Substantiating Your Business Expenses Is Critical to Keeping Them

By Gary A. Hensley, MBA, EA

By and large, the rules are straightforward:  the burden of substantiating the “income” of a taxpayer falls on the Internal Revenue Service (IRS) and the burden of substantiating expenses (or deductions) falls totally on the taxpayer.

The position of the IRS and their field revenue agents has been and will be inadequate or no expense documentation/substantiation equals no deduction.  The next recourse for the taxpayer is to go to IRS Appeals and argue that the revenue generated couldn’t have taken place without incurring “some” associated expenses (the Cohan Rule).  The results at the Appeals level varies widely in each case and, generally, the best case scenario is an allowance of “some” of the deductions claimed.  The expense of going to Appeals can more than offset whatever expenses are allowed by the appeals officer (especially if you retain professional representation).

Recent Court Decisions

Under Internal Revenue Code (IRC) section 274(d), for certain expenses, taxpayers are required to be able to provide specific detailed information to substantiate the expenses.

As demonstrated In the recent case of Garza, T.C. Memo. 2014-121, the result boiled down to an all-or-nothing proposition.  Without proper substantiation, no deduction is allowed for a Sec. 274(d) expense, even if the court believes that a legitimate expenditure was made.

Sec. 274(d) identifies four classes of expenses for which specific substantiation is required:

  • Sec. 274(d)(1) for travel expenses (including meals and lodging while away from home);
  • Sec. 274(d)(2) for any item with respect to an activity that is of a type generally considered to constitute entertainment, amusement, or recreation, or with respect to a facility used in connection with such an activity;
  • Sec. 274(d)(3) for business gifts (which are limited to $25); and
  • Sec. 274(d)(4) for expenses with respect to any listed property (as defined in Sec. 280F(d)(4)).

In Garza, the court said that “while we believe that petitioner had business travel expenses in relation to his employment, the Court must heed the strict substantiation requirements of section 274(d).”  To support its ruling, the court cited DeLima, T.C. Memo. 2012-291, in which the Tax Court indicated that it had no doubt that the taxpayer used a vehicle for business purposes, but it was bound to deny the vehicle expense deduction because she failed to follow the requirements of Sec. 274(d) and the regulations.

Substantiation Required

Sec. 274(d)(4) requires the taxpayer to substantiate “by adequate records or by sufficient evidence corroborating the taxpayer’s own statement”:

  • The amount of the expense or other item;
  • The time and place of the travel, entertainment, amusement, recreation, or use of the facility or property, or the date and description of the gift;
  • The business purpose of the expense or other item; and
  • The business relationship to the taxpayer of persons entertained, using the facility or property, or receiving the gift.

In light of the above requirements, the message from the above paragraph is that “a taxpayer’s own statement” by itself is not sufficient in the IRS’s consideration of whether to allow a deduction.  As Garza and other cases show, the IRS and the courts look for contemporaneous records with the details listed above and, without it, they may disallow the deduction.

Taxpayers and their tax advisers need to understand what type of substantiation is required to take a deduction (with a solid foundation) on a tax return.

 

 

 

Warning! Form 1099-MISC and Payments to LLCs

By Gary A. Hensley, MBA, EA

Most of you are aware that you need to issue a Form 1099-MISC to independent contractors you paid $600 or more for services (not goods) during 2014 no later than February 2, 2015 (also you send a copy to the IRS by March 2, 2015).  The payments reported cover only those payments made in the course of your trade or business.

Many entrepreneurs believe (incorrectly) that if a vendor has LLC or L.L.C. after their company name (meaning limited liability company) that no Form 1099-MISC is required to be sent.  Compounding this belief?  The member(s) of many LLCs will tell those that they have rendered services to that it isn’t necessary or required to send them a Form 1099-MISC.  The requirement to file Form 1099-MISC is the government’s attempt to reduce the multi-billion underground (untaxed) economy.  Thus, if you are required to file a Form 1099-MISC and do not, a penalty will be assessed for each form not filed.  The penalty for not filing or filing late depends on the extent of tardiness.

A LLC can fall into three different categories:  (1) a single-member LLC which is a sole proprietorship (filing Schedule C as part of the individual’s personal Form 1040); (2) two or more members organized as a partnership LLC (filing Form 1065); and (3) one or more members filing as a corporate LLC (either a “C” corporation or a “S” corporation, filing Form 1120 or Form 1120-S, respectively).  Categories (1) and (2) should always be sent a Form 1099-MISC if they provided $600 or more in services to you in 2014.  With very few exceptions, you are not required to send Form 1099-MISC to category (3) organizations.  Most LLCs choose to be taxed as sole proprietors (commonly referred to as a “disregarded entity” in tax-speak) and partnerships.  When in doubt, send a Form 1099-MISC to all vendors you paid $600 or more for services in 2014.  There is no down side in doing so.

