the end of 2011 to
claim a research credit, which won’t be available for post-2011 expenditures
unless Congress extends the credit.

•If you are self-employed and haven’t done so yet, set up a
self-employed retirement plan.

•Depending on your particular situation, you may also want to
consider deferring a debt-cancellation event until 2012, and disposing of a
passive activity to allow you to deduct suspended losses.

•If you own an interest in a partnership or S corporation you
may need to increase your basis in the entity so you can deduct a loss from it
for this year.

More to come on individual tax planning opportunities…

Larry

No one likes to get a notice from the IRS.

No one.

It is true that pretty much any IRS communication you get won’t be a letter sending admiration for your excellent tax filings over the years, most letters fit into 1 or 2 categories:

1. Asking for additional information – Many of these notices have no tax implications  directly. They are usually received because the IRS is looking for a form, a box on a form to be checked, or is a request for other clarification so that the IRS can close the door on a particular filing you have done.
2. A notice regarding a difference between their information and yours – This notice affects individuals and their annual 1040 filing most commonly.  When you receive a form such as a W-2, a 1099, a 1098 or some other tax reporting document, the IRS receives a copy as well.  It then looks to “match” the information on the form with what you report on your return. When there are differences, the IRS contacts you to explain the difference. Often this is when a client discovers a tax document they either never received or lost or forgot to provide to the preparer. Often, the simplest  solution is to let the IRS calculate the change in tax and you pay the difference.  The IRS will not necessarily contact you if its records indicate information that would increase your refund, unless it relates to either withholding or estimated tax payments you made. For example, assume you have a mortgage and an equity loan on your home. If you forget to include the interest from the equity loan on your return, chances are that you’ll never hear from the IRS about this, looking to possibly to refund you some tax.  However, if you miss reporting interest income from a bank account you own, it is very likely that you’ll get a notice asking why it was omitted.

If you click here you will go to an IRS web-page that explains many of the typical notices you might get. A notice number is often found in the upper right-hand corner of the first page of the notice. Match the notice number on your notice to the numbers on this page and you’ll get a sense of what the issue is.

I have found over the years that most notices aren’t worthy of panic, but that is easy for me to say.  The best move is to get the notice in the hand of a professional who can get to the bottom of it.

A sample notice below for your fun review (note that it is a Notice “CP45” which, according to the IRS website should refer to a change in amount applied to a tax return as an overpayment credited from a previous year…which in this case is exactly what the notice below is about):

If you maintain your office in your home, you may be entitled to a special tax break on your commuting costs. For most people, the cost of daily travel between home and a regular work location  is a nondeductible commuting expense. Clients often don’t realize that simply driving to your office is not deductible business travel. However, taxpayers who have an office at home can deduct the daily  costs of travel between home and another work location in the same business, regardless of distance and regardless of whether the other location is regular or temporary.

Note that you get this break only if your home is your principal place of business. In other words, you must meet the tests for deducting expenses of an office at home. Give me a call if you aren’t  familiar  with those tests. You must be able to substantiate the auto expenses that you claim through adequate records, such as a log or diary. You can either use the standard mileage rate or deduct your actual expenses.

If you are an employee and your employer reimburses your travel expenses, you needn’t report the reimbursements as income if they are made under a so-called “accountable plan.” An accountable  plan is one that reimburses  only deductible business expenses, requires you to substantiate your expenses, and requires you to return amounts in excess of your substantiated expenses. If the plan is not an accountable plan, the  reimbursement  must be reported as income, and your deductible expenses must be claimed as employee business expenses.

If your office at home isn’t your principal place of business, the costs of travel between your home and the first and last business stops of the day are nondeductible commuting expenses. However, the  costs of going between home and a temporary work location are deductible, if you have a regular work location away from home. Generally speaking, employment at a work location is temporary  if it is realistically expected to last (and does in fact last) for no more than a year.

If you have any questions about whether you are entitled to deduct your job-related travel expenses, please give me a call.

Do you buy or lease computer software for use in your
business? Do you develop computer software for use in your business, or for
sale or lease to others? Then you should be aware of the fun and complex rules
that apply to determine the tax treatment of the expenses of buying, leasing or
developing computer software.

Purchased software. Generally, the way to account for
the cost of purchased software is to amortize (ratably deduct) the cost over
the three-year period beginning with the month in which you placed the software
in service.

However, software that (1) is readily available for purchase
by the public, (2) is subject to a nonexclusive license and (3) hasn’t been
substantially modified (non-customized software), and (4) is placed in service
in tax years beginning before 2012 qualifies as “section 179 property,” and is
thus eligible for the Code Sec. 179 elective expensing
deduction that is generally available only for machinery and equipment. For tax
years beginning in 2010 or 2011, the deduction is limited to $500,000. The
limits are reduced by the cost of other section 179 property for which the
election is made. Also, the election is phased out for taxpayers placing more
than $2,000,000 of section 179 property into service during tax years beginning
in 2010 or 2011. Non-customized software acquired and placed in service after
Sept. 8, 2010 and before Jan. 1, 2012 is also eligible for a 100%-of-cost
depreciation deduction in the year that the software is placed in service
(bonus depreciation). The bonus depreciation is at a 50% rate if the software
is acquired or placed in service before Sept. 9, 2010. The bonus depreciation
for an item of software is reduced to take into account any portion of the
item’s cost for which a Code Sec. 179 election is made,
and regular depreciation deductions are reduced to take into account both the
bonus depreciation and any Code Sec. 179 election.

There are two other exceptions to the three-year
amortization rule. One exception requires that, if you buy the software as part
of a hardware purchase in which the price of the software isn’t separately
stated, you must treat the cost of the software as part of the cost of the hardware.
Thus, you must depreciate the software under the same method and over the same
period of years that you depreciate the hardware. The other exception requires
that if you buy the software as part of your purchase of all or a substantial
part of a business, the software must be amortized over 15 years (unless the
software is non-customized software).

Leased software. You must deduct the amounts you pay
to rent leased software in the tax year in which paid, if you are a cash-method
taxpayer, or the tax year for which the rentals are accrued, if you are an
accrual-method taxpayer. Generally, however, deductions aren’t permitted before
the years to which the rentals are allocable. Also, if a lease involves total
rentals of more than $250,000, special rules may apply.

Software you develop. Costs for developing computer
software (“writing the code yourself”) may be accounted for using any
of the following methods:

(1) amortizing the costs over a three-year period beginning
with the month that the software was placed in service;

(2) deducting the costs in the tax year in which the costs
are paid (if you are a cash-method taxpayer) or in the tax year in which the
costs are accrued (if you are an accrual-method taxpayer), but only if all of
your costs of developing the software are deducted this way;

(3) amortizing the costs over a five-year period beginning
with the completion of the development, but only if all of your costs of
developing software are amortized this way;

(4) amortizing the costs over a period longer than five
years, but only if the costs are Code Sec. 174 “research or experimental
expenditures.”

You should also be aware that if following any of the above
rules requires you to change your treatment of software costs, it will usually
be necessary for you to obtain IRS consent to the change by following
prescribed procedures.

Please give me a call if you have any questions.