Potential IRS Examination Areas
If the Internal Revenue Service should choose your tax return for an audit, there are several areas they are likely to scrutinize because taxpayers usually don’t have the proper records to substantiate these deductions. The IRS agent can then make an easy adjustment, assess additional taxes, and close the case.
The purpose of this section is to alert you to some areas that are often audited and inform you as to what documentation is required by the IRS. It is easier to take a few seconds at the time of the transaction to make the necessary notes and keep the receipts than to try and substantiate your deductions the night before the audit.
Enclosed are discussions on the following areas 1) travel and entertainment expenses; 2) auto expenses; 3) insurance premiums; and 4) worker classification.
Travel and Entertainment Expenses
The costs of business travel and entertainment (T&E) expenses are susceptible to IRS scrutiny because such expenditures may reflect personal as well as business objectives. Therefore, there are many requirements to be met in order to deduct these expenses. The following is an overview to those rules.
- Only 50% of the cost of business meals and entertainment is deductible.
- An employee’s meals/entertainment deductions must be aggregated with "miscellaneous deductions."
- The "quiet business meal" is no longer deductible.
- No deduction is allowed for food and beverages, which are "lavish or extravagant under the circumstances."
- The taxpayer must be present when food or beverages are furnished.
- Travel for investment purposes or for education cannot be deducted.
T&E Record keeping Requirements
Detailed record keeping is a must for travel and entertainment deductions. No deduction is allowed for any T&E item, which is not substantiated by adequate records. An “adequate record” is a contemporaneous diary, account book, log, expense statement or similar record. Additionally, in the following cases documentary evidence (e.g., receipts, paid bills, cancelled checks) must also be furnished: all expenditures for lodging while away from home and any other expenditure of $25 or more. You don't need receipts for local transportation (e.g., taxis) where such receipts aren’t readily available. Minor incidental expenses, such as tips, may be approximated (but must be entered in your diary or log). Documentary evidence may be adequate by itself; a diary or log entry may not be necessary, if the document discloses the amount, date, place and character of the expenditure.
In addition to these general record-keeping requirements, specific rules apply to 1) travel, 2) entertainment, and 3) business gifts.
- Travel costs: The taxpayer must prove, via diary, receipts, etc., all of the following:
- the amount of each separate expenditure for traveling away from home;
- the dates of the departure and return home for each trip, and the number of days spent on business away from home;
- the destination or locality of the travel; and
- the business reason for the travel or the nature of the business benefit derived or expected to be derived as a result of the travel.
- Business entertainment expenses: The taxpayer must prove all of the following:
- the amount of each separate expenditure for entertaining, except that incidental items like cab fares and telephone calls may be aggregated on a separate basis;
- by the date the entertainment took place; the name, address or location, and the type of entertainment;
- the reason for entertaining, or the nature of the business benefit derived or expected to be derived as a result of entertaining, and the nature of any business discussion or activity that took place; and
- the occupation or other information relative to the person or persons entertained, including name, title or other designation, sufficient to establish his business relationship to the taxpayer.
- Business gifts: The taxpayer must prove all of the following:
- when the gift was made;
- the reason for making the gift or the nature of business benefit derived or expected to be derived as a result of the gift;
- occupation or other information about the person receiving the gift, including his name, title, or other designation sufficient to establish his business relationship to the taxpayer; and
- description of the gift.
Travel Away from Home
Expenses incurred while traveling away from home for business purposes are deductible.
Deductible travel expenses include meals and lodging enroute and at the destination, baggage charges, air, rail and bus fare, cost of transporting sample cases or display materials, expenses for sample rooms, costs of maintaining or operating a car, telephone and telegraph expenses, laundry and dry cleaning costs, cost of a public stenographer, cost of transportation by taxi, etc., from the airport or station to the hotel, from the hotel to the airport or station, from one customer or place of work to another, transportation from where meals and lodging are obtained to the temporary work assignment, and reasonable tips incident to any of these expenses.
Mixed business and pleasure trips
Transportation costs to and from your destination are deductible only if the trip is related primarily to the taxpayer’s business. If the trip is primarily for business, but the taxpayer extends his stay for personal reasons, makes side trips, or engages in other non-business activities, he may deduct only the expenses, such as meals and lodging, that he would have incurred if the trip had been totally for business, but no allocation is required for transportation costs to and from the business destination.