One exception that will be relevant to writers, literary agents and publishers:  Any amount you pay in royalties of $10 or more, in the course of your trade or business, requires you to send a Form 1099-MISC.  [Please refer to my article on properly reporting royalties.]

The following steps will help you nail down your compliance in this area:

  1.  Review all your payments for services to each vendor during 2014 and determine who received $600 or more in payments from you.
  2. Review your vendor records to determine if you have the complete name and address for those identified in step 1 above and also that you either have the vendor’s Social Security Number (SSN) or Employer Identification Number (EIN).  If you are lacking any of these critical items, you will need to mail a Form W-9 to the vendor requesting this information.  Keep a copy of the W-9 in your vendor file documenting your attempt to get the needed information along with the date you mailed it.  A USPS Certificate of Mailing is an inexpensive way to show proof of mailing.  In the future, obtain the W-9 information at the time you retain the vendor.  If the vendor refuses to furnish the information or sign the form—buyer beware!
  3. Next, you will use the official IRS Form 1099-MISC for each vendor.  The form is in triplicate with the top copy (shaded in red) going to the IRS and the other two copies going to the vendor and your vendor file.
  4. Finally, you will summarize your Form 1099-MISC information on IRS Form 1096 which you can mail to the IRS or file electronically along with the red copy(ies) of Form 1099-MISC.

You may wish to engage a local accountant or payroll processing specialist to help you with steps 3 and 4.

For additional IRS information on this topic, you may refer to IRS Form 1099 at the IRS website—www.irs.gov.

I hope this article will clarify your reporting requirements and further audit-proof your returns.

 

2015 Optional Standard Mileage Rates

The Internal Revenue Service issued the 2015 optional standard mileage rates used to calculate the deductible costs of operating an automobile for business, charitable, medical or moving purposes.

Beginning on Jan. 1, 2015, the standard mileage rates for the use of a car (also vans, pickups or panel trucks) will be:

  • 57.5 cents per mile for business miles driven  (up from 56 cents in 2014)
  • 23 cents per mile driven for medical or moving purposes (down a half cent from 2014)
  • 14 cents per mile driven in service of charitable organizations (no change from 2014)

Mid-Year Tax Planning – 2014

Tax Season 2014 has come and gone and now it’s time to think about tax planning for tax year 2014. Items which could impact your 2014 taxes include certain life events and expired tax provisions.

Certain Life Events

Have you recently had a birth, adoption or death in your family? Have you gotten married, divorced, retired, or changed jobs this year? If so, you and your tax professional need to discuss the potential impact on your 2014 taxes. For example:

1) For Qualifying Children under the age of 17, a tax credit up to $1,000 per qualifying child may be allowed (which may be refundable.)
2) If you have retired (or are planning on retiring), you need to analyze how your change in income resulting from receiving IRA or pension distributions, and/or Social Security benefits will impact your tax liability.
3) A divorce or marriage could impact your tax situation in multiple ways (for example, alimony paid or received, deductions for mortgage interest and real estate taxes on your home, QDROs (qualified domestic relations orders) and potential changes in the standard deduction and personal exemptions allowed.)

Expiring Tax Provisions
Given the current political climate, it is not known if or when an agreement on extending the Expiring Tax Provisions (“extenders”) may be reached. These extenders have made tax planning a challenge for both taxpayers and tax professionals. Therefore, if any of these provisions impact you, it is important that you contact your tax professional or personally monitor legislative activity so that you are aware of the possible tax consequences:

1) Sales Tax Deduction: Prior to 01/01/2014, taxpayers may have been eligible to deduct state and local general sales taxes instead of state and local income taxes as an itemized deduction on Schedule A. This included the sales tax paid on the purchase of a vehicle. This deduction is no longer available to individuals.
2)Mortgage Insurance Premiums: Prior to 01/01/2014, taxpayers may have been eligible to deduct the amounts paid for qualified mortgage insurance premiums along with their mortgage interest (subject to adjusted gross income limitations). Effective 01/01/2014, no deduction is allowed for these premiums paid or accrued after this date.
3)Tax-free Distributions from Individual Retirement Plans for Charitable Purposes: Prior to 01/01/2014, taxpayers over 70 ½ may have been eligible to exclude from their gross income distributions up to $100,000 from their IRA to a qualified charitable organization. This permitted taxpayers to satisfy their Required Minimum Distribution (RMD) and not include the amount in their income. As this reduced their Adjusted Gross Income (AGI), which favorably impacted the taxable amount of Social Security benefits received, this was a large tax advantage for taxpayers. This special distribution provision is not available for distributions after 2013.
4) Qualified Principal Residence Debt Exclusion: Prior to 01/01/2014, the discharge of principal residence debt (qualified mortgage on a taxpayer’s main home incurred to buy, build or substantially improve his or her main home) was generally excluded from gross income. As many taxpayers are still experiencing financial difficulties resulting in foreclosures, short sales or debt forgiveness on their primary residence, the tax ramifications for 2014 will have major tax consequences.

Other Steps to Consider Before the End of the Year

You should thoroughly review your situation before year-end to determine the best tax strategies for 2014 and the impact on 2015 as well. Accelerating income/deferring deductions into 2014 or deferring income/accelerating deductions to 2015 are just a couple of approaches that could benefit you.

If you have any foreign assets, be aware that there are reporting and filing requirements for those assets. Noncompliance carries stiff penalties.

Be a “Professional” Writer — All Year Long

By Gary A. Hensley, MBA, EA

If you are new to the writing life, or even a veteran, you are in the business of writing if your intent is to write long-term and make a living (or at least a profit) from your work. You are self-employed (you work for yourself) and that means you are a sole proprietor for tax purposes. You will need to file a Schedule C with your federal Form 1040 to report your writing income and expenses.picture004

If you visit www.irs.gov and type Schedule C in the search box, you will see some of the expenses allowed. Part of your business responsibility includes keeping accurate business records, during the calendar year (not after), to track your income and expenses. You will be on the “cash basis” of accounting, i.e. you report your writing income when it has actually been received and your expenses when they have been paid.

Most of you hire someone to “prepare” your annual tax return. Many of you keep your participation to an absolute minimum. This is akin to turning in a partially-completed manuscript, replete with grammatical errors, to an editor, and then expecting him or her to return a bestseller to you.

You need to accurately summarize your income and expense records before you meet with your preparer (or do the return yourself). One example: make sure you have added up all your business miles for 2014 and multiplied them by 56 cents per mile. The law requires that you maintain a “contemporaneous” record of your business mileage during the year. Get a $5 day-planner at Walmart and put it in your glove compartment. Use it each time you head out on business. Jotting down the beginning and ending odometer readings, and the business purpose, makes you bullet-proof if you are audited. You will be amazed at the total amount of business miles (and very happy with the large expense deduction). Proper recordkeeping in other areas will yield the same results.

In addition to proper recordkeeping, you need to take additional steps to document (or support) your professional (business) status as a writer. A diary of your various business activities will be very helpful. A manuscript submission/rejection/resubmission record will show continuous activity. Attendance at a writer’s club and writing seminars will indicate you are trying to improve your skills. A separate bank account/debit card for the business is critical.

It’s not unusual for any new business to sustain losses during the early years; however, to have those losses allowed, you must be able to demonstrate that you are “active” in the business.

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This article originally appeared in the January 2014 newsletter The Write Life.

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Can a shareholder of an S corporation deduct the home office expense?

A shareholder of an S corporation cannot deduct expenses paid on behalf of the corporation without a corporate resolution [Craft, T.C. Memo 2005-197].

If the corporation has adopted a resolution requiring the employee/shareholder to incur expenses as may be necessary or required, and it states that such expenses will not be reimbursed by the corporation, the court ruled these expenses were deductible as employee business expenses which are miscellaneous itemized deductions, subject to the 2% adjusted gross income (AGI) limitation.  Otherwise, the court noted that the voluntary payment of corporate expenses by officers, employees, or shareholders are not deductible and must be considered capital contributions or loans to the corporation. A corporate resolution or policy in place requiring a corporate officer to assume certain expenses indicate that those expenses are his or her expenses as opposed to those of the corporation.

If the above requirements are met, a shareholder is allowed to deduct expenses for business use of the home, assuming the shareholder receives reasonable wages for services renderedSuch expenses are deducted  as employee business expenses on Schedule A, Form 1040, subject to the 2% of AGI limitation.

Exception for rentalA taxpayer is not allowed to deduct expenses for business use of the home attributable to rent paid by the employer if the employee is providing services.  The employer (the S corp) is allowed a deduction for rent paid, but the employee is not allowed a deduction for business use of the home [IRC 280A(c)(6)].