Foreign travel: Only the amount directly allocable to business is deductible in the case of a mixed purpose foreign trip. Even where the travel is primarily for business, a portion of transportation, meals, and lodgings, etc., expenses of the business part (as well as all the pleasure part) is nondeductible. The nondeductible part is computed on a time ratio, usually in the proportion of non-business days to all travel days.
This allocation and denial of deduction is not made if 1) the taxpayer, if an employee, isn’t related to his employer and isn’t a managing executive; 2) travel is for one week or less; 3) less than 25% of the time is spent in non-business activity; 4) the individual traveling had no substantial control over the arranging of the trip; or 5) a personal vacation was not a major consideration in making the trip.
Education, investment travel: The costs of travel as a form of education are not deductible, nor are the expenses of traveling for investment (as opposed to business) purposes.
Entertainment expenses are deductible if they are "ordinary and necessary” business expenses and strict substantiation requirements are met. But no deduction is allowed unless the taxpayer can show that the entertainment expenses are: 1) "directly related" to the active conduct of a trade or business, or 2) "associated" with the active conduct of a trade or business.
Taxpayers may entertain business associates or other persons with whom the taxpayer could reasonably expect to engage or deal in the active conduct of his trade or business. Examples of business associates are customers, suppliers, clients, employees, agents, partners, or professional advisors, whether established or prospective.
Entertainment expenses are deductible if they are "directly related” to the active conduct of the taxpayer's trade or business. This test is met if the entertainment is 1) involved in an active discussion aimed at getting immediate revenue, 2) occurred in a clear business setting such as a hospitality room or 3) the expenditure must be reported as compensation for services performed by an individual other than employee.
Entertainment expenses that do not meet the “directly related” test but that are “associated” with the active conduct of the taxpayer’s business are deductible if the entertainment directly “precedes or follows" a substantial and bona fide business discussion.
Entertainment facilities: No deduction is allowed for any expense paid or incurred with respect to “an entertainment facility" used in conjunction with an activity that is of a type generally considered to constitute entertainment, amusement or recreation. A deduction is now specifically not allowed in the case of social, athletic, sporting and other clubs dues even when the taxpayer establishes that the facility was used primarily to further the taxpayer’s business and that the item was directly related to the active conduct of that business.
Expenses incurred with regard to entertainment facilities that are disallowed include yachts; hunting lodges, fishing camps, swimming pools, tennis courts, and bowling alleys. Fees paid to any social, athletic, or sporting club or organization is treated as expenditure for an entertainment facility.
The cost of ordinary and necessary business gifts may be deducted up to $25 a year to any individual.
The owner of a small business often uses a car or truck for both business and personal purposes. The extent to which the company can claim depreciation deductions, any investment tax credit, or lease payments depends on the extent to which the owner (or other employee) uses car or truck for business purposes. In addition, the value of a closely held corporations stockholder’s personal use of a corporate-owned car or truck is a taxable fringe benefit.
Luxury Car and Listed Property Limitations
The definition of a "luxury automobile" is a passenger automobile or light truck with an unloaded gross weight of 6,000 lbs or less.
If an car or truck is placed in service after December 31, 1986, its cost must be recovered over at least five years using 200% declining balance depreciation with a switch to straight-line. The luxury car limitations place a special dollar limit on the depreciation and Section 179 deduction you can claim each year. Although the dollar amounts change, as an illustration, for a car placed into service in 1992, your total Section 179 and depreciation deduction in the first year cannot exceed $2,760; the second year cannot exceed $4,400; $2,650 the third year, and $1,575 each later year.
Listed property includes any passenger automobile; other transportation vehicles, e.g. boats; computers and related equipment, and cellular telephone equipment. If your listed property is not used more than 50% for business during any tax year, Section 179 deductions are not allowed and you must depreciate the property using the ADS method.
Percentage of Business Use
To the extent that business use of the automobile ("luxury" or otherwise) is less than 100% the allowable tax benefits and depreciation deductions must be reduced proportionately.
The Conference Committee Report on the Tax Reform Act of 1984 emphasizes that commuting is not considered to be business use of an automobile, even if business is conducted in transit. So, the Conference Report asserts, making or receiving phone calls on a mobile car telephone or holding a meeting in the car does not transform personal commuting into a business trip. Also, the fact that business advertising or promotional material is displayed on the car is not enough to make a Sunday drive in the country a business trip.
Mileage Logs and Other Substantiation
An automobile-related deduction for depreciation, lease payments or other expenses must be substantiated by adequate corroborative records that evidence the extent to which the vehicle has been driven for business purposes.
The rule requiring adequate substantiation extends to "listed property" which includes passenger cars; other transportation vehicles; computer equipment; and property used for entertainment, recreation, or amusement. However, certain vehicles, which by their nature cannot be or are not normally used for personal driving, are excepted from the substantiation requirement. These include, for example, marked police cars; ambulances; and certain categories of trucks, construction equipment, and farm vehicles. There are four essential elements of an auto-related expenditure that must be substantiated.
- Amount. This is the cost of the car, the amount of lease payments, all expenses for maintenance or repairs, and operation of the vehicle.
- Time. This is the date that the expenditure was incurred or the car is used.
- Business Purpose. The business purpose of the use or expenditure must be indicated.
- Business Use. For an automobile, business use is determined according to mileage (for other listed assets, the basis for determining business use is time of use). It is also necessary to keep track of total use so that a percentage of business use can be determined. In this regard, an odometer reading at the beginning and at the end of the year should suffice.
Adequate records of business driving can be maintained in the form of an account book, diaries, logs, statements of expenses, or trip sheets.
Such records should be augmented by documentary evidence, receipts and paid bills. However, it is not necessary to enter information in an account book or diary if it is already indicated on a bill or receipt, as long as the record and receipt "complement each other in an orderly manner."
An entry in the account book or diary should be made at or near the time of the auto-related expenditure or use. As indicated previously, "business purpose " is one of the essential elements that must be substantiated. However, if a business purpose is evident from the surrounding circumstances, a written explanation of the trip's business purpose is not required. Also, the degree of detail necessary to demonstrate "business use" may vary. Less information is needed if the vehicle is driven according to a regular pattern; more is required if business driving is sporadic.
Tax Return Reporting
A business claiming car and light truck related deductions must, on its tax return, provide certain information about the use of the vehicle. This information pertains to mileage (total, business, commuting, and other personal mileage), the percentage of business use, the date the vehicle was placed in service, and the existence of adequate records to support the business use being claimed on the return.
A business that provides more than five vehicles to its employees does not have to provide detailed information on its tax return. However, it must obtain relevant information from its employees and indicate that such data are in its possession.
A company that treats all use of company cars as personal use must indicate that on its tax return.
Use of a company car for business purposes qualifies as a working condition fringe benefit, and the value of that business-related use is not included in income. But to the extent the car is driven for non-business purposes, the value of such personal use is taxable (unless the employee reimburses the company for value of that use). IRS sets forth several alternative ways of arriving at the taxable personal-use value of a company car.
Hypothetical Lease. The first valuation alternative is the "hypothetical lease." What would it cost a hypothetical person to lease, insure, and maintain the same or comparable car on the same or comparable terms in the geographic area in which the car is used?
Annual Lease Value. The second method of valuing a company car is "annual lease value" as determined through the use of a table provided by IRS.
Commuting Rules. This is a special rule that may be used in valuing the personal use of a company car by certain employees when that personal use is limited solely to commuting. If certain conditions are satisfied, use of the car for commuting is valued at $1.50 each way, or $3.00 for each round trip commute by the employee. Also, a record of business driving need not be kept. This special computation can be used if:
- the car is leased or owned by the company and it is provided to one or more employees for use in connection with company business,
- there is a business reason for requiring the employee to commute to or from work in the car,
- the company has written policy under which the employee (or a member of his or her family) is precluded from driving the car for personal purposes other than commuting (or some relatively minor use such as an errand on the way home from work),
- the car is, in fact, not used for many other person driving, and
- the employee who is required to use the company car is not what IRS refers to as a "control employee". (A "control employee" is a company officer, a director, or an employee who owns 1% or more of the business.)
Cents-per-mile method. In certain circumstances, it is permissible to value the personal use of a company car on a cents-per-mile method may be used if
- during the year, the car is driven at least 10,000 miles by the employee; and
- the fair market value of the car, on the date it is made available or January 1, 1985 (whichever is later), does not exceed the luxury car limits on cost recovery deductions in effect for that year.
Generally, taxes must be withheld from the income attributable to personal use of a company car or some other taxable fringe benefit. Tax can be withheld each pay period or on a quarterly, semi-annual, or annual basis, regardless of when the employee actually receives the benefit.
However, an employer can choose not to withhold income tax attributable to the personal use of an automobile (any applicable Social Security tax must still be withheld). This election need not be made for all employees who are furnished with company cars.
The value of an employee's personal use of the car is still considered to be taxable income that must be reported on the employee's Form W-2. The company can assume that all use of the car by the employee was personal use and report 100% of the car's annual lease value as income. The employee can calculate the value of any business use on Form 2106, Employee Business Expenses, and report the resulting amount on his or her personal tax return.
Worksheet for Computing Additional Compensation
Resulting from Personal Use of a Company Automobile
Employee's Name Employee's Social Security Number
The following must be answered by the employee:
- Total miles driven during the year
- Personal use miles (including commuting)
- Percentage of personal use: #2 divided by #1
- Is vehicle used for commuting? If yes, what is daily commuting mileage?
- Is the vehicle available for personal use in off duty hours? If no, what is the number of commuting days?
- Do records or evidence exist to justify the business deduction? If yes, is the evidence written? yes/no
- What is the fair market value of the automobile? $
The following must be completed by employer:
COMPUTATION OF ADDITIONAL COMPENSATION (check applicable method)
Hypothetical Lease Method-available to any employee. Burden of proof rests with taxpayer.
|A) Cost to rent comparable auto|
|E) Total Cost (Add A, B, C, D)|
|F) Personal use precentage|
|G) Additional Compensation (E x F)|
2. Annual Lease Value-method available to any employee. Utilizes annual lease table. Fair market value of auto $
$_________________ x ____________________ x 1/12 x ______________ = _______________
Annual lease value Business months in use Personal Use % (A)
__________________ x 5.5 cents = ________________ + ______________ = $ ____________________
Personal miles (B) (A) Additional Compensation
3. Commuter Method-written policy by employer that only personal use of auto is commuting to and from work. This method is not available for officer or an owner of 1% or more.
______________________ x $3.00 = ______________________
Days commuting to work Additional compensation
4. Cents-Per-Mile Method-only available if the following statements are all checked correct.
Vehicle is regularly used in trade or business throughout the year.
Total business and personal miles driven at least 10,000 per year.
Vehicle is primarily used by employee (not family members).
Fair market value of auto does not exceed luxury auto depreciation limit.
Personal miles ___________ x 21 cents = $ _______________ of Additional Compensation.
Additional compensation to include on employee's W-2 Statement is $__________________.
Additional Social Security needed to be withheld from employee salary is:
_______________________ x _____________________ = $____________________
Additional Compensation Social Security rate
Insurance premiums are ordinarily deductible in the tax year to which they apply. If you make an advance payment of the premium for an insurance policy that covers more than one tax year, even a cash basis taxpayer must prorate the premium and only deduct that amount which applies to the current tax year. The balance may be deducted in any later tax year to which it applies.
Generally, you may deduct insurance premiums paid on business insurance policies. Medical insurance paid by a proprietor and life insurance premiums require additional consideration.
The following are some of the more common deductible insurance premiums:
- fire, theft, flood or casualty;
- merchandise and inventory;
- credit insurance to cover losses from unpaid debts;
- employee's group hospitalization and medical; and
- employer's liability;
- property and liability;
- workers' compensation;
- use and occupancy and business interruption;
- overhead; and
- performance bonds.
Life Insurance premiums are not deductible if you are directly or indirectly a beneficiary of the policy. The following is a discussion of different types of policies and the deductibility of the premium.
Credit Life Insurance - life insurance purchased to get or protect a business loan is not deductible.
Key-person Insurance - life insurance covering any officer, employee or other financially interested party is deductible only if: 1) the payment is in the nature of additional compensation, 2) the total amount of compensation is reasonable, and 3) the policy is not beneficial to you either directly or indirectly. Key-person insurance are wages subject to withholding.
Split-dollar Insurance - if the officers or employees designate their own beneficiary, the employer retains no incidents of ownership and is not directly or indirectly the beneficiary, then the premiums are deductible. If more than $50,000 of insurance is purchased, the officer or employee may have to include as income the premium on the excess amount.
Until 1987, the medical insurance premiums paid by a self-employed person were only deductible as an itemized deduction on his personal tax return. The TRA of '86 permits a deduction of part of the premiums paid in calculating his adjusted gross income; the amount does not reduce the net earnings from self-employment for the self-employment tax computation.
Certain insurance premiums that are not deductible include any self-insurance premiums, or any premium paid on a policy that pays you for your lost earnings due to sickness or disability. This is not to be confused with overhead or business interruption insurance which are deductible.